Report No. 27925-KH Cambodia Seizing the Global Opportunity Investment Climate Assessment and Reform Strategy for Cambodia Prepared for the Royal Cambodian Government by the World Bank Group August 12, 2004 Poverty Reduction and Economic Management Sector Unit Financial and Private Sector Development Unit East Asia and the Pacific Region Document of the World Bank Abbreviations and Acronyms AQIP Agricultural Quality Improvement LFS Labor Force Survey Project MAFF Ministry of Agriculture, Fisheries, APSARA Authority for the Protection and and Forestry Managementof Angkor and the Region MEF Ministry of Economy and Finance of Siem Reap MIME Ministry of Industry, Mines, and ASEAN Association of SoutheastAsian Nations Energy ATC Agreement on Textiles and Clothing MOE Ministry of Environment BCC BusinessCooperation Contract MOWRAM Ministry of Water Resources and BMO Business Membership Organization Meteorology BOT Build-Operate-Transfer MPDF Mekong Project Development Camcontrol Cambodia Import Export Inspection and Facility Fraud RepressionDepartment MPTC Ministry ofPostand ccc Civil and Commercial Code Telecommunications CDC Council for the Development of MRD Ministry of Rural Development Cambodia MPWT Ministry of Public Works and CDRI Cambodia Development Resource Transport Institute NGO Non-Governmental Organization CED Customs and Excise Department NPRP NationalPoverty Reduction CIB CambodianInvestment Board Program COM Council o f Ministers NPRS National Poverty Reduction Strategy CSR Corporate Social Responsibility PAP Priority Action Program EAC Electricity Authority of Cambodia PICS Productivity and Investment Climate EDC Electricte du Cambodge Survey ELVIS Electronic InformationVisa System PP PhnomPenh ESSP Education Sector Support Program PPI Private Participation in Infrastructure EU EuropeanUnion PPIAF Public-Private Infrastructure FDI Foreign Direct Investment Advisory Facility F A 0 Food and Agriculture Organization of the PSD Private Sector Development UnitedNations PSF Government-Private Sector Forum FIAS Foreign InvestmentAdvisory Service REE Rural Electricity Enterprises GATT GeneralAgreement on Tariffs and RGC Royal Govemment of Cambodia Trade SITF SpecialInter-MinisterialTask Force GMAC GarmentManufacture Association SME Small and Medium-sized Enterprise Cambodia SSCA State Secretariatof Civil Aviation GNI Gross National Income TBT Technical Barriers to Trade GTZ GermanAgency for Technical TFP Total Factor Productivity Cooperation TRIMS Trade-RelatedInvestment Measures ICA Investment Climate Assessments TRIPS Trade-RelatedIntellectual Property IFC International FinanceCorporation Rights ILO International Labor Organization UNIDO UnitedNations Industrial IPA Investment Promotion Agency Development Organization IPP IndependentPower Production VAT Value Added Tax IRL IndochinaResearchLimited WDR World Development Report KAMSAB KampucheaShipping Agency and WG Working Groups Brokers WTO World Trade Organization VOIP Voice-Over-Internet Protocol TABLEOFCONTENTS TABLE OF CONTENTS ..... .............................................. ...111 Abstract ......................................................................................................................................................... vi Acknowledgements Executive Summary ........................................................................................................................................viiii ..................................................................................................................................... ... CHAPTER 1: THE CHALLENGE OF PRIVATE SECTOR DEVELOPMENT INCAMBODIA...............1 1.1 Poverty, Productivity and Service Delivery...................................................................................... 1 1.2 The Competitive Environment.......................................................................................................... 4 1.3 Characterizing the Cambodian Enterprise ........................................................................................ 6 1.4 The Strategic Challenge . ...... ............................................ 7 CHAPTER 2: THE PRODUCTIVITY CHALLENGE................................................................................. 11 2.1 12 Investment Climate Priorities.......................................................................................................... What Drives Productivity?.............................................................................................................. 2.2 13 2.3 Governance and Corruption............................................................................................................ 14 2.4 Barriers to Entry and Competition.................................................................................................. 17 2.5 Trade Facilitation ............................................................................................................................ 18 2.6 Legal & Regulatory Environment................................................................................................... 20 2.7 Factor Markets ................................................................................................................................ 22 2.8 Infrastructure and Logistics ........................................................................................... 2.9 Rural, Urban, and Informal Investment Climate............. ......................................... CHAPTER 3: DIVERSIFICATION AND GROWTH............................................................................. 32 3.1 The Challenge of Diversification .................................................................................................... 32 3.2 What Contributes to Diversification? ............................................................................................. 34 3.3 The Garment Sector ........................................................................................................................ 36 3.4. Agro-Industry................................................................................................................................. 42 3.5. Institutionsto Support a Diversified Private Sector........................................................................ 48 CHAPTER 4: ENHANCING THE ROLE OF THE PRIVATE SECTOR INPUBLIC SERVICES ............55 CHAPTER 5: A PROGRAM OF REFORM................................................................................................. 69 5.1. Streamline Trade Facilitation.......................................................................................................... 70 5.2. Remove Impediments to Diversification ........................................................................................ 73 5.3. Strengthen Rule of Law .................................................................................................................. 75 5.4. Leverage Private Sector Value Chains to Develop Suppliers ......................................................... 75 5.5. Strategic Review of Camcontrol .................................................................................................... 76 5.6. Strengthen Governance for IncreasedPrivate Participation in Infrastructure ................................ 78 5.7. StrengthenInstitutional Learning through Business Associations.................................................. 81 5.8. Accelerate Leasing and Access to Finance ..................................................................................... 82 5.9. Moving Forward ............................................................................................................................. 83 CHAPTER 6: GOVERNMENT ACTIONS AND COMMITMENTS ......................................................... 84 6.1 Special Inter-ministerial Task Force on Trade Facilitation & Investment Climate ........................ 84 6.2 Twelve Point Plan: Government Commitments to Improve the Investment Climate and Trade Facilitation................................................................................................................................................... 86 6.3 The Government's Track Recordof Reform in Private Sector Development................................ 89 Investment ClimateAssessment & ReformStrategy Page iii ANNEX I:CAMBODIA AT A GLANCE.................................................................................................... 96 ANNEX 11: WORKER SKILLS AND THE CAMBODIANECONOMY ................................................ 100 ANNEX 111: METHODOLOGY: PRODUCTIVITY AND INVESTMENT CLIMATE SURVEY..........104 ANNEX IV: DOING BUSINESSIN2004 .CAMBODIA COUNTRYPROFILE.................................. 117 REFERENCES............................................................................................................................................. 136 TABLES 9 Table 2.1: Practicesof Competitors as Obstaclesto Own Firm.............................................. Table 1.1: ICA Main Survey Sample Structure............................................................................................... Table 2.2: Working and Investment Capitalof CambodianFirms......... Table 2.3: Schooling and SkillContent of Major Non-AgriculturalWa Table 2.4: Skill and Education Compositionofthe Workforceby Sector .............................. Table 2.5: Technology Use and Change, by Sector ................................................................ Table 2.6: Cambodia's InfrastructureAccessiCoverageIndicators........................................ .................................... 27 Table 2.8: Top Constraints:Main Sample, Informal, and RuralNon-Farm.................................................. Table 2.7: Electricity and Water Self-Provision................................................... 30 Table 2.9: Business-GovernmentRelations...................... ..................................................................... 31 Table 2.10: Main Customers, RuralNon-farmand Urban rmal Firms................................................... 29 Table 3.1: GDP Growthby Sector, 1997-2002............................................................................................. 32 39 Table 3.3: PartialList of Licenses and PermitsRequired................. Table 3.2: EstimatedAdministrativeCosts: 40 ft container Denim Jeans .................................................... ..................................................... 44 Table 3.4:Intensity of FormalTraining........... ..................................................... 41 Table 3.5: Summary:A Substantial Institution ..................................................... 49 Table 4.1: PPIExperienceinCambodia....................................................................................................... Table 5.1: Bank Loanvs. FinancialLease..................................................................................................... 59 81 FIGURES 3 Figure 1.2: Poverty Reductionand Employment............................................................................................ Figure 1.1: Annual ForeignDirect Investment................................................................................................ 3 Figure 1.3:CambodiaA Small Market inaDynamic Region ........................................................................ 4 Figure1.4:Agro-Industry:Small Firms Serving LocalMarketsiGarments:LargeFirms Senring Global Markets........................................................................................................................... Figure2.1: PerformanceGaps......................................................................................................... Figure2.3: Cambodia:Top 10 GeneralConstraintsto Private EnterpriseOperation and Growth............... 13 Figure2.2:Value Added: MedianValues..................................................................................................... 12 Figure2.4:Percento f SalesValue PaidInformally to Public Officials........................................................ 14 Figure2.5: Estimated Share of IncomeReportedfor Tax Purposes ........................ Figure2.6:How much influencedo these groups haveover recent nationallaws, r business?.................................................................................... .... ......................... 16 Figure2.7:Time to Start a Business(Days)................................ Figure2.8:Regulatory Constraintsto CambodianEnterprises..................................................................... ......................................................... 17 18 Figure2.9:Longest Days for Exportsto Clear Customs ............................................................................... 19 Figure2.10: Numberof Enterprise Inspections per YeariPercent of ManagementTime spent Dealingwith Public Officials, Regulation..................................................................................................... 20 InvestmentClimate Assessment & Reform Strategy Page IV Figure 2.11: Legal Creditor Rights Index....................................................................................... Figure 2.12: EstimatedProbabilities of PaidEmployment by School Level................... Figure 2.13 CambodianFirms MaintainHighInventory Levels to Buffer Uncertainty .. 29 Figure 2.15: Cambodia: Constraintsto Urban Formal and Informal Firms.................................................. Figure 2.14: Leading Generalconstraintsby Location ................................................................................. Figure 2.16: Seasonal Fluctuations in sales, Urban Informal and Rural Non-Farm Enterprises 31 Figure 3.1: 2001 Exports by Sector ....... ...................30 33 Figure 3.3: Garments vs. Agro-industry Figure 3.2: Employment Structure2000 ....................................................................................................... Figure 3.4: Garment Sector: Value Add ................................................................................. 36 Figure 3.5: New Garment Sector Invest Figure 3.6: Garments Sales to US: Higher volume outsidequota, but prices outside quota declining ........38 Figure 3.7: GovernmentInspectionsby Sector ............................................................................................. 39 Figure 3.8: Bribe Costs Associatedwith Regulations ................................................................................... 39 Figure 3.9: Administrative Intervention Analysis for the Productionand Export of 40 Ft Container of Denim .... ..................................................... Figure 3.10: Sourcesof External Financefor Investment............................................................................. 41 Figure 3.1 I: Agro-Industry: Value Added per Worker ................ .......................................................... 42 Figure 3.12: Distribution of Manufacturing Firms....................... Figure 3.13: Marketing and Distribution Channels inRural Cambodia. .......................................................... 42 Figure 3.14: Official vs. Unofficial Exports of Rice ..................................................................................... 43 Figure 3.15: Value Chain for the Production ofNeang Mali Rice inCambodia.................................. Figure 3.16: High Inventory Level inAgro-Industry Relativeto Garments................................................. 46 Figure 3.17:Agro-Industry with Transportation and FinanceProblems Suffer Greater Loss Due to Delivery Delays from Suppliers.............................................................................................................. 46 Figure 3.18: Capital Tied Up in Land and Buildings .................................................................................... 47 Figure 3.19: Share of Firms Self-providingInfrastructure............................................................................ 48 Figure 5.1: Summary Overview of Reform Initiatives.................................................................................. Figure 4.1: Public Sector Infrastructure Provision-The Annual Costs of Mis-Pricing and Inefficiency ....56 72 Figure 5.2: Daysto Start aBusiness.............................................................................................................. 74 BOXES Box 3.1: TOPSiRoyal Ahold Supply Chain Development Program: Catalyzing Supplier Upgrading.........51 Box 4.1: Permits. licenses. and consents required for atypical power project ............................................. 65 Box 4.2: The Importanceof Transparency inPPI......................................................................................... 67 InvestmentClimate Assessment & Reform Strategy Page v Abstract Seizing the Global Opportunity: Investment Climate Assessment and Reform Strategy has been accepted as a key input to Cambodia's private sector development strategy following extensive consultations with the Royal Government of Cambodia, its development partners and the private sector. It was prepared to help these stakeholders identify and prioritize policy reforms to achieve three related objectives: to enable the private sector to lead growth, to help diversify the economy, and to increase the role of the private sector in public service delivery. The report takes as its starting point Cambodia`s pro- poor trade strategy, which recognizes that as a small country, exports are critical to expanding job opportunities. However, Cambodia's policymakers are aware that the export opportunities cannot be captured if firms face an uncompetitive domestic business environment. The report employs an investment climate survey o f 800 urban, rural, and informal firms to identify how the policy and institutional environment impacts individual firms, and benchmarks the responses of Cambodian firms with those in China, Bangladesh, India and Pakistan. It builds on (a) Towards a Private Sector Strategyfor Cambodia: Value ChainAnalysis (2003); (b) a study of the policy and institutional environment for private participation in infrastructure; (c) the Bank's Doing Business indicators for Cambodia, attached as Annex IV; and (d) options for trade facilitation reform included in Chapter 5. The report begins by noting the profound link between economic growth and productivity. In spite o f Cambodia's rapid growth and a remarkable recovery in the last several years, the data suggest that both total factor productivity and labor productivity are low in comparison with countries that Cambodia must compete with in international markets, including Bangladesh, India, China, and Pakistan. Some key factors that contribute to low productivity, including corruption, weak rule o f law, informal practices and complex and costly regulation, are identified and benchmarked. Among the more surprising results, the share o f sales revenue paid by Cambodian firms in the form o f bribes is over twice that of Bangladesh and by far the highest among the comparators. Cambodia also has the most annual inspections, the highest cost per capita to officially register businesses, the second highest amount of time for management to deal with officials (after China). Trade facilitation practices are particularly constraining, with the second longest clearance times after Pakistan and some o f the highest observed incidence o f unofficial costs. In contrast with Cambodia's reputation as a liberal environment, in several key respects Cambodia appears to be a restrictive market due to the cumulative impact o f multiple agencies operating in an uncoordinated fashion. The governance findings are so acute that they overwhelm visible deficiencies such as finance, infrastructure, and human capital/skills. This is not to suggest that these factors are not relevant, but rather that the private sector i s not in a position to be constrained by them becauseof more urgent concerns. The structure of Cambodia's private sector is a reflection of the investment climate. There is a high degree o f informality, and little long-term investment in productive assets outside of sectors which enjoy either policy-based market advantages or unique cultural assets. The strategy of remaining informal appears to make short-term sense: informal firms as well as rural firms are less constrained. As a long-term prospect, the strategy is limited as the informal sector has a reduced capacity to trade with the formal sector, to obtain credit and to grow. Overall, the result appears to be a negative cycle in which firms remain small and informal, denying the Government the revenue base needed to improve public sector performance, which inturn contributes to weaknesses in the investment climate. Diversifying the private sector is an important goal o f the National Poverty Reduction Strategy, and most observers agree that Cambodia has the potential to grow through post-harvest agro-industry. The report explores diversification by exploring the constraints facing rural, non-farm agro-industrial firms. From a cost standpoint, it appears that agro-industry can be competitive. But the agro-industrial sector, which comprises the vast majority o f private manufacturing, is unable to trade outside of local markets, and i s largely limited to personal relations with customers and suppliers. Here the finding i s less about constraints imposed by the public sector, although they exist. Rather the key issue appears to be InvestmentClimateAssessment & ReformStrategy Pagevi fragmentation of markets due to the absence of institutions that reduce the risk and cost of making formal, arm's length transactions with distant counterparts. One symptom is that rural firms keep extraordinarily high inventory levels as a buffer against supply disruption. Another is their weak linkage to the large-scale formal sector. Because markets are not integrated in key parts o f the value chain?the basic driver of productivity - competition between firms - is not strong enough to spur productivity gains. As a result, revenues and productivity are very low and the basis to increase employment does not exist. The challenge here is to develop trade-supporting institutions - both public and private- without creating some of the problems associated with the urban, formal investment climate. Institutions typically evolve slowly, with significant input o f the private sector. The strongest institutions are those which are accountable to stakeholders. It is therefore important to build the voice and participation of the rural and urban private sector through strengthening business associations, leveraging private value chains, and continuing the successful Government-Private Sector Forum. Cambodia's poverty reduction strategy places an important priority on improving delivery o f public services, which were particularly weakened by years o f conflict and neglect. The poor state o f infrastructure raises the cost of doing business and limits access to markets. Because needs are so acute and resources so limited, we argue that the state should yield a substantial role for delivery o f public services to the private sector. In fact the private sector is involved in electricity, telecommunications, water, transport, education and health care. I n this respect, the private sector's most important contribution is not necessarily resource mobilization, but efficiency - to increase the return on infrastructure spending, whether by the taxpayer or user. Unfortunately, the practice of private participation in infrastructure in Cambodia is frequently characterized by a lack o f competition and transparency, undermining the efficiency goal. Because of the nature of public services, most o f the efficiency gains can only be captured at the point of transaction. To increase the impact o f private participation, the report focuses on the governance framework for transactions, and identifies a number o f legal gaps, institutional overlaps, and a lack o f clarity at each stage. The process is sufficiently "broken" as to require firms to circumvent it to secure transactions - a process that prevents effective competition and denies Cambodia most of the benefits o f private participation. A number of recommendations are proposed, with a particular focus on improving trade facilitation practices, integrating markets through institutions such as private value chains, and injecting competition and transparency in private participation in infrastructure. The most important reforms are questions of political will, and as such are facilitated as much by frank, factual discussion as by technical recommendations. The intent is also to contribute to the quality of discussion surrounding private sector development. particularly through the Government-Private Sector Forum. The response by the Govemment to this report indicates that the political will exists to confront the main challenges and "seize the global opportunity." A draft of this analysis was presented to the Government in February 2004, and was discussed in a series o f Cabinet-level meetings. Through Prime Minister's Decision No. 1212004 (see Chapter 6) and Decision N o 4412004 the Government established a Special Inter-Ministerial Task Force on Trade Facilitation and Investment Climate, Chaired by the Minister o f Economy and Finance and Vice-Chaired by the Minister of Commerce. This body has defined an integrated program o f reform to address the most urgent impediments raised in the report. The reform measures agreed - establishing a cross-agency reform team, consolidating inspection mandates across agencies and introducing selective inspections based on risk, implementing a Single Administrative Document and Single Window process, automating information flows across agencies, streamlining business registration procedures and recognizing ethical behavior in the private sector - will be initiated in July 2004 be implemented on an urgent basis by December 2005. These reforms address some of the more urgent constraints and strongly complement Cambodia's entry into the World Trade Organization. The details o f the reform program are described in the Executive Summary as well as in Chapter 6, which also documents the Government's reforms ina number o f areas o f interest to the private sector. InvestmentClimate Assessment & ReformStrategy Page vii Acknowledgements This report was prepared under the guidance of H.E.Keat Chhon, Sr. Minister of Economy and Finance, H. E. Cham Prasidh, Sr. Minister o f Commerce, H.E. Aun Porn Moniroth, Chairman of the Supreme National Economic Council, H.E. Sok Siphana, Secretary o f State, Ministry o f Commerce, H.E. Sok Chenda Sophea, Secretary General of the Council for Development o f Cambodia, H.E. Vongsey Vissoth, Deputy Secretary General o f MEF, H.E. Hang Chuon Naron, Deputy Secretary General of MEF, H.E.Pen Siman, Director General of the Customs and Excise Department, KhunNhem, Deputy Director General o f Customs and Excise Department, H.E.Lou Kim Chhun, Director General of Sihanoukville Port, Mr.Hong Tha, Director of Tax Department, Mr.Um Seiha, Deputy Director of the Tax Department, Mr. Suth Dara, Director o f Camcontrol Department, and Ty Norin o f the Electricity Authority of Cambodia. This group of Cambodian policymakers was very generous with their time over numerous meetings, giving clear direction and encouraging the team to be as frank as possible in delivering the assessment and recommendations. We would also like to acknowledge valuable comments and contributions from the private sector and donor community. While we met many managers, officials, and donors during the Bork, there was a core group o f private sector managers, closely associated with the Government-Private Sector Forum, that were particularly generous with their time and views. These included Oknha Mong Reththy o f Mong Reththy Group, Van Sou Ieng, David Van, and Ray Chew o f the Garment Manufacturer's Association, Phou Puy, President, Rice Millers' Association, Bretton Sciaroni, John Nelson, Seneka Fernando, Bertrand Sigwalt, and Teh Sing o f the International Business Club, Cambodian Federation of Employers, Michael Stephen of Mekong Bank, In Channy of Acleda Bank, Nang Sothy of the Chamber of Commerce, Tony Knoules, and Andrew McNaughton, an advisor in trade and agribusiness. Among development partners, Bob Hagemann o f the International Monetary Fund, Fabio Artuso of the European Commission, Urooj Malik and Charles Schneider o f the Asian Development Bank, Ladislaus Byenka-Abwooli and the staff of UNDP, Daniel Arghiros o f DFID, Juro Chikara-Ishi of JICA, Blair Exell and Fleur Davies o f AusAID, and Mogens Christensen of Danida were particularly helpful. The report was prepared by a cross-agency team within the World Bank Group managed by Magdi M.Amin. The Investment Climate Survey and its analysis was managed by Andrew Stone. Key members of the team and section authors include Huot Chea (Economist and local coordinator), Michael Schur (PPI), Yasuo Konishi (Value Chain), Adam Sack (MPDF), Steven Schonberger (rural business), James P. Brew (IFC), Lili Sisombat and Soneath Hor (MPDF), Cristobal Ridao-Can0 (Skills/Education), Simeon Djankov and the "Doing Business" team, Ragini Praful Dalal, Michel Zarnowiecki and Gerard McLinden (Customs), Hamid Alavi (Trade Facilitation), Eric Haythorne (Legal), Charles Udomsaph (corruption), Hooman Dabidian (econometrics, access to finance), and Phil Ieng Sovannora (supported consultations). The work has been supported by three external consulting firms that provide valuable and timely inputs. Tim Smyth and Celine Mollard of Indochina Research supported the survey execution, Trent Eddy, Joshua Morris and Mike Moran provided strong support on trade facilitation, and Ray Tomkins led ajoint team of Economic Consulting AssociatedCEPAiDFDL on PPI. Peer reviewers for the work were Simon C. Bell, Sector Manager, Private and Financial Sector Development in the South Asia Region, Ibrahim Ahmed Al-Badawi, Lead Economist and Manager of the Regional Program on Enterprise Development in the Africa Region, and Mary C. Hallward Driemeier, Sr. Economist in Development Research Group. Helpful advice was also received from Country Manager Nisha Agrawal, Wafa Abdelati o f IMF, Theresa Bradley, Sarwar Lateef, and Sok Hach of Economic Institute of Cambodia. InvestmentClimate AssessmentBi Reform Strategy Pageviii Executive Summary The Challenge of Private Sector Development The Government's National Poverty Reduction Strategy (NPRS) states that "the central objective of the Royal Government's policy is to promote broad-based sustainable economic growth with equity, with the private sector playing the leading role."' Cambodia is a small, predominantly rural country o f 13.1 million people, with per capita income of $280. As a result of decades of conflict, international embargo, and post-war population growth, the development challenge is immense.According to the NPRS, 36 percent of the total population lives below the poverty line of US$O.46-$0.63 per day, and 50.4 percent of children under age five are underweight. In a recent speech, insisting on the need to accelerate reform, Prime Minister Hun Sen explainedthat ifbusiness will continue as usual his country was not on track to halve poverty, but rather would expectpoverty incidenceof 28% in2015. The growth o f the private sector in Cambodia over the past decade has been remarkable in light o f the destruction wrought by years of conflict and has proven that private investment can create jobs at wage levels that can reduce poverty. In the period 1997-2001, industrial employment grew by an average of over 43 percent per year, compared with less than 2 percent growth of both agricultural and service employment. This growth was driven by the export performanceof the garment sector, which has grown from $28 million in 1995 to over $1.35 billion in 2002. D i s t r i b u t i o n o f E m p l o y m e n t , 2 0 0 1 iotai b e i t - w age em p l o y m en t em p lo). m en t em p lo ym ent S u b i o i u l , A g . , f o r e s i r y , f i s h e r i e s 7 0 . 2 6 9 . 2 2 2 . 7 Agriculture, hunting, forestry 66.0 63.1 2 0 0 Fishing 4 . 2 6 .O 2 7 M a n u f u c r u r i n g 8 . 7 7 8 2 6 . 4 S e r v i c e s , of w h i c h : 1 8 . 0 2 2 . 8 3 2 . 7 O f w h i c h : W holesale1 retail trade 10.3 16.7 2 . 3 Transport, storage, c o m m u n i c a t i o n s 2.7 3 9 6 7 Construction 1 . 5 0 6 7 6 Education 1 . 4 0.0 8 . 6 Other services 0 9 1 1 2 . 2 Private households 0 4 0 1 2 . 6 Health. social w o r k 0.4 0 2 2 .o Rea' estate, renting, business act 0 3 0 2 0 8 P u b l i c a d m i n i h l r a i i o n d e f i n r e 2 4 0 0 1 4 6 O t h e r 0 7 0 2 3 6 T u l o l 1 0 0 0 1 0 0 0 1 0 0 0 The employment impact of this growth, however, has been narrow and has failed to reach the ' Royal Government of Cambodia, hhtional Poverty Reduction Strategy.February 2003. p. iv. InvestmentClimate Assessment & Reform Strategy Page1 majority of the population. In terms of a share of its total exports, Cambodia has the second highest degree o f specialization in the garment sector in the world -othersectors have simply failed to match the performance o f garments.' Moreover, with the garment sector increasingly subject to international competition, the engine of growth and poverty reduction is at risk. Overall, the manufacturing sector still employs less than 9 percent o f the workforce, compared with over 70 percent o f employment in agriculture, forestry, and fisherie~.~ Manufacturing jobs can have a dramatic impact on poverty. Private sector development has proven to be an effective strategy to reduce poverty in Cambodia. Households headed by those with industrial employment had only 4 percent poverty incidence, while SO percent o f families in which the head o f household was employed in agriculture were poor. As a small country competing in a globally-integrated, dynamic, and fast growing region, Cambodia's private sector-led growth strategy must be anchored in trade. Cambodia borders on Thailand and Vietnam - each growing rapidly with distinct factor advantages. Cambodia itself has a small domestic market, due to its small population base, its poverty, and the fact that this population i s only 18 percent urban. In light o f this, the country`s leadership has wisely chosen the route of globalization. To the Cambodian authorities, WTO represents an opportunity to reap gains from integration with the global economy and broaden its industrial base, particularly in light o f its small domestic market. The Royal Government's commitment to private sector-led growth has been clearly demonstrated by the range o f reforms being pursued as a package by a cross-ministerial team led by Commerce. Accession to WTO will afford Cambodia market access to member country markets on a most-favored nation basis, but will also intensify competition. Unless steps are taken to remove impediments to domestic enterprises, it is unlikely that many of Cambodia's entrepreneurs will benefit inthe short-run from market access. Recent history destroyed institutions that support productive economic exchange, and human and financial resources in the public sector are overstretched. Any private sector development strategy must address this gap. Cambodia's challenge is compounded by the legacy o f internal conflict that not only depleted the country's reserves o f human talent on which entrepreneurship is based, but also disrupted the continuity of social institutions and formal and informal rules that provide the framework for trade and investment. The economic landscapereflects this lack o f key institutions, most notably the rule o f law. I t also reflects an attempt by the Government to fill the institutional vacuum through administrative measuresthat have largely not worked, and created opportunities for corruption. Beyond human and social capital, physical infrastructure is lacking. Basic public services are absent for much o fthe population. The decade from its first elections in 1993 has been spent consolidating peace and taking important steps toward a market-based economy, including dismantling much o f the central planning and state-trading infrastructure, selling state-owned enterprises, establishing macroeconomic stability, liberalizing trade, freeing prices, and passing basic laws that enable private investment. The right to private property was enshrined in the constitution. FDIresponded very well in the early years of liberalization, but gains from the first generation o f reforms appear now to have peaked prior to the combination of political instability and regional economic crisis in 1997-1998. The perception of entrepreneurs inside and outside o f Cambodia is that corruption is widespread, the rules o f the game are not fair or do not exist, and that the country is prone to instability. Consequently, foreign direct investment has fallen consistently since 1999. Cambodia now faces an historic opportunity to change its growth path. The Royal Government 'CalculationofSurvey revealed comparative advantage by ITC based on UNCOMTRADEdata for 2001 Labor Force 2001. InvestmentClimateAssessment & Reform Strategy Page 11 o f Cambodia enters its second decade having held relatively stable elections: and inthe broader context of a growing, stable, and integrating East Asian region. This provides a good context to undertake a second generation of reform not focused on establishment o f a market economy, but on enabling broad-based growth. The process o f accession to the World Trade Organization has been accompanied by a wide range of legal and trade-policy reforms and proposals that define the broad outlines of a new growth platform. Specific reforms that enable the private sector would constitute an important part of this platform. Stimulatinggrowth and employment will requiredevelopment of a policy reform packagethat rebuildsthe confidence of the private sector. Muchof the current status of the private sector, particularly the garment sector, responded to the first wave o f policy reforms - from 1993 to 1997. The impact of this package was cut short both by political violence and the regional crisis. A new package is now needed to reinvigorate investment andjob growth. Such a package must address the real costs and issues that reduce productivity and profitability for the private sector -- to encourage growth-- and also address the issues that are perceived as risks that impact the confidence of the private sector --to encourage new investment. Because of the magnitudeof the issues, reformsrequired, and limited resources,private sector development implies strategic choice. The process of setting priorities, making choices, and undertaking reforms i s what is referred to as private sector development strategy supported by this document. 1.The Productivity Challenge PerformanceGaps(NominalExchange M e , basecountry:India) The first challenge of private sector development is to address the productivity gap. Cambodian firms and workers are less productive than China, India, Pakistan, and Bangladesh: Total factor productivity i s some 18 percentage points below India, 24 points below China, while roughly even with Bangladesh. Because of its scarcity, the productivity o f capital i s high. The message from the survey is one of weak rule of law, bureaucratic costs, and corruption. Cambodia firms identify corruption as their leading constraint. The elections, while considered fair by international observers, were followed by a protracted period of negotiation to form a new government, At time o f tvriting, these negotiationshavenot been completed. 5 To enable benchmarking, comparator data unless otherwise noted in this report is drawn from parallel questions asked in Productivity and Investment Climate Surveys (PICS) undertaken by the World Bank in each o f these other countries. Vietnam, which may have also been a useful comparator, has not completed the PICS. InvestmentClimate Assessment & Reform Strategy Page iii Four-fifths o f the private sector sampled acknowledges the necessity of paying bribes, and 71% of large firms report that these payments are frequent. The private sector estimates that unofficial payments cost firms an average o f 5.2% of total sales revenue.6 Business's view o f agency integrity i s alarmingly negative, with the Judiciary and Customs viewed the most negatively. Comparing these ratings to results from a related 199912000 survey, perceptions of corruption have not improved. Unfair and informal competition and the functioning o f the judiciary are now rated as more constraining than before. Cambodia: Top 10 General Constraints to Private Enterprise Operation and Growth Corruption Crime, theft and disorder Anti-competitive or informal practices Regulatory Policy Uncertainty Legal systemkonflict resolution Customs and Trade Regulations Tax adm inistration Tax rates Macroeconomic instability Business Licensing, Operating Permits 0 0 0 10 002 0.00 30.00 40.00 50 00 60.00 70 00 8 0 0 0 % of Firms ldentlfylng Problem as "Moderate", "Major" or "Very Severe" The formal private sector faces myriad transaction costs and barriers to establishment and operation. It takes 94 days to start a business in Cambodia - 30 days longer to start than inVietnam and 52 days longer than in Thailand. Staying in the informal sector appears to be a rational response to the investment climate, because informal firms face lower taxes and bribes. They benefit little from formality. Trade facilitation practices in Cambodia stand out in having high official and unofficialcosts, delays, uncertainty, and discretion - a critical problem for a country that must rely on exports for growth. In contrast to the public perception of the Cambodian economy as largely free of red tape,' Cambodian firms are subject to an unusually high number of inspections, averaging 16 per year, second only to Pakistan and more than China among comparators. There is a high "time tax" associated with government inspections, and in this regard, Cambodia is secondonly to China. The corruption problem is so acute that it crowds out the poor functioning of factor inputs - finance, skills, and infrastructure -as constraints identifiedby managers, but this is more likely a result of a lack of competition rather than adequate supply of these important factors. Cambodian firms receive little extemal finance, except through informal networks o f family and friends. Commercial banks provide only 1 percent o f working capital, and demand for formal 6 Government officials argue that this unofficial payment is likely to include all the costs of intermediariesifacilitators often employed by the private sector to go through regulatory processes which raise the governance issue both within the public and privatesectors. That shouldbe addressed simultaneously. 7 For example, the Canadian Department of Foreign Affairs website on Doing Business in Cambodiastates that "Cambodia's open free market system, lack ofgovernment red tape, plentiful natural resources, and low-cost labor force offer many opportunities to investors." July 2002. InvestmentClimate Assessment & Reform Strategy Page IV financing is limited. Less than 4 percent of the firms who do not have a loan have actually applied and been rejected. Cambodia i s a cash economy, and the lack of an adequate payment system is one o f many impediments to trade. Similarly, skills are not identified as a serious impediment at present despite 63 percent functional illiteracy in rural Cambodia. Infrastructure is not viewed as an immediate constraint despite having the lowest infrastructure indicators (e.g., electrification, road density, telephone density) inthe region. As the private sector grows in size and sophistication of transactions, it will quickly confront the weaknessesin finance, human capital, and infrastructure as constraints. Given that these factors take time to develop, impediments inthe markets for these factors needto be understood and addressed. 2. The Diversification Challenge Garments vs. Agroindustry $2 500 The second challenge of private sector development is to broadenthe base of $2 000 - I economic opportunity and jobs. The private $1 500 - sector i s exceptionally narrowly-based. The $1 190 garment sector contributed nearly four-fifths of Cambodia's total official exports o f $1.44 billion. Yet, employment and the great majority o f enterprises numerically are concentrated in agriculture and agro-industry,s Value Added I Worder Sales 1 Employee Assets i Employee which exports little and has a labor productivity less than half than in the garment Source:The World Bank,CambodiaPICS 2003 sector. For reasons of equity, risk, and poverty reduction, the country needs a broader base o f firms and sectors that operate at higher productivity levels. From a cost and resources standpoint, Cambodia may have a comparative advantage in ago-industry. If value added can be raised, agro-industry can contribute to diversifying the economy by shifting more rural employment to manufacturing. The diversification challenge requires answers to the questions o f why value added is low, and what actions may be taken to raise it. To shed some light, the report uses PICS data to compare the larger urban formal sector, representedby the garment sector; with largely small-scale and informal agro-industrial sector. Diversification appears constrained by fragmented markets which limit competition and productivity gains. Integrating markets depends on institutionsthat support a transition from local, personal exchange to arm's length transactions over a wide geographical area. The increased market scope enabled by formal trade is the basis for competition, which in turn creates specialization and productivity gains. The key factors affecting this transition are the extent to which institutions exist to reduce the risk and cost o f exchange, including quality, price, and contractual risks, and the cost o f coordinating production, finding partners, and executing transactions. We compare the institutional environment for garments and agro-industry. The garment sector has proven its ability to export and grow, but it now faces the prospect of lower prices and therefore the need to increaseits efficiency. Like garment exporters throughout the world, Cambodian firms must contend with the liberalization of garment trade at the end of 2004. Cambodia's garment sector has grown in an environment of preferential access to the US and EU markets. Through the WTO Agreement on Textiles and Clothing, the US has given Cambodia a quota in its protected 'Both statistics are somewhat misleading, since a large share of agricultural trade and employment i s informal and not captured in official export or industrial data. ImestmentClimate Assessment & Reform Strategy Pagev ExecutiveSummary market, the volume of which depends on labor practices. Such agreements will be replaced by competition in 2005. There is a possibility that corporate social responsibility practices will become a source of competitive advantage, but Cambodia competes in high-volume segmentswhere demand is likely to be cost- sensitive. The evolution of price behavior in Cambodia's non-quota exports to the US suggest declining margins. As the global industry consolidates to reap economies of scale, Cambodia's industry is at risk. Therefore, the focus is on reducing excessive and overlapping bureaucratic processes and high associated costs - particularly in trade facilitation. There is a substantial gap in the scope of trade-supportinginstitutionsin the two sectors (see Table 3.5 in Chapter 3 for full table). Trade in the garment sector is supported by well-developed institutions that provide confidence and trust in Cambodia's exporters, even in absence of the formal rule of law. These institutions authenticate country o f origin, manage quota allocation, verify compliance with labor standards, verify fulfillment o f quotas both on the Cambodian side and inthe export destination, verify compliance with duty exemptions, and manage quality. Disputes are resolved overseas. Unions exist to organize and express the needs of labor, and the voice of the Garment Manufacturer's Association of Cambodia has clearly influenced policies that support the needs o f the sector. Garments Agro-Industry Value Addedworker $1,190 (low by international standards) $462 (extremely low by international standards) Firm Size 600+ employees -7 employees Market Scope Global markets: US 71%, EU38% Local, informal:70% individual Trade-Supporting GSP, Agreement on Textiles and Clothing None Institutioii Labor Law, ILO compliance monitoring,. Corporate social responsibility norms, Quotamanagementsystems, ELVIS Certificatesof Origin, Duty Exemptions, tax incentives, Foreign disputeresolution(e.g.,Singapore) Informal/Private I Garment Manufacturers' Association, I Village and community-based or I Institutions Corporate netRorks NGO-driven Quality measurement IICamcontrol IICamcontrol inspections Source The World Rank CamhodiaPTCS 200'1 Agro-industry does not benefit from trade-supporting institutions, so the vast majority of producers are small, informal, and serve local markets or middlemen. In Battambang, which includes many rice Marketing & Distribution Channels in Rural Cambodia millers, 70 percent of output is sold 100 directly to consumers and the balance to 90 local business. Competitive wholesale 80 OSmall Bus. marketing and distribution is absolutely 70 ---- essential to productivity, but there are 60 - signs of some monopolies in distribution. The risk environment causes firms in 50 WAg Producers/ rural areas to keep high inventory levels: 40 57 days of inventory in Battambang, 27 30 --- days in Kampang Cham, 37 days in 20 - Kampong Chhnang, and 35 days in 10 - Kratie. Firms indicate that if they had 0 7 better financing, they would keep even Battambang Kampong Kampong Kratie inventories of over half a year. Som Chhnang Source: The World Bank,CambodiaPICS BIS 2003. InvestmentClimateAssessment& Reform Strategy PageVI Since the scope of trade in agro-industry is local, exposure to competition - the driver of productivity- is severely limited. Demand for skills and capital is low. Extremely low levels of educational attainment and high levels of functional illiteracy characterize the working population in rural areas. Firms in the food sector provide little training to their employees. Firms do not report that infrastructure is a constraint, yet it takes rural firms 2.6 hours to reach their most important market, 3.6 hours to reach the supplier of their main input, and 3.6 hours to get to a financial institution. Commercial funding is almost absent for the agro-industrial sector - only 3 percent o f working capital is met from commercial sources. To support diversification,the focus is on integratingagro-industry and other rural firms into urban, and ultimately, international markets. This will require (a) removing impediments in such areas as trade facilitation, inspections, and exclusive licensing and (b) building trade-supporting institutions including dispute resolution, product quality and standardization, and market information systems. The rule o f law - particularly the enactment and enforcement of contract law embedded in the civil and commercial code - will be required, along with efforts to raise awareness among entrepreneurs o f their legal rights and obligations. Because most industries outside o f textilesigarments and tourism are at a formative stage, the role of both the private sector in organizing itself and o f institutional learning are essential. Given weaknesses in public administration, the report suggests a focus on the development of effective non-state institutions, including business and trade associations. 3. The Service Delivery Challenge The third challenge of private sector development is to play a role in improving access to efficient and affordablewater, electricity, transport, and telecommunication services. This can have major impacts on Cambodian living standards and on the investment climate. Efficient infrastructure is essential to sustain economic growth and industrial competitiveness. Cambodia has one of the lowest electrification rates outside sub-Saharan Africa; it has no power transmission system and has no large generation capacity. Where electricity is available, firms and individual consumers face some o f the highest energy costs in the world. Cambodia has the least developed road network in the region with the smallest percentageof paved roads. I t is difficult to see how Cambodia can address these backlogs in a short period of time using internal resources alone. Inadequate domestic revenue mobilization and skewed public expenditure allocations have kept Cambodia heavily dependent on foreign aid for financing the provision of basic goods and services. A 2002 study revealed that 65 percent of the costs o f all infrastructure projects to be undertaken between 1999 and 2001 had no identified source of funding.' Further, government resources are able to cover less than one-third o f the total annual cost of rehabilitation and maintenance." There is scope for the private sector to bridge the financinggap, but the most essentialrole for the private sector and market forces is to ensure that efficient choices are made in delivery and management of services. There is growing recognition around the world that the private provision of infrastructure, within an appropriate contractual and regulatory framework, can offer services at lower unit costs, with faster implementation, reduced whole life costs, better risk allocation, better incentives to perform, improved management o f quality, enhanced public management, and at times generate revenues. The need for efficiency in service delivery is a key driver for change and creates an opportunity for growth. World Bank and the Public-Private Infrastructure Advisory Facility (2002). A Country Framework Reporr: Private Solutionsfor Infrastructure in Cambodia. lo World Bank and Asian Development Bank (2003). Cambodia - Enhancing Service Delivery through Improved Resource Allocaiion and Insfitutronal Reform. Integrated Fiduciary Assessment and Public Expenditure Review. Report. InvestmentClimate Assessment& Reform Strategy Pagevii Executive Summaw A number of internationalfirms have already made substantial investments inpower, telecom, transport, and airports. Moreover, the local private sector is entrepreneurial and willing to contribute their own equity. However, PPI practices prevent Cambodia from enjoying the benefits of private participation: There is a general lack of transparency in the negotiation and management o f contracts between government and investors. Few if any concession agreements or negotiated contracts have been made available for review, publication, audit, or public scrutiny. Significant gaps pervade in the legal framework in a number o f sectors, with some over-arching sector laws still in draft, and persistent bypassing o f existing laws and processes. Scant respect i s paid to examining and documenting contingent and ongoing liabilities taken on by the public sector. Planning processes across sectors are generally inadequate, and as a result, private firms frequently present unsolicited offers independent of sector plans or in conflict with previously negotiated concessions. Little auditing of concessions takes place prior to or after implementation. The allocation o f roles and responsibilities between institutions is unclear. In several sectors there are multiple agencies providing oversight, licenses, and permissions to operate, but limited coordination between them. In some instances officially designated roles and responsibilities have been over-ridden by more senior individuals. The power sector is well-developed from a regulatory standpoint, but other sectors lag. The consequences o f these problems include unbankable projects, higher than necessary prices, unavailability o f information on the efficiency o f services and limited protection o f the public interest. The deficiencies in the legal framework are reinforcedby problems at various stages of the project cycle: Policymaking, planning, and project identification. Current laws and regulations do not provide a process for agreeing policy on development of PPI nor for setting priorities across projects or sectors. The approval process prior to award. Once individual projects have been identified, the 1993 Financial Budgetary Law requiresall PPI contracts, regardless of the sector, to be approved by the Ministry of Economy and Finance (MEF) prior to signing. However, this legal requirement is generally not followed." Negotiation and award of projects. A number o f cross-sectoral laws reflect the principle that contracts with the private sector should generally be awarded by competitive tender. However, these laws are simply not followed. Project implementation. Once agreement has been reached, investors must begin the burdensome task o f requesting all necessary approvals, permits, consents, licenses, and authorizations from multiple governmental entities. Management of PPI contracts. The legal framework does not make provision for post award management of PPI contracts. In practice, there is little evidence o f effective project monitoring or management. Regulation of infrastructure projects. In many sectors, the law i s unclear as to which entity has the power to regulate projects. The RGC will need to making immediate and fundamental changes to the current regulatory and institutional environment for PPI- focusing on transparency, predictability, competition, and accountability. "Itshouldbenoted, however,thatthere appearsto beatleastonerecent instance inwhichtheMinister ofEconomyandFinance used the provisions of the 1993 Law to refuse to sign an implementation agreement for a power generation, transmission, and distribution contract. until such time as his Ministry has had the time to review the draft contract inmore detail. InvestmentClimate Assessment& ReformStrategy Pageviii Executive Summary I t will need to reinforce government performance risk by using political risk guarantee instruments to protect foreign investors and lenders not only against war, currency transfer, and expropriation, but also against government breach o f contract risks. It will need to make a transition from subsidized tariffs to full cost recovering tariffs and connection subsidies to connect some o f the poorest households, employing private partners to ensure effective delivery o f subsidies and recognizing that at least some ofthe investment to achieve build-out targets will need to be kick-started by public finance. 4. GuidingPrinciples for Reform Private sector development is an evolving process, and a successful reform can only emerge from a continual effort to improve the investment climate. The following guiding principles emerge from the analysis as filters to help identify priorities: Ease the burden on business: a shyt from a culture of control to a culture of facilitation. Streamline institutional overlaps, particularly in trade facilitation, and reduce the large number of inspections and licensing requirements, particularly those related to ensuring quality. Empower markets and competition. The healthy development o f the private sector depends on removing policy distortions that prevent market signals from reaching the private sector and helping shape economic decisions. This includes elimination o f exclusive dealing arrangements. Do not go beyond the limited capacity of public institutions. Given capacity constraints, it is necessary to leverage non-state actors and to streamline the role of the public sector. The strategy should reposition the state to provide effective governance, accountability to the public, and a focus wherever possible on using well designed partnerships to deliver services rather than use limited public resources. Focus on reforms that are empirically shown to relate to improving competitiveness and productivity. There is a range o f institutions and reforms that can help the private sector, but in consideration of the survey and value chain analysis, a few that impact productivity the most. Increasing labor productivity is the most sustainable way to increasejob growth. Use private institutions to integrate rural and informal sectors. Integration means removing policy-related impediments, both formal and informal, that raise the cost o f doing business for firms that are now limited to either informal or small-scale, local trade. This will be achieved by (1) reducing policy- based impediments, particularly in such areas as trade facilitation and business inspections and (2) reducing entry barriers, such as unnecessary licenses and the high cost o f registering businesses. Focus on institutions that reduce risk and transaction costs. Reduce the cost o f measurement of quality and quantity by building standards and, where feasible, sustainable alternatives to state or donor- funded measurement systems. Focus on institutional learning, given the early stage of private sector development. Explore the role of local business organizations, scaling up the success of garment, rice millers and rural electricity enterprise associations. Introducing greater accountability in policy formulation and performance. No strategy or economic policy can have impact unless it is monitored and there are consequences for objectives and milestones that are not achieved. In Cambodia, donors currently provide a monitoring role. This is inconsistent with a program designed to achieve sustainability. The strategy should strengthen private sector and citizen monitoring o f public performance (including corruption) and capability to participate in policy dialogue - both to support Government-Private Sector Forum and rural areas. InvestmentClimate Assessment & Reform Strategy Page ix ExecutiveSummary Reform Initiatives The analysis suggests a number of reformsthat are clearly linked to restoringconfidence and raising productivity - prerequisites for new foreign or domestic investment. The following eight reforms emerge as initial priorities that (a) address some o f the key problems raised in the analysis that are closely associated with raising the cost of doing business, and (b) address what the private sector perceives as the key problems, and (c) support the WTO accession and the related legislative package. 1. Trade Facilitation. Any trade-led private sector development strategy depends on efficient trade facilitation. As described in the value chain analysis, Cambodia's trade facilitation practices are markedly inefficient, both in cost and time terms, due to a combination o f administrative overlap, inefficient processes, a lack o f automation, and high unofficial and official costs. Overlapping and obsolete roles and responsibilities should be eliminated. Rationalizing roles and responsibilities for shipment clearance, including documentation, inspection, and payment will entail some cross-training as well as a clearly defined process for sharing information across agencies. KAMSAB's role as agent o f record is now obsolete, since commercial shipping agents have entered the market. Pre-shipment inspection should continue to be outsourced, with an eventual transition to CED as it acquires skills. Documentationshould be radically reduced. Currently, over 45 documents - most requiring the same basic information are required to import one shipment. This plethora o f documents should - be replaced with a Single Administrative Document that consolidates the information requirements o f all agencies. This information should be shared by the government to minimize the necessity o f interface between the private sector and agencies. Processes should be streamlined and the automated. CED's current streamlining program - which is already defined - should eliminate a number o f non-value adding steps. Following this, comprehensive automation should be introduced, including documentation related to documentation, export licensing, certificates of origin, and risk management. Inspections should be conducted on each container, but only on those that clearly fall within risk parameters, which can be automated. The process should be reengineered as a single window with flat fee for service, governed by service level agreements with the private sector. 2. Removing Impediments to Diversification. A set o f administrative requirements, including some parts o f the business registration process, licensing, and inspections, should be eliminated as they are frequently ignored?and as currently designed, contribute to informality bribe payments. 3. Strengthen the Rule of Law. Contract law, as embedded in the Civil and Commercial Code, is of critical importance to a trade-led private sector development strategy. 4. Leveraging Private Sector Value Chains. This recommendation focuses on the use o f supplier development programs and value chain incentives to create linkages, rather than relying extensively on public institutions. This involves facilitating FDI inretailing, logistics, and agribusiness. 5. Review the role of CamControl. CamControl serves several functions, including regulating quality and public safety. Some of these mandates are vital for public safety, but the way it currently executes its mandate needs to be modernized. It should base the import inspection activities on a risk management approach and it should strengthen the efficiency of its knowledge-providing role, with its laboratories used more on a voluntary basis to facilitate product testing and trade. The review should consider the possibility o f merger with Customs, retaining as is, or establishing a new Foodand Drug authority. InvestmentClimate Assessment & Reform Strategy Pagex Executive Summarq 6. Strengthen Governance for Increased Private Participation in Infrastructure. A reform plan would rationalize institutional overlap and clarify processes at each stage of the project life cycle: primary and secondary approvals, responsibility for granting contracts, contract management and monitoring, and capacity building. 7. Strengthen Institutional Learning through Business Associations. Particularly at the early phases of organizing the private sector's responseto increased market opportunity, it will be important for the private sector to coordinate and share the cost of learning. Business Associations can increase access to market information. Over time, it is important that the private sector develop its own capacity to monitor development o f policy and to advocate sectoral interests within a fair political process. 8. Accelerate leasing. While access to capital did not appear as a high priority to many firms, it i s clear that it will constrain firms that compete. Leasing i s potentially viable as a form o f finance that depends least on a fully-functioning legal system, since title typically does not change hands during the transaction. PrioritizingReforms During stakeholder workshops and consultations in December, February, March and June, the reforms were discussed in terms o f their impact, urgency, degree o f further analysis needed, and their ease o f implementation. The outcome of the workshops suggested that trade facilitation and removing of impediments to diversification such as licenses would be the most immediate and actionable areas, despite significant political will required. This is largely due to the end o f garment quotas, which will require rapid reduction in costs to remain competitive. diversification Strategic Leveraging Review of Private value Accelerate Leasing I Camcontrol chains I Institutional Learning - Business Associations Strengthen Rule of Law GovernmentActions and Commitments The Bank team presented the findings o f the Investment Climate Assessment to the Government in February 2004. The Senior Minister of Economy and Finance, the Minister o f Commerce, with the support of the Prime Minister, called for a Government-wide discussion which took place in a series of government discussions in March. In one such the discussion, the findings o f the report were presented to a meeting o f approximately 90 senior Government officials. From these discussions, the Prime Minister issued Decision No 1212004 on March 22, 2004, creating a Special Inter-ministerial Task Force (SITF) for Improving the Investment Climate Assessment & Reform Strategy Page XI ExecutiveSummary InvestmentClimate and Trade Facilitation. This task force has the task of proposingimmediatemeasuresto reduce trade facilitation costs, reduce duplication and simplify processes, reduce the time required, and increase official Government revenue. On The Bank team met with the SITF on March 25, 2004 and agreed in principle to focus on (a) reducing product inspection burden. (b) implementing a single window, (c) developing a performance measurement system, and (d) restructuringhuman resources management. The Government, via the task force, decided to take several short-term reform measures inthese areas as a response to the findings of the ICA as discussed below. The Bank and Govemment mutually agreed on a two month period to develop these reforms. Following the two-monthperiod, the Bank metwith the SpecialInter-Ministerial Task Force(SITF) again on 7 June 2004. During this second meeting, the Government committed to a number of critical reformsto be undertakenover an eighteen-monthperiod from June 2004 to December 2005. A cross-agency reformteam was identifiedto lead this effort, includingall key agencies involved in investmentclimate and trade facilitation issues: Ministries of Economy and Finance, Commerce, Agriculture, Labor and Social Welfare, Interior,Industry,the CDC, and the Port Authority of Sihanoukville. The reformteam will report to the Special Inter-Ministerial Task Force Chaired by the Minister of Economy and Finance, will work closely with the Bank, and interact with the privatesector. The SpecialInter-ministerialTask Force (SITF) committedto developinga transparentperformance measurementsystem, measuringthe steps, time and cost to import and export product, includingall relevant agencies. The private sector will play a role in the monitoringsystem. SITF agreed to replacethe current frequent and discretionary inspections with a risk management approach, in which inspections will be selective, based on the risk profile of the shipment only. The SITF will lead the a process of simplifying and streamlining the process, includingremovingredundant steps, and replacingall current documentswith a Single Administrative Document to be filled out once by the private sector. Rather than have the private sector meet with each agency involved in trade facilitation separately, a Single Window process will be established and the roles o f various agencies will be rationalized. The SITF also agreed to simplifying licensing and registrationprocesses, and automation ofthe trade facilitation process. On 26 July, 2004, the Prime Minister's Decision 4412004 end the mandate of the Inter-ministerial Special Task Force for Investment Climate Improvement and Trade Facilitation and formed a Steering Committee for Private Sector Development, which will serve as the Government's focal point in determining, leading, implementing, and monitoring the implementation of the Rectangular Strategy on Private Sector Development, including improving the investment climate, trade facilitation? SME promotion, and PPI. Implementingthe reform program will require the engagement of all stakeholders. To help ensure that the private sector contributes to a new investment climate characterized by better governance, the Government will encourage, through the Government-Private Sector Forum, the development of codes of ethics in the private sector, and the creation of a national award for good corporate governance and citizenship. The Government has also encouraged the donor community to develop a Sector-Wide Approach (SWAP)to align its support, which is currently fragmented, to an agreed set of policy priorities. This report has been discussed with donors, and there is broad agreement on its relevance as a policy platform that donors can support. Other important efforts to be integrated include those of UNDP, Asian DevelopmentBank, JICA, the EuropeanUnion, AusAID, GTZ, and Danida. On the Government'srequest, the Bank is preparing a projectto finance some of the outlinedreforms. Detailson all of these areas and on actions agreed by the Task Force and the Bank can be found in Chapter Six. Chapter Six also includes previous reforms undertakenby the Government inrelatedareas. InvestmentClimate Assessment & ReformStrategy Pagexii Chanter 1 Introduction Chapter 1: The Challenge o f Private Sector Development in Cambodia 1.1 Poverty, Productivity and Service Delivery The recent National Poverty Reduction Strategy (NPRS) states that "the central objective of the Royal Government's policy is to promote broad-based sustainable economic growth with equity, with the private sector playing the leading role."12 This statement reflects both an important insight and a set of challenges. It is a recognition that the private sector is key to sustainable poverty reduction, but challenges policymakers to (a) identify ways to increase its growth; (b) do so in a way that improves the distribution o f wealth, or at a minimum,broadens the base o f higher-productivity enterprise; and (c) do so in a way that is sustainable. The challenge is formidable and long-term. Cambodia is a poor, rural country o f 13.1 million, with over a third o f its people living in poverty; over 80 percent in rural areas. More than two decades of conflict, followed by embargo, have marked its history since independence in 1953. It is well understood that among the many tragic consequences of Cambodia's political history was a depletion o f many of Cambodia's most skilled people - intellectuals, craftsmen, artists, engineers, and others - who may have helped form a nucleus o f a growing entrepreneurial class in the right enabling environment. Along with the depletion o f human resources was the loss o f the social institutions - organizations, norms, rules, and basic trust - that supported the productive interaction of citizens in the form o f economic exchange. As Nobel Laureate Douglass C. North put it in his prize lecture, "it i s the admixture of formal rules, informal norms and the enforcement characteristics that shapes economic performance. While the rules may be changed overnight, the informal norms usually change only grad~ally."'~Cambodia's lack o f a strong industrial tradition and the extent to which its governance has either been externally influenced or unresponsive to the needs of domestic entrepreneurs has meant that Cambodia has not benefited from a long history o f experiences crystallizing themselves in the laws, institutions, services, marketplaces, information channels, and norms that form the basis enabling environment for the private sector. Another feature o f Cambodia's post-conflict transition is the fact that the human and financial resources in the public sector are overstretched. This has several implications. First, basic services to be delivered by the Government are lacking, and the scarcity o f those services (electric power, water, etc.) is an important feature o f the business environment since the scarcity i s reflected in pricing. Second, in part because salaries are necessarily lower than would be without a severe budget constraint, many civil servants appear to be exploiting opportunities to seek rents. This complicates the business environment and links progress to civil service reform. Thirdly, any strategy going forward to improve the business environment must consider, wherever feasible, better targeting o f public resources. This may take the form of redefining the role of the state away from resource-intensive roles and towards policy setting and protecting service delivery standards. It also means leveraging, where possible, the role of the private sector and civil society in establishing institutions and market-based accountability mechanisms. In the public and private sectors, institutions required to effectively carry out a more focused and market-based mandate are weak, and capacity building must be considered integral to private sector development. "Royal Government of Cambodia, hhtional Poverty Reduction Strategy, February 2003. p. iv. "Douglass C. North,Economic Performance Through Time. Lecture to the memory o fAlfred Nobel, December 9, 1993. Investment Climate Assessment & Reform Strategy Page 1 Chapter 1 Introduction The economic landscape reflects this lack of key institutions, most notably the rule of law. A large share o f the private sector operates informally, including businesses that operate on a small scale and other businesses that operate illegally. Rural businesses appear to serve only local markets, primarily individuals and other small businesses located in the immediate vicinity. Light manufacturing or capital- and knowledge-intensive agribusiness with longer payback periods are eschewed in favor of trading businesses, garments, services or tourism, which depend on either low capital costs, high margins, or in the case of tourism, unique cultural assets. Cambodia has also been home to many businesses that have taken advantage of the lack of established rule of law to exploit human or natural resources, including trafficking o f people, smuggling, and illegal logging. The Government`s understandable reaction to this type of activity has been to impose bureaucratically-enforced regulations and inspections. These tools have not always had the desired effects, and form an important part o f the perceptions o f businessmen. Clearly, any PSD strategy must offer more efficient tools to manage risks and protect the public interest. Beyond human and social capital, physicalinfrastructure is lacking. Cambodia's indicators for road density, teledensity, electricity generation capacity, and availability o f water are among the lowest in the East Asia and Pacific region. The absence of public services has resulted in extremely high levels of self-provision o f services at high cost. Over 40 percent of small firms in rural areas, and 39 percent of all firms, generate their own electrical power, while 73 percent of small firms inrural areas have their own well (24 percent o f all firms). The authorities have taken a pragmatic and open approach to the private provision o f infrastructure. Private provision o f public services in Cambodia takes several forms, ranging from entry o f entrepreneurs in rural power and water, contracting of health services, privatization, joint ventures in telecommunications, and concessions to private operators to manage existing state assets in transport. The issue in Cambodia i s not only to open to private investment but to ensure that it i s done competitively, transparently, and has the highest possible development impact. Since service providers are often granted long-term rights to manage monopoly assets, the only opportunity for obtaining the benefits o f competition comes during contracting. Unfortunately, competition and transparency are not frequently features of infrastructure transactions in Cambodia. Because they are not conducted through competitive processes, these deals cannot hope to extract the efficiency gains that are the central promise of private provision. It is clear, therefore, that private sector strategy must consider infrastructure service delivery both as a feature of the investment climate, and as an important source o f growth. This i s the subject of Chapter 4. Yet, despite the burden of political and economic history and the absence of key institutions and infrastructure,the private sector has beenable to grow. The garment sector in particular has clearly indicated the potential impact o f a thriving private sector, growing from $20 million in exports in 1995 to over $1.4 billion in 2002. The recent past suggests that the private manufacturing activity can provide jobs at wages that dramatically change poverty incidence. In the period 1998 to 2000, industrial employment grew by an average o f over 43 percent per year, compared with less than 2 percent growth o f both agricultural and service sector employment. Households headed by those with industrial employment had a less than 4 percent poverty incidence` while families in which the head o f household was employed in agriculture or services had poverty incidence o f roughly 80 percent and 10 percent, re~pectively.'~ This growth was highly concentrated and shows signs of being unsustainable. As recently as 1995, the Survey o f Business Establishment identified only 829 firms with ten or more employees." Inpart due to the small base, growth performance was impressive over the 1996-2000 timeframe, in which total manufacturing output grew at 19.1percent, driven by textile/garment at 64.3 percent, followed by electricity and water at 8 percent, and construction and mining at 3 percent each.16 Growth i s exceptionally dependent on FDI, which comprised over 50 percent o f fixed capital formation in 1998 However, FDI iiiflows have RGC, Ministry of Planning (2002), CambodiaStatistical Yearbook2001 Cambodia Development Resource Institute (CDRI) (2002), Annual Economic Review 2002 l6RGC, MOP (2001), Socio-Economic Development Plan II2001-2005 InvestmentClimate Assessment& Reform Strategy Page2 Chaoter I Introduction dropped each year since 1998, falling from over $230 million in 1998 to just $113 million in 2001 and comprising 40 percent o f fixed capital formation. FDI was closely tied to Cambodia's ability to obtain a share of the protected US and EU garment and textiles markets. The country crossed the $1 billion export threshold several years ago, and exported $1.4 billion in 2002, of which 80 percent were garments. FIGURE 1.1 Annual Foreign Direct Investment 250 - 200 150 0 g 100 50 0 1998 1999 2000 2001 2002 Sourre IMF Because it started so recently from such a low base, the impact of the sector has been small relative to the magnitudeof poverty, and the growth of formal sector jobs has not kept pacewith new entries into the job market. Measured by income or other social indicators, Cambodia is among the poorest countries in the world, ranking 136fho f 174 in the u " s Human Development Iodex. According to the recent National Poverty Reduction Strategy, 4.5 million Cambodians, 36 percent of the total population i s in poverty, living on less than US$O.46-0.63 per day, and 50.3 percent o f children under age five are underweight. Economic growth averaged 6.8 percent between 1994 through 2001, but declining back to 5.5 percent in 2002 and is projected to drop further to 5.2 percent in 2003." Cambodia's low Gross National Income (GNI) per capita in 2002 of US$280 was in fact lower than that o f Lao PDR (US$310), Vietnam ($430/capital), and Thailand (US$1,980).'* Half o f Cambodia's poor would be lifted out o f poverty if six percent growth could be sustained for eight years.'' Roughly 200-250,000 Cambodians enter thejob market each year, sometimes including demobilized soldiers. Many are absorbedby the informal sector. FIGURE 1.2 Poverty Reduction and Employment 90 80 70 60 bY Industry 30 20 10 0 Employment,2001 Growth rate of Share under poverty employment`98-00 Source: Ministry of Planning, CambodiaStatisBcd Yearbook 2001 l7 Source: World Bank estimates. '*National poverty line is measured at a daily subsistence level of US$0.50 per day. l9 UA'DP (2001), United iVations Development Goals: Cambodia 2001. Investment Climate Assessment & Reform Strategy Page 3 Chapter 1 Introduction 1.2 The Competitive Environment Cambodia competes in a globally-integrated, dynamic, and fast growing region. With the exception of Lao PDR, Cambodia's neighbors have all chosen to pursue globalizationas economic strategy, have trade to GDP ratios that far exceed the world average, and usedthe decade of the 1990s to extend this lead. Furthermore, the economies of the region are integrating rapidly through regional trading arrangementssuch as the ASEAN Free Trade Area at the official level, throughnetworkedsupply chains in electronics and automotive manufacturing, through increasingly efficient logistics infra-structure and services,and through investment in roadnetworks. Cambodia is bordered on Thailand and Vietnam - each growing rapidly with distinct factor advantagesrelativeto Cambodiathat make it difficult to identify a growth strategy basedon itsown urban markets. In the battle for the hearts, minds, and purchasing power of the Cambodian consumer, Thailand and Malaysiaare certainly better equipped to provide high-valueproducts that depend on technological or capital intensity, while Vietnam is certainly better prepared to provide inexpensive or labor-intensive products. Cambodia itself has a small domestic market, due bothto its small populationbaseandto the fact that this population is only 18 percent urban, compared with 25 percent in Vietnam and 22 percent in Thailand. Cambodia's urban consumers are increasingly sophisticated and exposed, but will constitute the critical mass necessary to drive investment inalimitednumber of sectors. FIGURE 1.3 Cambodia:Asmall market in a Dynamic Region 140 120 100 80 60 40 20 0 l- 1 Cambodia Lao PDR Vietnam Thailand Malaysia In light of this, Cambodia has wisely chosen the route of globalization. To the Cambodian authorities, WTO represents an opportunity to reap gains from integration with the global economy and broaden its industrial base, particularly in light of its small domestic market. Cambodia completed its negotiations with its Working Party in July 2003 and was unanimously admitted in September 2003. Following endorsementby Cambodia's General Assembly, expectedby early 2004, Cambodiawill become the first least developed country to join the World Trade Organizationthrough a full working party process. This is a substantial milestone not only for Cambodia but for all Least Developed Countries that seek to leverage the benefits of trade. The working party appeared to be influenced by the following reforms and commitments, whichrepresenteffort by a broadrange of Ministries: Cambodia's work toward macroeconomicstability basedon a flexible exchangerate; Newtax and investment regimes, includingamendedLaw on Investment; InvestmentClimate Assessment & Reform Strategy Page 4 Chapter I Introduction Commitments to further progress on legal and judicial reform, including establishment of commercialcourts, as the code of civil procedure, commercialcode, and bankruptcy code; Transparency and continuedreformof state-ownedenterprises and any state-controlledprices; Reform of import licensingregimes; Reformof customs duties and charges andthe provisionof a dispute settlement mechanism; Immediateimplementationo f the Trade-RelatedInvestmentMeasures(TRIMS) Agreement; Implementationof the WTO Rulesof Origin Agreement byJanuary 1,2005; Implementationofthe Trade-RelatedIntellectualProperty Rights (TRIPS) Agreement by 2007; Implementationofthe WTO CustomsValuationAgreement by January 1, 2009; A commitmentto publishall laws and regulationson a website accordingto WTO requirements; Binding export subsidies for agriculture at zero. The Royal Government's commitment to private sector-led growth has been clearly demonstrated by the rangeo f reformsbeing pursuedas a package by a cross-ministerialteam led by Commerce. Many of the listed reforms - particularly the legal and judicial reforms - are substantial undertakings that were catalyzed and rewarded by the accession process. However, many of these laws remain in the General Assembly and constitute a large pipelineof pending legislation. The message is clear - Cambodia has chosen not to protect, but to compete. Accessionto WTO will afford Cambodia market access to member country markets on a most-favorednation basis, but will also intensify competition from foreign goods and enterprises in both domestic and internationalmarkets. WTO accessioncreates opportunities, but will also create a more competitivemarket environment for which an effective, competitive supply response is needed. As such, Cambodia's investmentclimate will need to converge towards internationalnorms by removingthe impedimentsthat put its exporters at a disadvantage relativeto other exporters competing for similar markets- includingChinaandVietnam intextiles. Figure 1.4 Trade in Goods as % GDP Source: WDR 2003 InvestmentClimate Assessment & Reform Strategy Page 5 Chapter I Introduction 1.3 Characterizingthe CambodianEnterprise While the investment climate provides the enabling environment for competition, it is enterprises that actually compete. Cambodia's enterprises are typically small, and currently often not integrated with global - or even national markets. The majority o f the private sector are in services, but within manufacturing, the bulk o f the private sector consists of small agro-industrial firms (e.g., fish paste producers or rice millers). As will be examined in detail in Chapters 2 and 3, Cambodia's domestic supply chains are characterized by substantial impediments created both by the public and private sector, high transaction costs, and uncertainty, which limit these local firms to local, personal markets. The contrast between the size o f a typical agro-industrial firm in Cambodia and Bangladesh or Pakistan is striking.*' Cambodian agro-industrial firms have average turnover of just $10,000 per year, achieved by seven employees. Bangladeshi and Pakistani firms are 22 to 26 times larger in terms o f sales, but with only 4 to 6 times the number of employees. Clearly, labor productivity is at issue, and Cambodia cannot hope to achieve the broad-based growth objectives it has described with dramatic change in labor productivity. The garment sector, by contrast, is designed from the outset to serve global markets and has competitive levels o f output per employee. However, capital investment i s smaller, with implications of any value-upgrading strategy. Chapters 2 and 3 try to identify the specific factors - regulatory, financial, skills, infrastructure - that contribute to this, while Chapter 3 focuses on the question o f integration and formalization. FIGURE 1.5 ~ Agro-Industry: Small Firms Serving Local ...with limited human and financial resources Markets relative to competitors i ' $60003 Avg Enployees 0 Sales /Worker assets Worker 7 53922 I I I 30 20 10 $1CO 00 Cambodia Bangladesh Pakistan Poland Carrbodia Bangladesh Pakistan Poland Garments:Largefirms serving global markets ,..Productive employees, but undercapitalized 700 9 00 - - hQ Employees 5 00 4 0 0 - - 300 - 2 00 100 7 7 r Cambodia Bangladesh China India Poland Cambodia Bangladesh China India Source The World Bank, Productivityand Investment Climae Surveys (PICS) for each respective country 2oThese data are generated from Productiv'ity and Investment Climate Surveys (PICS) conducted in each observed country. As Cambodia is the first IDA member to have carried out a PICS in the East Asia region, sound comparisons with other firms in East Asia and Pacific are not currently available but are expected over the next two years. InvestmentClimate Assessment & Reform Strategy Page 6 1.4 The Strategic Challenge A decade after the elections of May 1993, Cambodia faces a historically-important opportunity. As recently as 1989, all enterprises were state-owned, prices were controlled,and economic planningwas centralized. During the initial decade of democracy, pricing and exchange rates have been liberalized, macroeconomic stabilization was largely achieved, a two-tier banking system was introduced and subsequently reformed, trade liberalized, prices freed, and the number of state enterprises was substantially reducedthrough privatizationand leases. A public enterprise law was enactedthat legislateda level playing field between state and privately-ownedfirms, and many of the most obvious examples of direct state ownership have given way gradually to private investment. In 1994, the creation of an investment climate open to foreign investmentwas signaledthrough the passage of the Law on Investment, resulting in a substantial increase in FDL2' During this time, the Cambodian economy has withstood a number of shocks, includingpolitical violence and killings, particularly in 1997, the Asian financial crisis, floods, anti-Thai riots, and SARS, and generally exceeded 5 percent growth. The year 1997 appears in retrospect to have been a turning point, to the extent that FDI has declined progressively since that point. However, over the decade, it has never (a) broken the frequent impression of both foreign and domestic investorsthat corruption is not only tolerated but a basic way of doingbusiness; (b) truly clearedthe legacy o f economic history by fully empowering the market and moving away from direct contact and control of producers; and (c) firmly established confidenceamong domestic and foreign investorsthat the political risk and uncertainty are of the past. Many observerspointto the Government-PrivateSectorForum, an open and constructive mechanism for dialogue designed around seven working groups:' as an indication of recent progress, Clearly, despite the Forum and other mechanisms, policymakers have not fully convinced investorsthat Cambodia is on the pathto sustainableprivate-ledgrowth. Why is today different? The Royal Government of Cambodia faces its second decade with a mandate from relatively smooth election^:^ new acceptance into the international community through WTO accession, security in the sub-region, an absence of economic crisis, signs of growth in all major markets, and increasing partnership among donors. These are many of the pillars on which a new platform of economic growth can be built. What remains to be achieved is a credible program of reformthat addresses the most findamental issues impactingthe privatesector. The basic problem, as described above, is to accelerate and broaden the process of establishing formal private enterprise and integrate into global markets. As Country EconomistNick Stern advised the Cambodian authorities, "the lesson from countries that gain from integration- improve the investment climate and invest in people. For Cambodia, addressing governance can raise productivity and integrate the informal sector."24 The Investment Climate Survey and value chain analysis provide a startingpoint to help understandthe status of the institutions,formal and informal,that governperformance. While it is widely knownthat a variety of administrative and market-basedbarriers impedethe development o f the private sector in Cambodia, very little baseline data currently exists, particularly regarding the performance of the private sector, to help guide the Government in making sound policy decisions. The objective of this project is to identify specific administrative and market-basedbarriers to growth, quantify *`** The World Bank (1999a): Cambodia Public Expenditure Review. Government-Private Sector Forum working groups are Banking and Finance; Export Processing and Trade Facilitation; Manufacturing and SMEs; Energy and Infrastructure; Agriculture and Agribusiness; Tax, Law and Good Governance: and Tourism. Each Working Group is co-chaired by a nominee of the Government, typically a Minister, and a nominee o f the private sector. The IFC provides coordination and support to the Forum. 23 The elections. while considered fair by international observers, were followed by a protractedperiod o f negotiationto form a new '`government.a At time of writing, these negotiations have not been completed. "Building Climate for Investment, Growth & Poverty Reduction in Cambodia." Presentation by Kicholas Stern, Vice President and Chief Economist, World Bank, May 2003. InvestmentClimate Assessment & Reform Strategy PageI Chapter 1 Introduction the impact of these barriers on the competitiveness of companies operating in Cambodia, and to shed light on possible policy options to help remove distortions that impede the development ofthe economy. Because o f the magnitude of the issues and reforms required, private sector development implies strategic choice. Institutional development and structural reform call for considerable financial and managerial resources. I t is important, therefore, that considerable effort be invested in deciding which institutions are most important, and sequencing and focusing these in a way that is most conducive to sustainable reform. This does not necessarily mean "picking winners." Rather, what it means i s evaluating the potential consequences of various reform options on Cambodia's strategic goals, sustainable private sector-led growth with equity/broad-based employment growth, in order to provide a coherent path most likely to provide a payoff. At an aggregate level, there are many impediments that face the entire private sector, for which the decision to prioritize is non-controversial. However, with many policy or institutional investment options, particularly at the sectoral level, there will be tradeoffs: equity vs. efficiency, rural vs. urban, short-term investment vs. sustainability, human capital vs. physical capital. We note, for example, that Export Processing Zones have come into favor. They have a particular logic that rests on labor costs and geographical advantage, but it is not clear that they would have the type o f broad-based impact that is the imperative of the NPRS. The Government's strategy of agricultural modernization and diversification through agricultural-based manufacturing may have a broad impact, if impediments can be removed. To help prioritize and undertake reforms and investments, the Royal Cambodian Government is developing a private sector growth strategy, anchored in Cambodia's success as the f i r s t least-developed country to join to the World Trade Organization. WTO accession will result in substantially improved market access for Cambodian producers; yet WTO does not provide the supply responseto the market. I t is clear to the RGC that opportunities afforded by WTO will not result in growth o f productive employment unless business environment constraints are removed and market-supporting institutions built. The RGC has asked the World Bank Group, including the World Bank, Mekong Project Development Facility, and International Finance Corporation, to support the development o f this strategy, and the Bank has agreedto provide analytical inputsto the strategy inthree stages: 1. A Value Chain analysis, which was delivered in June 2003. I t employed a channel mapping technique to help quantify both production and administrative costs associated with operating a business in Cambodia. The use o f this technique resulted in a detailed breakdown o f both administrative and production costs, which were then selectively benchmarked against costs incurred in similar enterprises operating in other countries. The administrative barriers identified through this process were then matched against specific laws and regulations to help focus the attention of the Government inintroducing policy reform initiatives. Investment Climate Assessment, based on a survey of 502 urban firms, 200 rural firms, and 100 urban informal firms. The results o f this survey are described in the current document. The importance o f this approach is that it is based on the private sector`s own views and based on comparing answers provided by the private sector in Cambodia with similar answers provided by the private sector in other countries. Since Cambodia has taken the commendable policy route of economic openness, it is important that it employs benchmarking with other countries as a tool for policy reform because, in many ways, its investment climate must now be seen as part o f its international competitiveness. 3 . PPI Governance Framework. The third part of this series will be a framework to improve the role of the private sector inthe delivery o f public services. The Productivity and Investment Climate Survey was conducted to focus on the microeconomic and structural dimensions of the business environment, viewed in an international InvestmentClimate Assessment & Reform Strategy Page 8 Chaoter 1 Introduction perspective. To this end, the remainder of this chapter looks in detail at factors constraining the effective functioning of product markets, financial and non-financial factor markets, and infrastructure services, including in particular,weaknesses in an economy's legal, regulatory, and institutionalframework. It does so by identifying three things: the reform priorities of Cambodianbusinesses, areas of elevated costs and delays, and the relationship of key investment climate variables to firm performance. However, a survey by itself will not fully reveal the reform agenda for Cambodia's Table 1.1. economy because firms express private benefits (e.g., lower taxes) while governments must be concerned with public benefits (e.g. public revenue for social purposes), the deviation between private and public time horizons (e.g. government may wish to invest in reforms with a long-termpayoff that are of little interest to entrepreneurs today), and the limited nature of the private sector given existing weaknesses in distortions (Le. surveys cannot interview investors who never enteredthe market). The World Bank Group oversaw a survey of over 500 enterprises in five main cities. The survey questionnaire was built upon the Bank's standard core investment climate survey and implementation methodology, which has been or will be administered in over 60 countries worldwide. The survey allows countries to understand enterprise performance in international comparative perspective, as well as to better understand which investment climate conditions may be impeding growth or imposing excess costs that constrain competitiveness. The questionnaire contained additional questions to explore the issues of governance, regulatory and administrative compliance costs, and logistics. The sample is organized into key sectors, so that performance (productivity and growth of investment, sales, and employment) can be meaningfullymeasuredand relatedto investment climate variables. The survey, successfully administeredby IndochinaResearchLimited (IRL) inearly June, interviewed managers of 502 enterprises in 10 sectors in five major Cambodian cities: Phnom Penh, Siem Reap, Kampong Cham, Sihanoukville, and Battambang. These enterprises ranged in size from micro (fewer than 10 employees) to large (over 100 employees) and included both domestic firms and those with foreign ownership. This sample is the basis for most o f the analysis inthis chapter and the next. In addition to the main survey, a survey of 200 rural non-farm enterprises was conducted, evenly divided between rural firms around Battambang, Kampong Som, Kampong Chhang, and Kratie. Comprised entirely of firms that were private, domestically-owned, and non-exporters, the random sample included 82 percent micro enterprises and 18 percent SMEs. 44 percent of firms were registered, while 56 percent were not. By activity, firms were divided between consumer services (30 percent), retail (30 percent),and foodprocessing(40 percent). ImestmentClimate Assessment & Reform Strategy Page9 Chapter 1 Introduction Finally, to better understand the urban informal sector, 100 unregistered urban firms were randomly sampled in Phnom Penh. 95 percent of these were micro enterprises, all were private, and none exported. The firms were dividedby activity, with 40 percent in consumer services, 42 percent inretail, and 19 percent in food processing. The recommendations presented herein require strong leadership. We have presented what we believe is a credible program of reform; one that does not avoid difficult issues or suggest sweeping, non-specific change. We take as an assumptionthat the General Assembly will ratify the protocolto join the World Trade Organizationand complete the legal and institutional agenda to which the country has committed. The following represents a programof reformthat attemptsto leveragethis opportunity. These reforms are based both on the Government's own statements and commitments, particularly through the NPRP and WTO Working Party Report, and on the confidential views of over 800 firms throughout Cambodia. The reforms will be difficult. But they represent what we believe, and what firms have expressed, are the most urgent actions necessary to unleashthe potentialof the private sector throughout the country ~~ InvestmentClimate .4ssessment & Reform Strategy Page 10 Chapter 2 The Productivity Challenge Chapter 2: The Productivity Challenge NPRS Goals: Ensure a competitive, and eficient investment climatefor foreign and domestic businesses.2s Ensure an enabling environment thatfacilitates a vibrant micro, small and medium-sized enterprise sector able to increaseproductivity and employment. -NP&6 Chapter Summary. This chapter examines the challengethis poses to Cambodianfirms to become more productive, and hence more competitive. As Chapter 1 makes clear, Cambodia's accession to WTO will bring unprecedentedmarket access in export markets, but will also intensify competition from foreign goods and enterprises in both domestic and international markets. Even without WTO, global integration would have inevitably posed these challenges. Cambodian firms lag behind firms in other Asian nations both in labor and total factor productivity. While part of this effect may be attributed to differences in worker skills and firm capabilities, investment climate conditions are significantly associated with firm productivity and growth. Critical investment climate conditions include the quality of governance (and the burden of corruption), regulatory burden, and the weakness of the court system and legal environment for market competition. These are urgent areas of reform. Comparativedata on the transactions costs of firms dealing with key legal and administrative proceduresindicates Cambodian firms face both excess costs (in time or money) and uncertainties. Factors that were not highlighted by firms in the survey - finance and infrastructure- are nonetheless critical for the long-term IC agenda. Productivity is the single most important factor in explaining national income differences among nations. Hall and Jones' review of international evidence suggests that over two thirds of country differences in national income can be accountedfor by productivity, rather than the contribution of physical or human capital. This suggests the central role productivity i s playing in economic growth. Other work has clearly shown that the income of the poor rises in rough proportion to overall economic growth, indicating that a growing economy i s the single best anti-poverty strategy. The effects of growth for poverty alleviation can be strengthenedthrough appropriate investmentsin people. Evidence on productivity indicates that Cambodian firms and workers are generally less productive than those in a variety of countries in the world, including major Asian producers such as China, India, Pakistan, and Bangladesh." Whether in nominal or purchasing power parity (PPP) terms, Cambodian firms are not as productive as firms in these comparator countries. Total factor productivity i s some 18 percentage points below India, 24 points below China, while roughly even with Bangladesh. However, the labor productivity is roughly 65 percentage points behind India, 62 percentage points behind China, and about 10 percentagepoints below Bangladesh. Comparative data suggests that Cambodia's low labor costs do not wholly compensatefor the lower productivity of its workers. *'RoyalGovernment of Cambodia, NationalPoverty Reduction Strategy (Februaty 2003), p.184. 261bid.D. 185. 27Value added was calculated based on survey data provided by firms. TFP was then estimatedusing a Cobb-Douglas production function In the following specification (TFP is the residual): In(0u tpu 4 = c on + P. In(.+if @I+P, In(La b Q8+ p. In( Cap I a te r 1 tu I + Secto r D u m m 3 + 1 e Z P.Dn+8, n - InvestmentClimate Assessment & Reform Strategy Page 11 Chapter 2 The Produchvity Challenge FIGURE2.1 PerformanceGaps ( M i n d hhange Fate,base country:inda) 0TFP Gap ILabPiodWtlUtyGap FIGURE2.2 Value Added: Median Values $4 500 $4000 - $3500 - 1 $2500 - $1 500 4 $1 000 4 $500 Cambodia Bangladesh Pakistan India China 113VaIue Added Per Worker (Nommal) -+-Labor Cost as % Of Value Added Source.The World Bank, PICS for each respectikecountry 2.1 What Drives Productivity? Productivity results from investment in people, institutions, and the investment climate. Further international work clearly shows the important impact o f investment climate conditions on economic growth. For example, countries that globally integrated during the 1990s experienced growth rates of more than three and a half times the rate of countries that did not.28 Other work clearly demonstratesthat key conditions including corruption, regulation, and the rule of law are strongly associated with economic growth.*' It is thus important to understand how Cambodia compares to other countries 28Dollar and Kraay, Trade, Growth and Poverty (World Bank, June 2001). 29Kaufmann and Kraay, "Growth U'ithout Governance", Economia, Volume 111, Number 1 (Fall 2002) InvestmentClimate Assessment & Reform Strategy Page 12 Chapter 2 The Productivity Challenge along these critical dimensions As Cambodia moves towards full global integration, how will other conditions affect its growth? How can the opportunity of WTO be capitalized upon to best benefit the Cambodian people? And what should be the policy priorities in seeking to maximize these gains? Douglass North (1990) discussed how transaction costs, shaped by institutions, critically affect the ability o f economies to realize the gains made possible by increasing specialization and division of labor?' The analysis that follows points to Cambodia's elevatedtransaction costs, created inlarge part by policy and institutional weaknesses. These weaknesses must be addressed as priority reforms if Cambodia is to attain sustained and rapid economic growth, requiredto meet its daunting poverty. 2.2 Investment Climate Priorities The top priorities of firms focused on governance, rule of law and regulation. Cambodia firms identify corruption as their leading constraint to the operation and growth o f Cambodia, followed by crime and anti-competitive practices and/or informal competition. A number o f regulatory concerns rank in the top 10 constraints, including regulatory policy uncertainty, customs and trade regulations, taxes and tax administration, and business licensing and operating permits. The fifth-ranking constraint, however, relates to the legal system and formal conflict resolution. The ninth-leading constraint concerns macroeconomic instability. Somewhat surprisingly, neither financing nor infrastructure placed among the top 10 obstacles as rated by the 2003 sample. FIGURE2.3 Cambodia: Top 10 GeneralConstraints to Private Enterprise Operationand Growth Corruption Crime, theft and disorder Anti-competltive or informal practices Regulatory Pollcy Uncertalnty Legalsystemlconflict resolution Customsand Trade Regulations Tax administration Tax rates Macroeconomic Instability BusinessLicensing, Operating Permits 0 00 10.00 20.00 30.00 40.00 50.00 60.00 70.00 EO.( % of Firms IdentifyingProblemas "Moderate", "Malor" or "Very Severe" Source: The World Bank, CambodiaPICS2003. Comparing these ratings to a parallel question in the 1999/2000, two constraints are rated as more severe: unfair and informal competition and the functioning of the judiciary. While generally there are improvements in the rating of major constraint severity, the perception on the severity of corruption as a constraint remains virtually unchanged. ' ODouglass C. North, Institutions, Institutional Change and Economic Performance (Cambridge: Cambridge University Press, 1990). InvestmentClimateAssessment & Reform Strateg) Page 13 2.3 Governance and Corruption The governance problem is reportedly pervasive, and most firms acknowledge that payments to public officials are frequently, mostly, or always requiredto "get things done". Ofthe 447 firms that answered the question on bribepayments 82 percent (368 firms) reported a positive level o f bribe payments. Some 71 percent o f large firms suggest such payments are frequent. The private sector estimates that the magnitude of payments exceeds 5 percent of annual sales revenue, on average, but increases with firm size and formality, exceeding 6 percent of total sales value for large firms in the main ample.^' Firms' financial data suggeststhat unofficial payments are a large component o f the cost o f doing business. FIGURE 2.4 Percent of Sales Value Paid Informally to Public Officials 7.00 6.00 5.00 4.00 3.00 2.00 1.00 ,o.oo I All Sectors Garment Agro-Industry Source: The World Bank, PICS for each respective country. The share of revenue consumed by unofficial payments is more than double that found in a parallel survey in Bangladesh, Pakistan or China. Clearly, some types of firms pay more than others, and the international comparison for the garment sector paints a particularly poor picture of the relative costs of corruption in Cambodia. The implications either for the total cost to business or foregone revenue to government are substantial. Yet unofficial payments are not the only form o f corruption - firms also acknowledge than an average o f 5 percent o f contract value must be paid to secure business with public agencies. 3' Government officials pointed out that the estimated figure is disputable in its nature and content, since it likely includes the high cost of intermediaries/facilitators used to comply with regulations. Even if the actual amount of unofficial payments to public officials may be somewhat less, the Government acknowledges the seriousness of the problemand is determined to address it through reformboth inthe public andprivate sector. InvestmentClimate Assessment & Reform Strategy Page 14 Chapter2 The Productivity Challenge In many countries, unofficial payments are seen as a mechanism to expedite delivery of services. In Cambodia, this does not appear to be true. Larger firms tend to be more "formal" as measured by the share of income reported for tax purposes. Large firms report over 60 percent, micro- enterprises report 33 percent, and firms in the urban informal sample, less than 2 percent. The larger and more "formal" the enterprise, the higher the bribes as a share of sales. Firms of all sizes acknowledge paying bribes. Statistical analysis of bribe data suggests that it is rent-seeking, with bribe revenue disproportionately extracted from f m s with higher profitability, moreworkers, and capital. FIGURE2.5 EstimatedUnofficialpayments as YOshare of sales r rureign ._ . Large .- C..F J WE>: . ,,icros: Lrban- Rural $ 5 . `' 6.9% 6.1"I" =="` 3.310 4.0% lnformal \on-farm 2.3% 1.3% e>. Source: The World Bank. CambodiaPICS 2003 The "efficiency grease" theory of corruption - that bribes expedite service - does not appear to hold true. Firms note that bribes are routinely required for connection to public services, including power and telephones. There is no statisticaldifference betweenthe speed of administrativeproceduresfor firms reporting higher versus lower ratios of bribes as a share of sales for essential services such as utility connections. Overall, business's view of agency integrity is alarmingly negative, with the Judiciary and Customs viewed the most negatively. Over 80 percent of firms perceive the judiciary and customs negatively. More than 60 percent of firms gave negative ratings to the Ministry of Commerceoffice dealing with trade, the military, and central government leadership. Finally, more than half of all respondents negatively rated pre-shipmentinspectionservices and then national assembly. Taken in total, these reviews suggest a widely-heldview that governmentcorruptionis pervasive. Firms perceive influenceto be concentratedamongcertain privileged groups. Over 70 percent of respondents view "dominant firms or conglomerates in key sectors" and two-thirds see individual or firms with close personal ties to political leaders as wielding substantial influence over national laws and regulations affecting firms. Foreign firms, organized crime, and international development agencies and foreign governments round out the groups perceived by the majority of respondents as wielding at least moderateinfluence over nationaldecisions. InvestmentClimate Assessment & Reform Strategy Page 15 Chaoter 2 The Productivitv Challenee FIGURE2.6 How much influence do these groups have over recent national laws, regulations relevant to your business? Dominant firms or conglomerates in key sectors dividuals or firms wlclose personal ties to political leaders Foreign firms Organized Crime Int'l dev't agencies or foreign governments Other Domestic firms Regional or Local government Business associations Military Labor Unions Your firm 0 10 20 30 40 50 60 70 80 % Reporting Source has "moderate", "major", or "decisive" influence over government decisions Source: The World Bank, CambodiaPICS 2003 2.3.1 Crime and Security Crime, theft, and disorder was the second-leading constraint identified by enterprises in the main sample. Among the sample of 502 firms, 317 (63 percent) report spending money on security measures to protect themselves from crime. 101 firms identifiedthemselves as having sustained positive losses due to theft, robbery, or other crimes in the last year. For these firms, the average loss to crime as a percentage of sales was 2.3 percent. A significant minority o f firms (30) reported losses o f at least 10 percent o f their sales value from theft and other crime. Firms were apparently somewhat reluctant to report incidents o f crime to police - two-thirds of firms suffering crimes sometimes reportedthem to police, but on average they did so in only 59 percent of incidents. Among responding firms, they suggested that police solved 40 percentof cases reported. Compoundingthis is the perceivedfailure ofthejudicial system to enforce laws. Investment Climate Assessment & Reform Strategy Page 16 Chapter 2 The Productivity Challenge 2.4 Barriersto Entry and Competition 2.4.1 BusinessRegistration The business registration process one of the slowest and least affordable systems for business - entry in the East Asia region -is being reformed. .According to the 2003 Doing Business study, it takes 94 days to start a business in Cambodia - 30 days longer to start than inVietnam, and 52 days longer than in Thailand. Especially slow steps include incorporation in the commercial register, VAT registration, and Ministry of Labor notification. Doing Businessmeasuresentry costs interms o f per capita GDP, and by this standard, Cambodia has the least affordable costs in the region at 554 percent o f per capita GDP. This compares to a cost o f 30 percent of per capita GDP in Vietnam and 7 percent in Thailand. The Minister of Commerce has undertaken rapid measures to both reduce the time and cost o f registration. H e has committed to reducing the incorporation cost component from $650 to $280 or less, with a ten-day turnaround time (see Section 5.2 for the detailed process steps). I FIGURE 2.7 ~~~ Time to Start a Business (Days) I Australia Singapore Malaysia TPailand Philippines South East Vietnam Cambodia Indonesia Asia Averaae Source:The World Bank,DoingBusiness Database 2003; Djankov et al. (2003). 2.4.2 Anti-Competitive Practices A majority of firms identified unfair or informal competition as at least a moderate problem. Firms gave a number o f indications o f the ways in which they viewed the economic playing field as uneven. O f a variety o f potential practices o f competitors evaluated, over a third o f firms suggested that competitors conspiring to limit their access to markets and suppliers was a major or very severe problem. This suggests that dominant firms can act with some impunity to prevent entry o f potential rivals. 32 percent of respondents identify the issue of competitors subsidies or toleration o f arrears as at least a major problem, suggesting the perception that government does not treat all firms equally. 31 percent suggested that violation of intellectual property rights posed at least a major constraint. Interviews suggestthat part of this problem lies in the prevalence of fake or fraudulent products, which can undermine retailers' relationships with increasingly quality-conscious consumers. Exporters, who are generally larger, are more likely to have foreign ownership, are subject to more regulatory scrutiny, and are dramatically more likely than non- exports to i d e n t i ~unfair or informal competition as a major or very severe constraint. This difference is InvestmentClimate Assessment & Reform Strategy Page 17 Chapter 2 The Productivity Challenge especially striking with regard to competitors' violation of intellectual property rights, failure to pay duties or observe trade regulations, avoidance o f taxes, and avoidance of labor regulations and taxes. Table 2.1. Practices of Competitors as Obstacles to Own Firm Competition (%finding it a "major" Source: The World Bank. CambodiaPICS2003 2.5 Trade Facilitation Trade facilitation practices in Cambodia stand out in the high costs of corruption and long delays for clearances procedures. Import and export processing, involving a multiplicity of steps, introduce substantial delays, uncertainty, and discretion into the process of trading goods. Among the major steps reported by trading firms are customs clearance, Ministry of Transportation border authorization or border police, veterinary and phytosanitary inspection, and C A M control. Each involves delays, formal costs and informal payments. Customs clearance by itself imposes substantial delays and great variation, and hence, unpredictability. On average, firms report that imports take 6.5 days to clear customs, while exports take 4.5 days. However, this timing i s variable, and firms report that in the last year they have had to wait an average o f over 11 days for at least one shipment, and 16 days to clear an export shipment. Firms report documentation problems in 56 percent o f cases for imports and 41 percent o f cases for exports. FIGURE 2.8 Regulatory Constraints to Cambodian Enterprises Tax administration Customs regulations Standards end certificatic Businesslsectoral licensing Price regulation Registering a new enterpris Business inspections (of all type FirelSaftery and sanitary regulatic Environmental regulation Procedures fcr access to land and premis Labcr regulatio 0.00 10.00 20 00 30.00 40 00 50.00 60.00 70.0C % of Firms Rating Constraint as "Moderate" "Major" or "Very Severe" ~ InvestmentClimateAssessment & Reform Strategy Page 18 Chapter 2 The Productivity Challenge Boundaries between the responsibilitiesof agencies involvedin control over importationsare ambiguous, and lead to overlaps. Inaddition to Customs, CamControl i s responsible for the inspection of goods, both when they enter the country and in the domestic markets. While Customs are in charge of revenue collection, protection o f the economy, and trade facilitation measures, CamControl operates under a legislation that provides that agency with broadly similar powers o f investigation and control. Although controls made by CamControl at the borders should be coordinated, they are often overlapping, and there is apparently no integration o f procedures betweenthe two agencies. Arriving ships are placed under the control of numerous agencies, yet their roles are not clearly identifiable,and their functions could be easily delegated to the key administrations (viz., Customs and the Immigration authorities). Clearance usually involves several agencies, including the Port Authorities, Border Police, Customs, and CamControl. While the role o f Customs brokers or clearing agents would be to facilitate interaction with these authorities, there i s substantial evidence that practices o f some brokers and agents contribute to the unofficial costs. Certification of Customs brokers would in the short term contribute to an increase intheir professionalism and improve egciency and transparency. Procedures are unclear and superfluous. Clearance at the port of Sihanoukville involves, for Customs purposes only, twelve steps, which mainly consist in visiting, sometimes repeatedly, key officials. Importers must see during the clearance (i)Customs headquarters, (ii)twice the chief of Customs at Sihanoukville, (iii)twice the chief o f port Customs, and (iv) twice his deputy; two different positions are responsible for affixing stamps on the declarations. Each step may involve long waits, and possible negotiations. I t is likely that numerous other bureaucratic steps are also necessary at factory premises, and for outward processing, export licensing and duty exemption in Government offices. All cargo that is neither sealed nor pre-inspected by SGS is submitted to a routine X-ray scan (with very limited rates of detection of irregularities), after which a decision is made whether or not to inspect the shipment. All goods taken out of the port can be re-examinedat the gate. FIGURE 2.9 Longest days for exportsto clear customs I o ~ e a n ~ a y a 1 0 Garment -Mean 14 14 Source:The World Bank, PICS for each respective country. InvestmentClimate Assessment& Reform Strategy Page 19 Chapter 2 The Productivity Challenge 2.6 Legal & Regulatory Environment 2.6.1 Regulatory Inspections Cambodian firms are subject to an unusually high number of inspections, averaging 16 per year. A key issue in the application of regulations is the discretionary and often corrupt use o f FIGURE 2.10 bureaucratic poNers when firms interact with public officials. While officials assert that this Number of Enterprise Inspections per Year i s caused by widespread informal and often I illegal activities, an international perspective ~ J 20 25 suggests that inspections are both frequent and 15 imposing. The most common and time , consuming inspection reported is by tax ~ officials, but visits by police are also quite common. ~ management o f Cambodian firms. In general, P e r c e n t o f M a n a g e m e n t Tim e S p e n t Dealing w i t h Public Officials, Regulation Cambodian firms are just behind Chinese firms unofficial payments as a share o f sales revenue rales was noted above. However, in addition, Source: The World Bank, PICS for each respective country specific regulatory and administrative interactions were evaluated in terms o f typical informal payments required. The largest average payment was associated with import and export transactions, but smaller payments were often associated with numerous areas o f regulation, includingtaxation, business registration and licensing and every form o f business inspection. 2.6.2 Tax administration There was an improvement in the perceptionof the private sector on tax administrationsince the 1999/2000 business environment survey, but it still appears to impose substantial costs, both formal and informal. The Tax Department has, with IMF support, undertaken a range of reforms to increase revenue and the results of this work have been impressive. However, there i s a gap between stated policies of the Tax Administration and results reported by the private sector. For example, roughly a third o f firms lnrestmenr Climate Assessment & Reform Strategy Page20 Chapter2 The Productivity Challenge should receive a tax audit each year according to policy. But of firms subject to tax inspections, the average number reported per firm in the last year was just over 7. The average inspection lasted 2 days, generally involved fines, and also involved informal payments inmany cases. 2.6.3 Confidence in the Judiciary As Cambodia's economy grows and formalizes, the judiciary will become more important as a means to protect economic rights of businesses and uphold contracts (including the enforcement o f debt). As noted above, o f a number of public institutions and agencies rated for their integrity, the judiciary rated lowest. In specific ratings of the courts, 91 percent of respondents say that the judiciary is only "sometimes", "seldom", or `(never'' fair or impartial, 83 percent rate it negatively interms of quickness, and 70 percent give a negative review for affordability and enforcement of decisions. The 2003 Doing Business ratings indicate that Cambodia is both a costly place to enforce a contract: "The indicators make clear that contract enforcement in Cambodia i s very expensive in comparison to many other countries in the region, and five times the regional average as measured by percent of per capita income. Interms o f time, contract enforcement appears on a par with Thailand and below the regional average. However, other nearby countries, including Singapore and Vietnam, resolve conflicts inmuch less time." The 2003 Doing Business ratings assign Cambodia a zero, the lowest possible score, in its legal creditor rights index. I t notes: "Cambodia clearly lacks essential structure in both fields - creditor rights and information sharing. There is neither a debtor-oriented rehabilitation procedure in Cambodia nor institutions that assure credit information sharing. The decision to rehabilitate is made by a creditor meeting, once insolvency proceedings have commenced and foreclosure is stayed throughout this process. Direct liquidation is the most likely procedure to be used inthe case o f insolvent debtor firms." 2.6.4 Regulatory and Policy Uncertainty and Regulatory Burden Beyond specific regulations, Cambodia especially stands out in enterprises' evaluation of the consistency and predictability of regulatory interpretation. About 55 percent o f Cambodian firms agree that interpretations of regulation are "consistent" and "predictable", while over 44 percent disagree. This compares favorably to Pakistan, but unfavorably to Bangladesh and China. Among larger firms, less than 49 percent agreed that regulatory interpretations are consistent and predictable, while just 46 percent o f firms with foreign ownership agreed. Policy predictability and, in particular, the formulation and implementation of regulations, was identified as a substantial constraint to firms surveyed. Around 76 percent of firms surveyed identified laws and policies affecting them as to some extent "unpredictable". This negative perception declines somewhat with firm size; nonetheless, over two-thirds o f large firms find such changes affecting them hard to predict. Closely linked to both policy predictability and informal competition is the issue o f regulation. Regulations are generally regarded as constraining, with a majority o f firms identifying tax and customs regulations as moderate or greater constraints. The Index o f Economic Freedom rates Cambodia a 4 in regulation, indicating a "high level": "Cambodia's bureaucracy is politicized, cumbersome, and inefjcient, and this creates problems for both potential and existing businesses. Non-transparent regulation and the lack of infrastructure continue to burden business. " Certain categories o f regulation clearly constrain exporters considerably more than firms producing exclusively for the domestic market, including customs and trade regulations, business registration, business inspections, fire and safety regulations, environmental regulations, and labor regulations. InvestmentClimate Assessment & Reform Strategy Page21 Chapter 2 The Productivity Challenge 2.7 Factor Markets 2.7.1 Access to Capital Although finance is not viewed as a leading constraint by the enterprises surveyed, Cambodian firms receive little external finance, except through informal networks of family and friends. Cambodia is a cash-based economy, and local commercial banks provide only 1 percent of working capital overall and a similar share of investment capital (foreign banks provide slightly more). Within Cambodia, by sector, loans are much more common among manufacturing firms, where 21 percent have a bank loan, compared to only 4 percent o f trade firms and 6 percent o f service firms. Large firms and foreign firms are more likely to have bank credit than small firms: 22 percent o f large firms versus 5 percent of micro firms have bank loans. Demand for formal financing is limited, especially among smaller firms. The survey reveals that less than 4 percent of the firms who do not have a loan have actually applied and been rejected. Conversely, more than 94 percent of the Cambodian firms who do not have a loan have never applied for one. When asked why, about 83 percent o f these firms respondedthat they did not need a loan. Cambodia is a cash economy. One important explanation i s the large amount of cash kept outside o f the banking system. Family and friends provide an unusual amount o f finance (roughly one-fourth all finance overall). These personal networks appear to be preferred to the formal financial system, which requires disclosure o f closely-guarded financial information and may carry a certain stigma among the more traditional firms. For the generally very small enterprises in both the rural non-farm and urban informal samples, family and friends provided close to 50 percent of overall financing. Growth in Cambodia is financed through the use principal (borrowing cash from friends and family) rather than leveraging principal to gain access to debt instruments. In the absence o f debt as a growth tool, the rate o f economic growth is limited by the availability o f cash. All Firms Micro Small Large Foreign- Domestic The enabling environment is not conducive to secured lending. Bankers note high reserve requirements contribute to higher interest rates. Limited competition, poor information and high risk contribute to a general reluctance o f banks to lend to all but well-known and trusted firms. Specifically, in Cambodia much of the land and capital that might serve as collateral is unregistered, enterprise financial records are generally weak and unreliable, and enforcement through the court system is difficult. Efforts to Investment Climate Assessment & ReformStrategy Page22 Chapter 2 The Productivity Challenge foreclose on collateral generally yield lengthy court procedures with multiple appeals, and the outcomes are seen as determined by the "highest bidder". Accounting practice i s poor, making client evaluation more costly. Furthermore, there is no credit bureau and sharing of credit records between banks has been discouraged by privacy regulations. Inaddition to these business climate factors, credit skills inthe banking sector are weak and in needof development. FIGURE2.11. M " " 1 ~ ~ ~ r e e i i oG lnn-h i l l L e g a l C r e d i t o r R i g h t s I n d e x n o n g K o n g S i n g a p o r e T h a i l a n d I n d o n e s i a S o u t h E a s t M a l a y s i a P h i l i p p l n e i V i e t n a m C a m b o d i a ( C h i n a )' A s la A v e r a g e 2.7.2. Worker Skills and the CambodianEconomy Both the economic literature and much o f past analysis of Cambodian human resources suggest the strong role that worker education and skills play in productivity. Much o f the NPRS discussion focuses on the question of employment. Over 200,000 Cambodians enter the job market each year, including demobilized soldiers. The key questions are (a) whether or not the private sector can increase employment at a rate commensurate with new entries and (b) whether the skill composition o f the labor force poses a constraint to employment growth, economic growth, and/or income growth. The nature of employment is predominantly temporary and agriculture, a low-skill sector and by far the largest employer. The lack of technological content o f agriculture keeps down the demand for skilled labor. Nonetheless, wage employment has increased considerably in recent years, especially in the garment and tourism sectors. However, for the most part these two sectors have done little to increase overall demand for skilled workers. Overall, the standard sources o f demand for skilled labor internationally -technology, trade, foreigndirect investment(FDI),andtheintensityofformaltrainingprovidedbyfirms- appear to be weak inthe Cambodian labor market. Table 2.3. Schooling and Skill Content of Major Non-Agricultural Wage Sectors32 Skill Content Schooling-" 1""" .._.l-.l..l_l-l.l" 1"" lllllll.~ ----.----- Skilled Unskilled Manufacturing Total 3.04 96.96 5.39 Garment 1.09 98.91 5.83 Construction 1.64 98.36 5.29 Public administration & defense 42.92 57.08 8.19 Education 99.24 0.76 10.75 Total wage employment (non-agricultural) 26.00 74.00 6.94 Source:The World Bank, CambodiaPICS 2003. "Notes: Fishing is also excluded. Schoolingrefers to mean years of schooling. Skilled occupations are legislators, senior officials; managers, professionals, technicians. and associateprofessionals. Unskilled occupations are clerks, service and sales workers, craft and relatedtrades workers. pantimachine operators and assemblers, armed forces, and elementary occupations. InvestmentClimate Assessment & ReformStrategy Page23 Chaoter 2 The Produchvitv Challenae Formal Sources of Demand for Worker Skills. As noted above, technology, trade, FDI, and the intensity of formal training provided by firms are normally key drivers of demand for skilled workers. Cambodia, however, has few of these. The formal-sector,urban-based sample of the ICA survey captured the upper end of the Cambodian labor market in terms of skills. Table 2.4 reports, for each sector, the number of firms and workers, the percentage of skilled workers, and the percentage o f workers with upper secondary education or higher. It nonetheless reinforces the lack of a dynamic demand for skills. Only 15.71 percent of the firms surveyed export some percentage of their sales (either directly or indirectly through distributors), in spite of the recent surge in garment exports. Foreign investors owned some share of 18.49 percent of firms. Again, the garment industry has the highest average percentage of foreign ownership (71.78 percent), followed at a distance by transportation/shipping/trade and water (Table 14). However, as we have seen, the garment industry in Cambodia is not skill-intensive. Table 2.4. Skill and EducationCompositionof the Workforce by Sector33 No. firms No. workers YOSkilled YOU. Sec + Garment and textile 63 79,130 79.19 33.26 Water 28 592 70.95 35.88 Construction 53 2,588 47.37 13.08 Restaurants,hotels & tourism 110 2,225 60.09 62.04 Information technology/electronics 47 826 56.17 87.26 Foodprocessing 70 725 58.48 13.56 Transportation, shipping & trade 83 1,987 58.03 53.09 Electric power -Total 49 183 85.79 40.19 503 88,256 76.87 34.21 Source:The World Bank, CambodiaPICS 2003. Altogether, 19 percent of workers in the sample use a computer in their jobs (Table 2.5). ITielectronics is the sector with the highest provision o f computers (68.01 percent), followed by transportation, shipping and trade, restaurants, hotels and tourism, and garments. A small percentage of firms do spend on R&D (16.5 percent), with this percentage being highest in garment, followed by restaurants, hotels and tourism, and IT/electronics. Thus, although technology is a potentially important source of demand for skilled workers, it i s unlikely to be a major source in the context of the current labor market in Cambodia. Table 2.5 also indicates that the majority of firms report having adopted new technology (60.44 percent), particularly in the garment industry. This may indicate that there has been a technology-inducedincrease inthe demand for skilled labor inrecent times. Table 2.5. Technology Use and Change, by Sector Computers R&D Nem technology Garment and textile 18.74 28.57 71.43 Water 7.41 10.71 53.57 Construction 3.88 9.43 66.04 Restaurants,hotels & tourism 24.01 26.36 68.18 Informationtechnology/electronics 68.01 21.28 65.96 Food processing 1.08 1.43 51.43 Transportation, shipping & trade 27.46 15.66 54.22 - Electric power 0.55 8.16 44.90 Total 18.83 16.50 60.44 Source: The World Bank. CambodiaPICS2003. Finally, only 22.47 percent of firms provide formal training to workers. Altogether, 16.18 percent of workers in the sample receive training. In general, the most technologically-advanced sectors are those with the highest demand for training, which highlights the importance of technology-skills 33% Skilled is the percentageof total workers in the sector in skilled occupations (managers, professionals, and skilled production workers). % U. Sec is the percentage of workers in the sector with upper secondary education or higher. This information is as reportedby the employer. InvestmentClimate Assessment & ReformStrategy Page 24 Chapter2 The Productivity Challenge complementarities. However, the overall demand for training is small. The average duration of training (in weeks per year) inthe sample is 8 weeks. Inspite of the limited demand, there are positive, sizable, and increasing returns to schooling inthe labor market both in terms o f wagedearnings and employment-related outcomes. A profit analysis of the 2001 Labor Force Survey data indicates that the returns to schooling in terms o f paid employment are very sizable. Having primary school completed increase the chances o f working for pay by 12 percent with respectto no school level completed. Wage returns to schooling increase with school level, but this is more accentuated at the lower and upper ends o f the wage distribution. These returns reflect shortages in the supply o f educated workers and reflect, at least inpart, differences in productivity. FIGURE2.12 Estimated Probabilities of Paid Employment by School Level 120% 1 100% 4 96% No school Primary L.. Sec H. Sec Tertiary I s the current supply of skills a constraint to the development of new sources of growth (as opposed to current sources o f growth)? The current sources of dynamism in the economy, garment and tourism, are likely to do little to increase the overall demand for skilled workers in the labor market. Godfrey (2002) argues that Cambodia enjoys a current comparative advantage in natural resource-based production, initially involving relatively unskilled labor, rather than in the non-agricultural labor-intensive activities for which countries like the Philippines and Vietnam, with high skill levels and labodland ratios, are better suited. Even ifthe economy adopts the path dictated by its underlying comparative advantage, the supply o f skills is likely to be a constraint as the use o f irrigation and modem farming technologies require skilled workers. InvestmentClimateAssessment & Reform Strategy Page 25 Chapter 2 The ProductivityChallenge 2.8 Infrastructure and Logistics Access to infrastructure in Cambodia is relatively poor compared to its neighbors and countries of similar income levels. Cambodia's low income, low population density, and history o f conflict are reflected in the poor coverage, quality, and efficiency of muchof its infrastructure. The services that exist are mainly concentrated in urban areas, and the substantial rural population suffers from lack of access to markets, unsafe and unreliable water supplies, and dependence on traditional biomass forms o f energy or high-cost alternatives. Efforts to augment public capacity and financing through private provision has thus far yielded concessions that were awarded in an uncompetitive and nontransparent fashion, generally yielding high costs to consumers. Power. Cambodia has one o f the lowest electrification rates outside sub-SaharanAfrica; it has no power transmission system and has developed no large generation capacity. Where electricity is available, firms and individual consumers face some of the highest energy costs inthe world. Electricte du Cambodge (EDC), the state-owned utility, operates 22 isolated systems, which serve Phnom Penh and the capital towns o f the provinces. The private sector has also emerged as an important provider, through independent power production (IPPs) providing generation to EDC; through small-scale provision in rural areas; and through auto-generation for individual domestic and business consumers. In addition, there is extensive self- provision. The survey finds that 63 percent o f large businessesand 39 percent overall own a generator. Table 2.6. Cambodia's Infrastructure AccessiCoverage Indicators Includes both mobile and fixed line Source The World Bank, World Development Indicators2002, ITU Yearbook2002 Water and Sanitation. Although over 90 percent of the population lives outside the capital, Phnom Penh is the only city with a municipal water system with significant coverage o f its population (roughly 70 percent). There is little sewerage and no wastewater treatment in the country. Solid waste management consists of open dumping sites. Water supply coverage in other cities and towns is substantially lower, at approximately 13 percent o f residents, while only about 23 percent o f rural residents have access to safe water. The majority o f the systems are publicly owned and operated, but sixteen licenses have been awarded to private providers, offering treated, piped water delivery to parts o f provincial and district communities. Water self-provision is even more common than power self-provision among Cambodian businesses(44 percent o f respondents overall), but declines with firm size. Investment Climate Assessment & Reform Strategy Page26 Chapter 2 The Productivity Challenge Table 2.7. Electricity and Water Self-Provision Cambodia Micro Small Large Exporter Non-Exporter Have own generator (YO) 38.97 27.63 43.72 63.29 54.43 36.08 IHave own well (YO). , A ~ , R G .-.-- -_... 3911 I C AG -.-- --.-- A9 39 I 44.14I 50.88 , Source The World Bank. Cambodia PlCS 2003 Telecommunications. Cambodia's fixed line telecommunications network is a public monopoly covering little more than Phnom Penh. Four mobile companies offer services and internet access that are now available in the capital and even in some provincial towns. Inaddition, two private companies operate international gateway services in a joint venture arrangement with the Ministry of Post and Telecommunications (MPTC). Mobile services are used for basic telephony because the quality of the fixed network is so poor and coverage so low. However, the combined fixed and mobile penetration rate i s currently only around 1.91 per 100 inhabitants (0.25 for fixed; 1.66 for mobile telephony), which is low by both regional and international standards. Cambodia has both high telecom charges relative to other countries in the region, although they have come down in recent years. Residential connection rates, for example, are almost five times those for Malaysia and about double those for Lao PDR. Businessmonthly subscription tariffs are seventimes those o f Lao PDR, almost four times those o f Thailand and Vietnam. As with the energy sector, Cambodia has failed to reap all the benefits o f competition and private involvement in service provision inthe telecommunications sector becauseeachprivate license or cooperation agreement has been promulgated in a nontransparent manner that does not encourage competition. Transport. Despite substantial government and donor investments in transport from the early 1990s, the network elements of the sector - roads, rail, and waterways - still struggle with insufficient maintenance, degradation from floods, and lack o f investment funds, all in the face o f increasing demand. Cambodia has the least developed road network in the region with the smallest percentage o f paved roads. Cambodia's railroad is single-line, slow (average speed o f only about 15 km/h), and inefficient (subject to regular delays and cancellations). The country's rail infrastructure and rolling stock capacity i s considerably smaller than that of all its neighbors, the network remains unconnected to Thailand, and its efficiency is extremely poor. Cambodia's one deep-sea port at Sihanoukville is an inefficient public monopoly, used mainly for general cargo and container traffic, and is the primary channel for imports and exports, handling approximately 70 percent (by weight) o f all cargo in and out o f the country. I t is also one of the most expensive in the region when unofficial charges for container handling, Camcontrol, customs, policing, etc. are included. There is evidence that poor FIGURE 2.13 transportation has a significant 80- negative impact on the operation Cambodian Firms Maintain High lnventoly Levelsto Buffer Uncertainly - and growth of Cambodian firms. Cambodian firms maintain extremely 70 high levels o f inventory compared to 60 firms in other developing countries, indicating greater unreliability o f 50 delivery and/or high transaction costs ' 40 of individual shipments. Inventory t! 30 of inputs (Le., raw materials excluding fuel) as a percentage o f 20 total sales averages 46.3 percent for 10 Cambodian firms compared to 5.5, 12.6, 7, 6.6, and 4.7 percent in 0 Carbodia Baipladesh C m a India Malaysia Pahstai Bangladesh, China, India, Malaysia, Inventory of lnDuts/btal Sales Inventoryof CutDuVTotalSales Source:The World Bank,CambodiaPICS 2003. InvestmentClimate Assessment& Reform Strategy Page 27 Chapter 2 The Productivity Challenge and Pakistan, respectively. Even more striking is the disparity in the level of output inventories (i.e., finished good and work-in-progress). For Cambodian firms, inventory o f output averages 72.4 percent of total sales, while the means for Bangladesh, China, India, Malaysia, and Pakistan are 9.3, 12, 17, 7.5, and 9.6 percent, re~pectively.~~ Furthermore, Cambodian firms experiencing transportation and finance problems suffer greater sales loss due to delivery delays from suppliers. For firms that perceive transportation to be an obstacle to the operation and growth of their business, the average loss due to delivery delays from suppliers i s 5.9 percent o f total sales, while those that do not perceive transportation to be a problem lost 3.6 percent in sales. For large firms, SMEs, and exporters that face transportation problems, the losses are particularly acute at 4.8, 9.9, and 11.5 percent of total sales, respectively. Large firms, SMEs, and exporters who did not perceive transportation to be an obstacle reported much lower losses due to delivery delays from suppliers o f 1S, 3.2, and 3.7 percent o f total sales, respectively. Similarly, the need to maintain high levels of inventories in order mitigate uncertainty in supply chains is reflected in the negative impact lack of access to financing has on the operations and growth of Cambodian firms. Better access to finance allows for the flexibility and means to stock up on crucial inputs necessary for continuous production. Expectedly, firms that perceive access to financing to be an obstacle suffer greater sales loss due to delivery delays from suppliers than those that do not, 6 versus 3.7 percent of sales, respectively. For SMEs and exporters that face access to financing problems, the losses are particularly acute at 8.1 and 8.8 percent of total sales, respectively. SMEs, and exporters who did not perceive access to financing to be an obstacle reported much lower losses due to delivery delays from suppliers of 4.4 and 3.7 percent o f total sales, respectively. The working capital demands imposed by unreliable and costly transport i s especially visible among rural nonfarm enterprises surveyed separately, which keep much higher inventories than their urban counterparts (see below). Cambodia has the least developed road network in the region with the smallest percentage of paved roads. Given the fiscal constraints facing the Cambodian government, private provision o f services is an important tool to achieve service delivery goals. In the absence o f an appropriate legal, institutional and regulatory framework, however, many ofthe benefits frequently associatedwith private provision are weak. Despite the poor quality, quantity, efficiency, and cost-effectiveness of most of Cambodia's infrastructure system, infrastructure does not appear among the leading constraints rated by the 2003 survey sample, even among rural non-farm firms. There are a number o f likely explanations for the "low" ranking o f infrastructure among the key constraints. These are explored in some detail in Chapter 4, which also describes the relevance and importance o f an enhanced role for the private sector in infrastructure and public service delivery to Cambodia's overall PSD strategy. 2.9 Rural, Urban, and InformalInvestment Climate Inthe context of understanding the possibility of diversification, it is important to understand how the investment climate may be different outside of the capital. It i s clear that the investment climate in Battambang and Kampong Cham, two important areas for agro-industry, needs particular attention. While investors/enterprises inKampong Cham appear extremely displeased across all categories, investors in Battambang appear particularly concerned about anti-competitive practices by other firms and corruption. Firms in Sihanoukville and Siem Reap appear to be the least constrained, perhaps indicating a favorable environment for investment intourism. l4All firms with inventory shares 3 times the interquartile range above the third quartile are classified as outliers and dropped from the calculations. InvestmentClimateAssessment & Reform Strategy Page28 Chapter 2 The Productivity Challenge The national government is viewed unfavorably by those outside of Phnom Penh, and this appears associatedwith degree of formalization. In light ofthe problems firms encounterwith corruption and regulation, it is understandablethat 60 percentof firms, and fully 67 percentof micro enterprises,regard national government as unhelpful. Local government is held in higher regard - only 36 percent of firms regard provincial government as unhelpful, while 33 percent view municipal govemment as unhelpful. Perspectives on government helpfulness varied substantially by location, with the most favorable views generally prevailing in Phnom Penh and Battambang, and the least favorable in Kampong Cham. It is worthwhile to note that the three cities with the lowest rating on national government helpfulness are also characterizedby the lowest firm estimatesfor how muchof firm's income is reportedfor tax purposes. A supplemental survey o f 200 ruralnon-farm enterprises in 4 locations was conductedto understand the similaritiesand differences betweenurban and ruralnon-farmenterprises. These firms were found to be mostly very small - 90 percent classified as micro-enterprises(fewer than 10 employees) and 10 percent classified as SMEs (10 to 100 employees). A second supplemental survey was administered to 100 urban informal enterprises - of which 95 percent were micro-enterprisesand 5 percent were SMEs. Virtually all firms were unregistered with the centralgovernment,although over a quarter of the rural firms had licenses from local governments. The rural non-farm sector is principally run by sole proprietors: 95 percent of businesses are run by one principle owner, while the rest hire external individuals to manage their businesses, Within the urban informal sector, either sole entrepreneurs or their families own 90 percent of businesses, while 10 percent of the businesses take the forms of partnerships. Almost 10 percent of both samples are registeredwith localauthorities. Being informal pays a comparison of formal vs. informal firms shows systematic advantages - to informality. It also shows that formality is a continuum, and even large and foreign-ownedfirms are not wholly formal. First, urban informal firms report themselves to be systematically less constrained than urban formal firms. They suffer less impact from corruption, weakness of the legal system, tax administration, and every other manifestation of public control of the economy. Labor regulations, trade regulations and tax rates were not rated as a major or greater constraint by any urban informal firms, showing the great advantageof informality in avoidingregulatory andtax burden. FIGURE2.14. L e a d i n g G e n e r a l C o n s t r a i n t s , b y Location Corrvirtion trimc.theft iind dirordcr E c o n o m i c , Regulalor) Poiie) L n c r r t i r i n l y Anti-compelitire or i n f o r m a l prsctice9 Le gal s) stemlco nflict resolution C u r t a m r and Trade Regulations Source:The World Bank, CambodiaPICS BIS 2003 Imestment Climate Assessment & Reform Strategq Page 29 Chapter 2 The ProductivityChallenge FIGURE 2.15. Cambodia: Constraints to Urban Formal and Informal Finns Source: The World Bank. CambodiaPICS BIS2003. Overall, while rural non-farm enterprises generally reported themselves less constrained than urban formal firms, they rated three factors as more constraining than did the main group: macro-instability, infrastructure (power, transport), and the cost o f finance. Macroeconomic stability is a concern despite relatively stable exchange rates and low inflation. While agreeing on corruption, crime, and economic and regulatory policy uncertainty as their top three constraints, they placed macroeconomic instability next on their list. Likethe urban sample, anti-competitive and informal practices was among their top 5 constraints. Table 2.8. Top Constraints: Main Sample, Informal, and Rural h'on-Farm Urban- Main Sample Urban-Informal RuralNon-farm Corruption Crime, theft and disorder Corruption Crime, theft and disorder Corruption Crime, theft and disorder EconomiciRegulatory Policy EconomicBegulatory Policy EconomiciRegulatoryPolicy Uncertainty Uncertainty Uncertainty Anti-competitiveiunfair practicesAnti-competitivehnfair practices MacroeconomicInstability Legal systemiconflictresolution Legal systemiconflictresolution Anti-competitiveiunfair practices Customsand Trade regulations MacroeconomicInstability (inflation,. ..)Cost of Financing(e.g. interestrates) Tax Administration Electricity Legal systemkonflict resolution MacroeconomicInstability) Transportation Electricity Tax Rates Tax Administration Transportation Electricity Skills & Educationof availableworkers Tax Rates Source:The World Bank, CambodiaPICS 2003 and CambodiaPICS BIS 2003. Second, all measured costs imposed by the formal economy are substantially less for both urban informal and rural firms. Along a number of regulatory dimensions, both informal and rural firms benefit from being somewhat "under the radar screen" o f public officials. Urban informal firms regard bureaucratic behavior as equally arbitrary as do formal firms, and rural firms have an even more negative view than urban firms o f the consistency o f regulatory enforcement. However, both rural and informal firms are subject to far lower compliance costs, due to their greater informality and smaller average size. They spend much less time dealing with regulations and inspections, report paying fewer unofficial payments, and typically report far less o f their income for tax purposes, and hence, pay very little in revenue-basedtaxes. Formal firms' visibility not only requires higher formal payments to government, but InvestmentClimate Assessment & Reform Strategy Page 30 Chapter 2 The Productivity Challenge also appears to invite greater attention and harassment from public officials. Table 2.9. Business-GovernmentRelations Main Sample RuralArea UrbanInformal Interpretationsof regulations consistent, predictable(% disagreeing) 44.35 53.62 45.54 % senior management's time spent dealing with regulations 11.12 2.37 1.08 Total days spent in inspections or required meetingswith officials (days) 22.70 11.80 12.24 % revenues typically paidto officials to "get things done" 5.18 1.27 2.30 % total firm revenues typically reportedfor tax purposes 48.00 4.95 1.65 Source: The World Bank, Cambodia PICS 2003 and Cambodia PICS BIS 2003. On the other hand, the main survey makes clear that formal participation in the economy brings relatively few of the traditional benefits that it might be expected to bring in a better-developedeconomy. The legal system is held in low regard and protection of property and contractual rights is poorly rated. Formalfirms have extremely limited access to finance, with banks supplyingonly 2 percent of their needs. Anecdote and the value chain study also suggest that informalmarkets may in some respectsfunction more efficiently than formal ones - for example, smuggling is highly developed, quick, and relatively inexpensive,while formal border logistics are weak, slow, and costly. FIGURE2.16. Seasonal Fluctuations in Sales, Urban Informal and Rural Nom Farm Enterprises 2 60 2 40 2 20 2 00 1 80 160 1 40 120 100 InvestmentClimate Assessment & Reform Strategy Page31 Chaoter 3 Diversification Chapter 3: Diversification and Growth NPRS Goal: Export Divers$cation: "reduce Cambodia's dependence on GSP exports and leverage market access opportunities of WTOto diversijj range of exported commodities" Chapter 2, on improving productivity, discussed impediments facing the existing manufacturing base in Cambodia. Chapter 3 discusses diversification - broadening the base o f higher productivity enterprises to include new sectors. The garment sector has driven export growth in the past, but for reasons of equity, risk diversification and poverty reduction, policymakers are interested in broadening the base of growth to include new sectors and economic activities, particularly those that may raise income for the rural poor. Accession to the World Trade Organization and other initiatives, such as the ASEAN-China Early Harvest agreement. provide an opportunity to expand the export base, particularly in agro-industry. But can agro-industrial enterprises replicate some o f the productivity performance o f the garment sector? To understand the challenge of diversification, this chapter compares the conditions and factors contributing to the performance o f two sectors, which are meant to capture the two extremes currently in Cambodia: that which has benefited from globalization - the urban, large scale, and formal sector, represented by the garment industry; and that which remains primarily a local industry: the rural, largely small-scale, and informal sector, represented by agro-industry. The key messagethat emerges is that expanding productivity overall is about removing impediments, but diversification rests to a large degree on creating new institutions. 3.1 The Challenge of Diversification Cambodia's NF'RS calls for more than growth - it calls for the expansion of economic opportunity. For reasons of equity, risk and poverty reduction,diversifying and broadening the base of private sector growth is an important goal. From an equity standpoint, the diversification policy i s a response to imbalanced growth - garments and tourism have expanded at a much faster pace than the national economy since 1997,while sectors that include the vast majority o f workers remained stagnant. Table 3.1. Real GDP Growth by Sector, 1997-2003 Growth Rates (YO) 1997 1998 1999 2000 2001 2002 2003 -_ (est.) _l_l_lI__--- GDP 6.8 3.7 10.8 7.0 5.7 5.5 5.2 Agriculture 6.4 5.8 3.4 -1.5 2.2 -2.7 9.2 Industry 19.6 -2.5 19.3 30.7 12.9 17.7 6.7 (o.w. Garments) 89.9 30.0 34.6 63.4 22.7 21.0 15.0 Services 3.4 4.8 10.9 5.7 4.2 4.5 1.6 (o.w. Hotels and Restaurants) 3.3 -1.3 18.5 14.4 18.1 11.4 -10.0 Source: The World Bank There are risks created by excessive dependence on one sector for a large share of productivity and exports. Garments contributes four-fifths of Cambodia's total official exports of $1.44 billion, but the risks created by the end o f the Agreement on Textiles and Clothing are well known. Tourism has grown rapidly, but the SARS experience is indicative of the volatility o f this sector. InvestmentCiimale Assessment & Reform Strategy Page32 Chapter 3 Diversification From a poverty reduction standpoint, the case for diversification rests on the fact that a majority of workers are located in low;productivity, low-growth, non-exporting jobs and firms. 20,000 firms are involved in agro-industry, a sector that largely does not export. The contribution of agriculture to value added has declined from around 48 percent in 1998 to around 37 percent in 2001.36 Industry, with only 8 to 9 percent of employment, has increased its contribution to GDP from 14 to 22 percent due to its higher productivity. This imbalance is inpart a result of policiesthat focused on or forced labor into agriculture. In 1968, therewas afar larger share of employmentintrade and ind~stry.~' Increasing post-harvest agro-industrial investment can raise productivity of agriculture and create jobs. From equity, risk, and poverty reduction standpoints, there i s a compelling case for rural agribusiness. As Binswangerrecently observedempirically,agro-industry can havea beneficialimpactboth on inter-villageand within-village inequality by (a) locating in villages with the lowest wages and (b) first employingthe landlesswithin those villages, and ultimately, innearbyvillages?' Diversification means continuing the growth of existing sectors and enabling new sectors to raise their value added so that they attract more FDI and domestic investment. Agro-industry is highlighted in this chapter because it offers real possibilities in Cambodia and because it is typical of the challenges any new sector may face. To understandthe factors that may help close the productivitygap, it is necessaryto explore influencesonthe productivity of small, informal firms. FIGURE3.1. FIGURE3.2. EmploymentStructure Trade 2001 Exports by Sector LFS 2000 Non-Food Food Agriculture-, 1% Foresty & Furnture 20% / 5% Manfactur . 7 % Textile/ Garmnt Constructi 76% on I Source:The World Bank. CambodiaPICS 2003 Source UNCTAD / ITC 35Both statistics are somewhat misleading,since a large share of agricultural trade is informal and not captured in official export or industrial data. Furthermore, a large share of workers who report employment in agriculture are engaged in informal, off-farm employment, "W`orldBank,WorldDevelopmentIndicators2003. 37Ros Chantrabot, La Ripubiique Khmere: 1970-1975, Paris, 1993, quoted in "Cambodia's Economic Developmentand History: A Contribution to the Study of Cambodia'sEconomy," UndergraduateThesis, SophalEar, March 1995. jg Binswanger (2003) is based on empirical evidence from India. It differs from a `factor market dualism' approach, which suggested that the way to increase output per capita was to affect migration to more productive urban employment, thereby increasing average landholding for the remaining farmers. Variants of this phenomenon occur through the region, as labor left villages for factory jobs or EPZs. However; this does little to address the urban informality that often accompanies rural-urban migration. the stress on infrastructure, or the unequal distribution of gains. Binswanger's evidence suggests that off-farm investmentat the village level is equity-enhancing, InvestmentClimate Assessment& ReformStrategy Page 33 ChaDter 3 Diversification 3.2 What Contributesto Diversification? The data suggest that value added per worker is 2.6 times higher in garments than agro- industry. Understanding this gap is key to diversification. Removing impediments that reduce the productivity o f ago-industry could raise value added and attract both foreign and domestic investment. The key, argued in this chapter, is that agro-industry isn't subject to as much competitive pressureas the garment industry. In well-functioning markets, competition forces firms to specialize, raise productivity levels, satisfy customers more effectively than competitors. Firms that fail to do so perish or are acquired by more competitive firms. Survivors stay in the market by raising productivity. This competitive dynamic has influenced garments to a much greater degree than agro-industry. Why? For a line of economists from Smith to Sachs, a key issue is the geographical scope of market^.^' Garment firms compete globally, but agro-industrial firms may compete only locally due to transport or communication barriers, therefore limiting the intensity o f competition for customers. Given the state o f infrastructure in Cambodia, physical market access is certainly a factor, and one that is frequently cited by outside observer^.^' FIGURE3.3. Garments vs. Agroindustry 1 $2 500 - L G G T $2 000 Agroindustry $1 500 $1 036 $1 000 $500 I $0 Value Added iWorker Sales / Employee Assets iEmployee Source: The World Bank, CambodiaPICS2003 But building infrastructure does not necessarily create trade. The new institutional economics (follouing North, Coase, Hayek, Stiglitz and others) has focused less on physical impediments and more on transaction costs - the cost required to search for exchange partners, execute contracts for exchange, and coordinate the production proce~s.~'North (1987, 1990)`* observed that transaction costs are high in absence of formal and informal institutions that emerge to reduce particular risks and costs - the time required to identify buyers and suppliers, the cost o f measuring the value of traded products, and the risk o f a failure o f trading partners to make good on their commitments. H e saw economic development is essentially one o f graduating from informal, personal markets with high transaction costs to formal, arm's 39"The dibision of labor, so far as it can be introduced, occasions, in every art, a proportionateincreaseo f the productive powers of labor.,. as it is the power of exchangingthat gives occasion to the division of labor, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent o f the market." Adam Smith, The Wealth ofn'ations. Ch.3. See also Rodrick. 40See for example, World Bank (1999), Cambodia Poveri;i; Assessment; pp 66-71, which focuses on inadequate infrastructure, transport costs, and particularly, credit to explain the lack o f integrationwith urban markets. 4`Coase (1988),TheFirm, the Market, and the Law. 42N~rth987),"Institutions, TransactionCosts and EconomicGrowth", Economic Inquiry; North(1990), Institutions, Instihrtionai (1 Change and Economic Performance. ~~InvestmentClimateAssessment & ReformStrategy Page34 Chapter 3 Diversification length markets that have lower costs. Institutions (clear rules) create efficient markets, which create competition, which create productivity. A strong base of empirical research has supported the view that institutions go far to explaining differences in productivity among developing c~untries.~`Particularly in rural Cambodia, the absence of key institutions such as legal infrastructure is easily observable, but little empirical research exists that explains the impact of the institutional environment on transaction costs. To have policy relevance, it is insufficient to simply identify that institutions matter or that physical infrastructure may limit the geographical scope of markets. The task i s to help point to specific institutions. For reasons described in Chapter 1, it is clear that the legal, political, and regulatory environment is at an early stage of development, and this limits competition. For the same reasons, it is also clear that the state of physical infrastructure limits the geographical scope o f markets, particularly in rural Cambodia. While both are relevant, from a policy standpoint the implications are dramatically different - one explanation would suggest a focus on building rural transport and communication linkages, while the other may focus on market-supporting, human capital investments such as commercial courts. While both may be necessary, the government must prioritize and sequence these investments. Furthermore, there are problems with an approach that depends exclusively on the state. While acknowledging the role o f non-formal institutions, the process o f development described by North ultimately depends on the emergence of the state as a neutral party, independent o f exchange partners, to enforce contractual commitments. Development o f formal institutions is a largely political dynamic, facilitated by democratic processes. At present, however, given the lack of organization of rural enterprises, low levels of literacy and awareness, the rural private sector is only partially able to influence the design of formal instit~tions.~~ But in Cambodia, an approach to institutions that rests on state enforcement can only be viable in the long-term, because the state's capacity has been depleted by conflict. As described in Chapter 2, the role o f the state is also associatedwith corruption and rent-seeking. In East Asia and Pacific, a strong case can be made that non-state, informal, and private institutions play an unusually large role in private sector development. Much o f the private sectors of Taiwan, Thailand, Japan, and China have evolved from informal trading networks (based frequently on ethnic coinmonality) to highly sophisticated production networks, largely without highly developed formal legal systems enforced by effective judiciaries. Hayami (1998) provides an example o f the role of informal institutions, suggesting that relational contracting mechanisms between rural manufacturers and urban buyers in East Asia (Ja an, Thailand, Taiwan) are facilitated by personal ties, well-developed community norms, and obligations! These community-based institutions have contributed to growth despite absence of the formal rule of law. WorldDevelopment Report 2002: Building Institutionsfor Markets (2002) also recognized the potential contribution o f informal institutions, but also suggested limits. Informal institutions could exclude groups that did not share its cultural characteristics, and could break down when the number of participants or the complexity o f transactions grew. The private sector itself develops ways to cope with high transaction costs. In coordinated value leading firms establish governance standards - rules for how products will be exchanged, verification, and enforcement mechanisms - for large numbers of suppliers. Large buyers 43 See especially Hall and Jones (1999), "Why Do Some Countries Produce So Much More Output per Worker than Others?,'` QzrarlerbJournal ofEconomics: and Keefer and Knack (1997), "Why Don't Poor Countries Catch Up: A Cross National Test o f an Institutional Explanation," Economic Inquiry. 44 Donors are active in advising the government on design of formal institutions, but the extent to which the results reflect the institutional requirementsof the local private sector, as opposedto donor experience, is a source of debate. 45 Yojiro Hayami, "Toward an Alternative Path o f Economic Development" in Hayami (ed.) (1998), Toward the Rural-Based Development of Commerceand Industry: Selected Experiencesfrom East Asia. 46 As an analytical tool, the value concept popularized by Michael Porter (1980), Competitive Strategy: Techniquesfor Anaiyzing Industries and Competitors, helps to illustrate the economic actors and agents value-addingprocesses both inside and outside the firm. InvestmentClimateAssessment & ReformStrategy Page35 may often outsource verification to third parties, or may provide technical, financial, or material support to help value chain participants meet their obligation^.^' Suppliers are rigorously measured against standards that often are more rigorous than regulatory norms, and those that cannot adhere to the established norms simply exit the chain. This form of governance clearly addresses North's variables - standardization/ measurement, transaction processes, and enforcement, but without relying heavily on public institutions. The incentive to join and remain in a Carrefour, Toyota, or Motorola supply chain i s strong because of the larger firm's market power and its dependence on suppliers to meet customers' cost, quality, and delivery requirements. This same incentive may in other contexts be provided by legal liability to make good on contractual terms. This is not to suggest that the rule of law is less important - production networks are often led by investors for whom the rule of law is asine qua non. But in Cambodiatoday, one can observe several instancesof value-chain driven trade, as discussed inVolume 1. To understand the diversification challenge, it is therefore necessary to understand the competitive dynamics at the sector level, and how trade-supporting institutions, geography, industry structure,and factor markets create the conditions for specializationand productivity gains. 3.3 The Garment Sector Compared with regional peers, productivity and value added in Cambodia appears to be at the low end for both garments and agro-industry. Value addedper worker in garments i s around $1,190 for sampled firms, compared with $462 per worker in agro-industry. However, the Labor Law is currently not enforced in the agro-industry sector, meaning that despite the low value added, the cost structure of Cambodian agro-industry appears competitive FIGURE 3.4, with Bangladesh, India, China, and Poland. The picture in garments is somewhat different. The 1 - Garment Sector: I ratio of labor cost to value added is the highest Value Added Perworker among the major garment sector exporters in the $9000 region, but lower than Poland, which operates in a $8 000 $7 000 higher-value niche than Cambodia. This suggests $6 000 $5 000 that cost competition - which i s more likely to be $4,000 the case as international quotas in textiles are 53 000 $2 000 abolished, will pose a challengefor Cambodia. $1,000 5- 3.3.1 CompetitiveDynamics I I The garment sector is by far the most dynamic part of the private sector, Much Source The World Rmk PIC7 for each reqnective coiintrv attention is paid to Cambodia's garment sector48as a symbol of the impact of private investment and trade on poverty, and because of its explosive growth from exporting $20 million in 1995 to over $1.4 billion in 2003. Cambodia i s on track to export over $1.26 billion to the US market alone in 2003, and is now the 14'h largest supplier to the US market in volume terms and the 2lStlargest in value. The sector has provided employment to over 200,000 factory workers and, assuming a ratio of four dependents for each worker, income for up to one million Cambodians. Along with tourism, it is the largest source of foreign exchange. The sector has been a key driver of Cambodia's integration into the world economy, through both bilateral and multilateral agreements. Particularly through the bilateral agreements, Cambodia's garment sector has pioneeredthe practice of corporate social responsibility and has embedded these principles in the Labor 47Raphael Kaplinsky (2000), "Spreading the Gains from Globalization: What can be Learned from Value Chain Analysis?," Instituteof Development Studies Working Paper 1IO. 48The sector is currently the subject of studies or projects by UNCTAD, UNDP, ADB. and ILO. A full profile of the sector was included in Volume 1, Value Chain Analysis. InvestmentClimate Assessment & Reform Strategy Page 36 Law, adherence to which is monitored by the International Labor Organization (ILO). Some o f the most important economic institutions have been first initiated in the garment sector, including labor unions and businessassociations. Despite the upcoming transition to free FIGURE 3.5. trade, new investment continues to flow. Following two successive years of decline, sixteen New Garment Sector Investment Projects new garment and accessories investment projects 25 with a total value o f $25 million were approved by 0Accessories the Cambodian Investment Board in 2003. In 20 addition, over $39 million in expansion projects were approved for 2003. 15 The scope of competition in garments is 10 not limited by geography infrastructure. The 5 ICA sample o f 55 garment firms directly exported 70.5 percent o f their production and indirectly 0 exported another 19.7 percent. The U.S. is the 2000 2001 2002 2003 destination of 71 percent o f Cambodia's garment Source GMAC exports, the EU 27 percent, and the remainder is distributed among a range o f European and Asian countries. Interviews with industry representatives in Cambodia suggest that, while Cambodia has MFN/GSP relationshi s with a number of countries in industrialized markets49and countries with economies in transition:' the single most important export market continues to be the U.S. Most garment factories are located near Phnom Penh, Sihanoukville, and along National Road 4. The location o f factories appears to reflect sources of labor and transport. The structure of the industry is concentrated due both to policy and market causes, but does not appear to reflect monopoly power in the private sector. The garment sector has never been a protected industry and has been export-oriented and foreign-invested from its origin. While it is difficult to determine how many independent corporate entities are actually represented in the sector, as some may belong to a common overseas parent, owners o f the 186 garment factories in Cambodia come from Hong Kong, Taiwan, China, Singapore, Cambodia, South Korea, and the US. Currently, slightly over 8 percent (15 companies) o f the factories command over 50 percent of sales. This high concentration ratio is likely the result of both market and policy causes. Much of Cambodia's exports are in mass-market medium- quality garments that require large production volumes, implying high concentration. Since the banking sector does not provide much o f the sector's working capital, larger, well-capitalized firms have a clear advantage. The concentration does not appear to resultfrom larger firms exercising monopoly power. 3.3.2 Impediments to Competition: Quotas and Bureaucracy While the playing field is not distorted by inter-firm competition, it certainly is distorted by internationaltrade rules. International trade in garments is managed by the Agreement on Textiles and Clothing (ATC): signed as part of the General Agreement on Tariffs and Trade (GATT) in 1994. The ATC lays out a process for liberalization o f yarns, textiles, and garments from 1994 through 2005. Cambodia's industry emerged at the mid-point of this process - within the period o f managed trade. The US-Cambodia Bilateral Textile Agreement o f 1999 offered Cambodia a quota in lucrative segment^,^' which could be increased by up to 18 percent per year based on adherence to core labor standards. The quota for 2003 was 49Countries include:Australia, Canada?SouthKorea, Japan, New Zealand,Norway, Switzerland, US, and EU. "Countries include: Belarus, Bulgaria, CzechRepublic, Hungary, Poland, and Slovakia. Inthe trouser segment, Cambodia producesfor Levi, Original, OldNavy, Union Day,No Boundaries, and LA. Jeans InvestmentClimate Assessment & Reform Strategy Page 37 Chapter 3 Diversification 12 percent larger than the previous year, and the quota for 2004 was increased by14 percent. This economic rent is shared between government, public officials, labor, and factories. Quotas are auctioned, which also favors well-funded firms able to maximize the volume under a specific quota and match this to customer orders. A precise calculation of welfare gains and losses attributable to the quota is beyond the scope of this report, but it i s clear that the arrangements shielded participants from direct competition and offered them artificially high prices. This has helped attract some f m s to Cambodia. As the quotas are eliminated, the garment sector will need to adjust, and this could be painful. When the ATC is finally eliminated at the end of 2004, Cambodia will access the US market on a most- favored nation basis, along with other WTO members, unrestricted by quotas. In this short run, Cambodia may see an increase in investment as garment factories in non-WTO members- who will still be subject to quotas- shift to Cambodia. Inthe long-run, without reform, cost pressuremay force consolidation. It is fair to assume that the post-2005 garment sector will roughly follow the example o f current non-quota exports to the US.52Cambodia already sells much more involume terms outside the quota than inside, and non-quota business has expanded very rapidly. However, prices for products restricted by quota are nearly five times higher than non-quota prices. Furthermore, prices for non-quota sales have declined continuously since 2000 and are now barely above $1 per square meter. As volumes increase and prices decline, the industry is likely to (a) depend heavily on cost competitiveness; (b) become, to a greater extent than before, a volume- driven business; (c) become even more concentrated, with fewer very large factories dominating the sector; and (d) consolidate across borders, as firms that are currently located in multiple locations decide to concentrate production to enjoy economies o f scale. While none o f these factors are expected to be immediate, it is not clear how long Cambodia will remain a large garment exporter. FIGURE3.6. - Garment Sales to US: prices outside quota declining Higher volume outside quota ... ...but $6.00 1 f b $5.00 a 400 $4.00 300 U -1 L $3.00 -.og E 200 '% 100 $2.00 o n 2 $1.00 d 2000 2001 2002 2003 $0.00 2000 2001 2002 2003 (.Outside Quota OUnder Quota 1 -Outside Quota Inside Quota Source:US Customs Data, Bank Staff Analysis "The U.S.does not place quantitative restrictions on all garment product categories. The current non-quota sales do not perfectly represent the post-2005 situation, as the dynamics o f the protected products may be considerably different, and producers in different countries may choose to leave or continue to compete in many sectors. Investment Climate Assessment & ReformStrategy Page38 Chapter 3 Diversification Cambodia is trying to differentiate itself through corporate social responsibility (CSR), but this may impact only a small share of current exports. The ILO synthesis report53is influential in confirming the compliance with internationally recognized core labor standards and the Cambodian labor law, and thereby provided the U S confidence that Cambodia was largely adhering to its international FIGURE 3.7 labor commitments. Even after the quotas end, the Government would like to maintain CSR as a potential source of advantage. The Foreign Investment Advisory GovernmentInspectionsbySector Service (FIAS) is currently engaged in an effort to quantify 35 the impact of Cambodia's CSR approach in order to 30 evaluate CSR as a survival strategy. There is no doubt that 25 some buyers will prefer Cambodia for this reason, and the 20 FIAS work will help identify both the size of this potential 15 market niche and what will be required to support it on a I sustainable basis. This strategy would be even more viable in combination with other efforts to raise skills to pursue higher value product niches. However, necessary Gamnt Food Processing 1 ~ ITlElectmlcs investments in skills have not been made. I Source. The World Bank, Cambodia PICS A more viable strategy for all segmentsmay require both raising value (including through corporate social responsibility) and reducing the cost o f bureaucracy and related corruption that cannot be passed to buyers in a fully-competitive environment. As described in Chapter 2 and in the Value Chain Analysis, export and import transactions are closely associated with bribe payments to a number of agencies. The average cost of each bribe is also highest for importing and exporting, which the garment sector must do for each order. As Cambodia moves toward a highly competitive free trade environment, the incremental cost of bureaucracy and corruption may outweigh the competitiveness o f Cambodian labor. Using the example of Denim Jeans from the Value Chain Analysis, the labor content o f a typical order 5 button 10/12 weight denim jeans isjust 15 percent. FIGURE3.8 7-p Stages of Admin. Costs BribeCostsAssociatedwith Regulations Production $450 Pre-production $448.20 (44%) 5e2 Import clearance $4W Transport $350 Production $30.83 (3%) $300 ~ Cuttingilayering 1 $250 0Mean Sewing/assembly 5 $2W 5 4 Finishing 1I $132.08 (13%) $150 Finishing .EB$1W S50 Post Production $406 (40%) 5c 50 Source:The World Bank, CambodiaPICS 2003. 53International Labor Organization (2002), Second SynthesisReport on Working Conditions in Cambodia's Garment Sector. InvestmentClimate Assessment & Reform Strategy Page 39 Chapter 3 Diversification Consequently, even if labor productivity is improved, that alone would have limited any impact on the overall competitiveness of Cambodian garment exports. Thus, focus must also be directed at understanding factors that contribute to reducingmaterial input costs, which dominate the overall cost of production. The value chain analysis reveals that administrative costs associated with importing denim material and accessories, producing and exporting denimjeans in a 40 foot container may cost as much as $1,017.37 before transport costs andGSP quota fees.54 FIGURE3.9 Administrative Interventions -. Import/ProductionI'Export o f 40 F t Container o f Denim Jeans Trucking High fuel costs Quality certificate.48% CP inspection:20% Phnom Penh: SO,42/litre Bangkok: 50 32iiitre Customs Clearance Saieon: $0.30/litre Import permit: 40% Document process: 40% Including late Chief inspector signature: 0% charge Process CP application:S% Document check: 8% assessed by government CO application,28% inspectors Visa:45% Late charge assessed by Q government inspectors Source The World Bank (2003c), Towards a Private Sector-Led Growth Strategyfor Cambodia - Volume I. Value Chain Analysis. As evident from the value chain, 55 muchof the administrativecosts are incurredduring importing and exporting stages of production, particularly by the Ministry of Commerce/CamControl and Ministry of Economy and Finance/Customs, and packing and loading finished goods were often cited by factory managers as disruptive and unnecessary. In some cases, government inspectors would arrive late while containers were already beingloadedto meet a shippingdeadline. Insuch instances, loadersare requiredto unload the already filled container to allow inspectors to check the cargo. In another instance, inspectors come to the factory site merely to inspect the quality of the boxes in which the finished goods are being packed. Such disruptions are contributing to investor frustration, as well as costly delays, both resulting from overtimepayments for factory workers andinspectors, and sometime missingshipments. 54A 40 foot container can carry approximately 2,250 dozen trousers. 55The question of linkages is a longtime staple of development literature, going back to Albert Hirschman (1958), The Strategy of Economic Development, and linked closely to national competitive advantage and productivity by Michael E. Porter (1990), The Competitive Advantage of Nations, -- see p. 105, on Japanese silk industry, particularly relevant to Cambodia, and Michael Fairbanks (1997) Plowing the Sea, p. 76-92. A large literature explores supply chains in the context of understanding spillovers from FDI. The supply chain is increasingly relevant to looking at SMEs. InvestmentClimabe Assessment& ReformStrategy Page40 3.3.3 Efficient Factor and ProductMarkets Labor is the critical input, and appears to be available because the garment sector pays wages that exceeded prevailing wage levels. Skilled labor comprises only 1.1 percent o f labor use and unskilled labor 98.9 percent, according to the Labor Force Survey. Training unskilled labor is more of a concern. While there has been a vocational institution supporting the garment sector with Japanese funding, skilled labor, primarily foremen and supervisors, were frequently imported by garment factories from other overseas operations of the parent company. The average years o f schooling o f workers in the garment sector i s 5.29 years. Because the current operations are not particularly skill intensive, the availability of skills does not appear to be a severe constraint on productivity. However, should more complex, value- added strategies be employed inlight of full competition, skill shortages would ensue FIGURE3.10 The Garment sector obtains Sources of Eternal Finance for Investmena informalSources capital from parent companies. While a l l firms in Cambodia lack access to ,M capital relative to international peers, it is 0Sales of Equity 1w clear from the analysis that the garment 2 sector has superior access to commercial 80 i= 60 0Family & Friends banking and investment funds. Nearly 340 15 percent of external financing needs for - 2 0 o Commercialbanks I investment are from formal sources s o Garment Agrdndusw Services investmentfunds I nOther leasing including banks, investment funds, credit cards, and leasing. Source: The World Bank, Cambodia PICS 2003 Infrastructure. Infrastructure adds to the cost of production, but reliability of power inputs does not appear to be a major constraint due to a high incidence o f self-provision. 67.2 percent o f surveyed garment firms have their own generator, and 19.7 percent have their own well. While the degree of self- generation is extremely high by international standards, only 3.2 percent o f production was seen as lost due to power failures. Containerized shipments are typically trucked down NR4 to the Port of Sihanoukville. A large number of firms report losing sales due to delays, related in part to management o f infrastructure. Trucking services are fairly competitive, and the key issue appears to be unofficial charges intransit. 3.3.4 Trade-Supporting Institutions The success of the garment sector has depended on both formal and informal institutions that link Cambodia with network partners, provide trust, and enforce terms of transactions. Formal institutions exist to establish and authenticate country of origin, to manage quota allocation, to verify compliance with labor standards, to verify fulfillment of quotas both on the Cambodian side and in the export destination, to verify compliance with duty exemptions, and to manage quality. As a private institution, the Garment Manufacturer's Association o f Cambodia is by far the most effective business association in Cambodia and has played a very active role in negotiatingthe US-Cambodia Bilateral Textile Agreement, raising policy issues with the Government, co-Chairing the Export Processing and Trade Facilitation working group, developing policy approaches, sharing potential solutions to problems of logistics, and shares information on market conditions among the 192 or so active members. While not explored in depth, it is likely that informal institutions such as linguistic and cultural linkages with members o f the garment industry outside of Cambodia elements play an import role in facilitating trade. The key issue is to make the formal institutions more effective and efficient. Trade facilitation costs in particular pose athreat to the viability o f this sector, and any sector that exports incost-sensitive markets. InvestmentClimate Assessment & Reform Strategy Page4 1 Chapter 3 Diversification 3.4. Agro-Industry $10,285 Cambodia Bangladesh Pakistan Poland I Source:The World Bank, PICS for each respective country. 3.4.1 Competitive Dynamics Industry structure is atomistic and dispersed. The agro-industrial sector consists of a large number o f small and micro-enterprises, which comprise the vast majority of manufacturing firms in Cambodia - even as a small number of large manufacturers, textiles and garments dominates output. Of over 21,300 agribusiness firms, 91 percent are small, employing less than five employees, and having a capital outlay of less than $1,000. The few large firms in the sector do not constitute a large share of employment, but do play importantroles inproductionand distribution. FIGURE 3.12 Dlstrlbutlon of Manutaoturlng Firms I 25,000 ~ p o ~- 000 b5.000 P Food beverages &Fabricatedmtal Other Wood and wood Non-mtal mneral Textile and Ulem, rubber,and Paper and paper tobacco products manufacturing products wearing apparel plastics products Source MME I Investment Climate Assessment & Reform Strategy Page42 Chapter 3 Diversification Domestic micro-enterprises and SMEs are not linked as suppliers to large companies and multinationals. Specifically, urban informal firms supply none of their output to either large domestic firms, multinationals, or government and only 5 percent of output to traders who might serve as intermediaries. Rural firms also supply nothingto large or multinational companies or to government, but supply a greater amount of output to traders. Whether this output goes to other firms or to consumers cannot be determined. But the general finding suggests that large companies rely very little on small domestic firms for their inputs and supplies. FIGURE3.13 FIGURE 3.14 I I Marketing 8 Distribution Channels in Rural Cambodia 0 fficialvs. Unofficial Exportsof Rice 0SmallBusiness 100 90 500 80 0Traders 70 ,400 60 E300 50 HAgricultural ProducersiCoops f 40 200 30 0IndividualConsumers 100 20 10 0 0 1 Officialexportsof rice Unofficial exportsof Battambang Kampong Kampong Kratie paddy Som Chhnang Source:The World Bank, CambodiaPICS 2003. Source:The World Bank, CambodiaPICS 2003. Most sales go to individual consumers or is exported informally. Little goes directly to processors -andverylittlecontractfarmingtakesplace. InBatambang,whichincludesalargenumberofricemillers, 70 percent o f output i s sold directly to consumers and the balanceto small local businesses. KampongSom and KampongChhnang have considerable volumes, roughly 30 percent of output, soldthroughtraders, and in KampongChhnangthere is also some sales through agriculturalproducers and cooperatives. Less than 1 percent of rural firms' product is sold to government, large enterprises, or multi-national companies. On average in the urban informal sector, 86 percent of product is beingsold to individual customers, 5 percent to trade or merchant intermediaries, and 8 percent to other smallbusinesses. InKratie, the vast majority of trade is to individual consumers. Overall, trading behavior for rural Cambodia suggests that exchange relationships are still at an early stage of formalization. This is consistent with an earlier finding from the value chain analysis that muchof the output of rural Cambodiais exported with no value added. Unofficial exports of rice far outstrip official exports. Giventhat local agro processorsare limited to personalmarkets, it follows that they would only havethe capacityto purchasea small share output. This implies that traders and intermediaries are the crucial link to the large and formal economy, to the extent that one exists. Given the many anecdotal accounts of weaknesses in distribution and monopolization in some regions, concern (and future analysis) about rural firms' access to markets and supplies might suitably focus on the role played by these traders and intermediaries. Rural micro- enterprises supply 72 percent of their product to individual consumers, and substantially less to small businessesand through intermediariesthan do rural SMEs. Also, rural firms keep higher inventoriesthan similar urban firms, potentially indicating either greater unreliability of delivery (since firm maintain inventories to avoid running out in case of delays) or high transaction costs of individual shipments. High inventories may imply weak and/or unreliable supply systems or the need to order in bulk. In the urban sample, microenterprises and SMEs keep around 20 days o f inventory. By contrast, rural firms keep 57 days o f inventoryin Battambang, 27 days in KampangCham, 37 days in KampongChhnang, and 35 days in Kratie. Firms indicate that if they had better financing, they would keep exceptionally large inventories coveringfrom halfa year to a year's worth oftheir main input. InvestmentClimate Assessment & Reform Strategy Page 43 3.4.2 UncompetitiveDistributionChannels If competition is the key to productivity gains, then competitive marketing and distribution channels are essential. There are signs that these are not in place. As described in Chapter 2, around 35 percent of firms frequently cite informal practices - attempts by competitors to limit market access as a major or severe problem. As is typical in many post-conflictcountries, many firms grew during earlier stages of the economy as a result of their ability to provide a neededcommodity during a time of restricted trade. Once trade is opened, some such firms are unable to make a transition to competition based on quality and cost, and therefore try to maintain an environment of restrictedtrade and exclusivity. There is plenty of anecdotal evidence for this, includingthe attempt to monopolizeexport of NeungMali rice. Any restrictionson distributionchannels, however, negativelyimpactsdiversificationobjectives three ways: (a) The bargaining power of suppliers is reduced, so that their ability to obtain reasonable prices, supplier credit, or improvements in distribution services is also reduced; (b) Feedbackfrom customers on productquality, cost, or delivery requirementsis muted; and (c) Access to new customers, particularlyfor new products, i s severely limited. Licensing requirements are excessive but ignored. Despite Cambodia's clear transition away from state ownership of productive assets, a large number of state-sanctioned exclusive trading arrangements and local monopolies still exist. For example, only pharmaceutical company registeredwith the Ministry of Commerce and authorized by the Ministry of Health and agricultural technicians and his company registered with Ministry of Commerce and authorized by the Ministry of Agriculture, Forestry, and Fisheries are eligible to apply for licenses to import or trade agricultural inputs. Agricultural inputs including raw materials, semi- and finished products are subject to import licensing maintained under the Law on Drug Management of May 9, 1996 and the Sub-Decree on Standards and Management of Agricultural Materials o f October 28, 1998. Only 5-6 firms are knownto have registered, and giventhe low populationdensity in Cambodia, any given agriculturalregion is unlikely to be supported by more than 1-2 of the registered firms. CDRI's recent study of the tree resin trade suggests that no firms have actually applied for a license since 2000 years, despite an annual trade exceeding $6 million.56 Table 3.3. PartialList of Licenses and PermitsRequired Ministry License Department Comment Ministryof Industry, Operating License for SME Small Industrv & Handicraft at Annual Mines& Energy . Municipal Level Certificate of Processing Department of Industrial For export order, requires on-site Technique inspection Certificate of Scales Department of Metrology Market scales Certificate of Product Department o f Industrial For product registration, labeling, Registration Standards product safety and health. Ministry of Health Certificate of Hygiene Hospital Department For food processors, restaurants. Ministry of Commerce Import License Department of Foreign Trade Export License Department of Foreign Trade Exemptions for GSP exports BusinessLicense Legal Department Trademark License Intellectual Property Dep't Operating License Municipal level Certificate of Inspection Camcontrol quality of traded items. Certificate of Origin GSP Department Ministry of Social Individual Health Department of Labor, To work in a factory all employees Affairs Certificate Inspection& Health and employer MAFF Fish purchasingpermit Ministry of Land Mpt, LandiProperty Certificate Land CadastralDepartment Property and land ownership L'rban P1nnnir.g Sortrcr : De\ elupmmt Consulting Internarional .Asian Devslopment Bank Private Sector Assessment 12003) 56CDRIstudy on resin trade, quoted in The CambodiaDaily, Wednesday, May 7, 2003. Investment Climate Assessment & Reform Strategy Page 44 Inspection requirements are not as onerous as in the garment sector. Quality assurance is an important part o f the institutional support needed to enable arm's length, impersonal, long-distance trade and is in support of the public interest. However, the Government's policy for assuring quality is a disincentive to full competition. Camcontrol's authorizing legislation, the Law on the Management of Quality and Safety of Products and Services, prohibits the commercialization of any product that has not been inspected. While there is some detection of smuggled, expired, and illegal goods, the regulatory cost is high and creates the perplexing reality that most normal commercial activity is, in fact, illegal. While it i s obviously not possible for a government to inspect all commercial activity, this type o f regulation can be used to suppress specific businesses and to limit competition. In a recent case in Kampong Chhnang, an ice wholesaler was apparently blocked from selling low-priced ice by officials who believed that the ice was imported illegally from another province in which the cost of producing ice is lower.57 The inspection requirements have an important indirect effect: they create an atmosphere of intimidation and discretionary authority that undermines investor confidence. 3.4.3 Value Chains are Not Integrated Whether described as cluster analysis, backward- and forward-linkages, or value chains, the role of inter-firm linkages and supplier industries in creating productivity is well understood. It i s particularly important in agro-industry, where the perish ability of product demands efficient handling at each stage. However, there are a number o f supply chain gaps. Cold chains - refrigerated storage, refrigerated transportation, pre-chilling - do not exist. Milling capacity is insufficient. Cambodia produces nearly 4.12 million tons of paddy each year, but milling capacity is only 1.31tons, creating a deficit of 2.81 tons. More than 50 percent o f available capacity is in inefficient village mills where the paddy to polished rice conversion ratio is less than 55 percent (the conversion ratio of village mills in Cambodia are lower than the average conversion ratio in Lao PDRwhere it is 60 percent, as opposed to Japan and China, which achieve a conversion ratio of over 73 percent). FTGIJRE 3.15 V a l u e C h a i n f o r t h e P r o d u c t i o n o f N e a n g M a l i Rice in C a m b o d i a F e r t i l i z e r U r e / Y i e l d R a t e F e r 1 U s e Y i e l d i h a (tons) ~ C a m b o d i n % 4 8 i h a 1 8 5 T h n i l n n d $ I j i h a 2 0 9 7 0 % o f f u r t i ! i z e r ,old in C a m b o d i a I A dtlutcd fo I 3-1 2 ofaclt,al cunceiilratron Source., Towards a Private Sector-Led Growth Strategyfo j7"Police Block Ice Wholesaler," The Cambodia Daily, Wednesday October 8, 2003. InvestmentClimide Assessment & Reform Strategy Page45 Chapter 3 Diversification Inaddition to the lack of available high quality milling capacity, millers themselves face a problem o f accessing adequate working capital financing as commercial banks do not recognize capital equipment, even large scale high equipment, as collateral. The lack o f access to working capital has the effect o f forcing millers with high quality equipment to underutilize their milling capacity as millers are unable to shore up paddy during harvest season, which in turn force rice farmers to rely on poor quality village mills or to sell paddy at a discount to Vietnamese and Thai rice traders. Once commercial mills have a stockpile o f rice, it must now confront high electricity and fuel costs, high custom clearance charges, Camcontrol inspections, and port charges before it can make a shipment to markets in Europe and Asia. High administrative costs combined with uncompetitive energy prices add yet another layer o f costs that diminish the competitive potential o f enterprises operating in Cambodia and their ability to integrate. The data suggest that agro-industry FIGURE 3.16 faces greater uncertainty and sales loss due High Inventory Levels in Agro-Industry Relative to Garments to investment climate constraints, and have 120 , reacted by raising inventory stocks. Agro- industry firms maintain higher inventory levels than those in garments as well as other sectors, which may indicate a greater need to buffer 80 + I-- against uncertainty. Inventory o f inputs (Le., raw materials excluding fuel) as a percentage o f total sales averages 51.6 percent for agro- industry firms compared to 32.7 percent for garment firms. The level o f inventory for all firms is 46.3 percent. Even more striking is the disparity in the level o f output inventories (i.e., Inventwyof InputsrTolalSales finished good and work-in-progress). For firms All Sectors a Garments Agro-Industry in the agro-industry sector, inventory o f output averages 115.6 percent of total sales, while the means for garments and all sectors are 60.1 and 72.4 percent, re~pectively.~' Agro-Industry Flrms wlth Transportation & Finance Problems Agro-industry firms experiencing Suffer Greater Lo= Due to Delivery Delays from Suppliers transportation and finance problems suffer 8 greater sales loss due to delivery delays from suppliers. For agro-industry firms that perceive transportation to be an obstacle to the operation and growth o f their business, the average loss due to delivery delays from suppliers is 7.7 percent o f total sales. For garment firms that perceive transportation to be an obstacle, the average loss i s lower at 6 percent o f total sales, which i s similar to the average loss o f 5.9 percent for all sector^.^' For firms that perceive access to Last Cue to Delivery Delays fromSuppliers Last Cue to DeliveryDelays fromsuppliers finance as an obstacle to the operation and for Firm FacingTransportation Roblam for Firm FacingAccess to Finance Roblem growth o f their business, the average loss is 6.3, 1 All Sectors Garmots 0 Agrplndustry Source:The World Bank, CambodiaPICS 2003. '*Allfirms with inventory shares 3 times the interquartile range above the third quartile are classified as outliers and dropped from the calculations. 59 In stark contrast, for firms that do not perceive transportation to be an obstacle to the operation and growth of their business, the average loss due to delivery delays from suppliers is 0.2, 1.5, and 3.6 percent of total sales for agro-industry, garment, and all sectors, respectively. InvestmentClimate Assessment & Reform Strategy Page46 1.5, and 6.1 percent o f total sales for agro-industry, garments, and all sectors, respectively.60 3.4.3 Factor Markets Human capital. Demand for skilled labor in agro-industry is low, and availability of skills is not reported as a constraint by agro-industry firms. This is a reflection o f the low level o f sector development and could change quickly. At prevailing levels o f value added, firm sizes averaging seven employees, and annual revenues o f less than $10,000, there i s little scope for job specialization and the productivity levels to enable higher wages i s absent. Firms therefore do not report major problems obtaining sufficiently skilled manpower. More skilled personnel are likely to quickly sense the higher returnsto their skills in other sectors. Table 3.4. Intensity o f Formal Training --- % of workers Duration Mean Std. Dev Garment and textile 16.58 8.14 9.87 Water 5.91 3.00 0.00 Construction 12.33 9.87 11.28 Restaurants, hotels & tourism 16.76 6.29 5.93 Informationtechnology/electronics 21.22 16.40 7.27 Food processing 1.62 0.00 0.00 Transportation, shipping & trade 12.06 5.87 4.85 Electric power 4.95 1.oo 0.00 Total 16.18 8.09 8.58 Source: The World Bank, Cambodia PICS 2003. What is o f a larger concern is the extremely low levels o f educational attainment, and high levels o f functional illiteracy for the working population in rural areas, combined with the lack o f training provided by the food sector. Whereas the garment, construction, and tourist sectors provide some training to their workforce, the food sector is at the bottom in terms o f training provided, despite food processing being somewhat technology-intensive. This means that any attempt to increase quality or introduce technical sophistication into operations to add value will almost immediately hit a skill constraint. While in aggregate there may be skills available in Cambodia to supply a more technically sophisticated sector, they are currently concentrated in urban areas and are unlikely to move to rural areas, , FIGURE3.18 Capital tied up in land ... ...and buildings I00 80 , , 60 40 0Owned building 20 0Leased building 0 20 Garments Agro- 0 industry Garments Agro-industry 6oIn stark contrast, for firms that do not perceive access to finance to be an obstacle to the operation and growth of their business, the average loss due to delivery delays from suppliers is 0.3, 0.9, and 3.7 percent of total sales for agro-industry, garment, and all sectors, respectively. InvestmentClimate Assessment & ReformStrategy Page41 Chapter3 Diversification Only 3 percent of working capital is met from commercial sources - and the capital is used inefficiently. As noted above, inventory levels are high, meaning that excess capital is used to maintain extra stocks. Unlike the garment sector, which primarily leases property, 75 percent o f land and 86 percent of buildings in agro-industry is owned. This accounts for a much higher ratio o f assets per employee and overcapitalization relative to garments. However, given the high failure rates in the industry, there may be a reluctance to borrow commercially and pledge real property, which may also serve as a home and the most important store of wealth. Firms do not report this to be an issue, but clearly access to capital i s a hidden cost and contributes to the loss o f sales to better funded foreign buyers. Inthe short-run, however, increasing the availability of commercial lending would not be a complete solution because of the underlying risk. Mechanisms, such as leasing, in which agro-industry firms would not take title, could be viable. Infrastructure. Reported shipment losses are low and infrastructure is not perceived to be a constraint - but this is another reflection of the low level of development. The key infrastructure gaps are in the quality o f tertiary roads to obtain market access and the high rates o f self-provision of , FIGURE3. 19 infrastructure. Over 91 percent of surveyed agro- industrial firms maintained their own well for Share of firms self-providing infrastructure provision of water - a critical input to almost any 100 7 food production process, and over 30 percent 80 generated their own power. It i s clear that this puts Cambodian agribusiness at a cost disadvantage and 60 accounts for some loss of value-added. Moreover, 40 logistics i s at an early stage in its development. 20 On average, it takes rural firms 2.6 hours 0 to get to their most important market to sell Garment Agro-Industry Services products or services, 3.6 hours to get to the market or supplier of their main input, and 3.6 hours to get to a bank or financial institution. - Source: The World Bank, CambodiaPICS 2003 Businesses travel 16 times per month to product markets, 7 times per month to input markets, and twice a month to banks. It is possible that some trips are multipurpose - for example, firms may buy inputs and sell products inthe same towns, or they may stop at the bank while traveling to product markets. This establishesa possible range of travel time from 83 hours (two standard workweeks) to 148 hours per month. Travel time varies substantially by location, with longer travel times to product markets in Sihanoukville and Battambang regions and very long travel times for Kratie firms to input markets, due to weak ground transportation. Should Cambodia diversify its agricultural base, it is likely that the road density, lack of a viable rail option, and lack of cold chain logistics service providers ranging from refrigerated warehousing to transport would quickly become constraints. Without such innovation and investment, post-harvest losses for perishable items would be prohibitively high. Infrastructure investment would need to be both physical and managerial. Significantly better use could be made o f back-haul capacity from shipments of consumer goods going from Phnom Penh to rural Cambodia. 3.5. Institutions to Support a Diversified Private Sector Competition between agro-industrial firms, which is a prerequisite to raising productivity levels is insufficient, and the key reason appears to be a lack of formal or informal institutions to support market linkages. The high cost o f search, coordination, and contracting are not supported by institutions that reduce the cost o f measurement and the cost o f contracting or increase enforcement capability. This is reflected throughout the ICA results and appear to be more o f a constraint than the InvestmentClimateAssessment & Reform Strategy Page48 Chapter 3 Diversification availability of working capital or physical infrastructure. Intuitivelythis makes sense. Even if agro-industrial firms had easier access to credit, the risk of contracting with many small suppliers is a binding constraint. Firms are coping with the risk environment by staying small, building high inventories, and limiting themselves to trading partners they know well. Both property rights and secure transactions need to be strengthened. But the development and behavior from these institutions, as North reminded us, are not created overnight. Institutions result from discovery, repeated interaction, learning processes, and at times, the formal legislative process. Many of the institutions -particularly the ruleof law -implyapoliticaldecisiontoempowermarketsto amuchgreaterdegreethanexiststoday, sothattherule o f law and markets overcomes bureaucracy. Market institutions that would reduce transaction costs, such as information systems, commodity exchanges, and broker certification, need to be better understood. Cambodia will need to build public sector institutions - but any realistic strategy has to rely on the private sector organizing itself. Private value chains, self-regulation and advocacy are central. A number o f good international models exist of institutions that have helped set market standards and promoted competitiveness in agro-industry. ProChile, The Chilean Trade Commission, for example, support and advance Chilean business interests in the global marketplace by assisting in the development of the export process, establishing international business relationships, attracting foreign investment and forging strategic alliances. It does so through its market research, international trade data and networking, with a focus on promoting non-traditional products. It also does extensive research on customs regulations to ensure that exporters are in full compliance with international trade laws. Garments Agro-Industry Value Addedworker $1,190 (low by internationalstandards) (extremely low by international standards) Firm Size 600 + employees -$462employees 7 Market Scope Global markets:US 71%EU 38% Local, informal: 70% individual Trade-Supporting GSP, Agreement on Textiles andClothing None Institutions Labor Law, ILO compliancemonitoring Corporate social responsibilitynorms Quota managementsystems, ELVIS Certificates o f Origin Duty Exemptions, tax incentives Dispute resolution outside of Cambodia (e.g., Singapore) nforcement of ForeignArbitral Awards (1958); ASEAN Protocolon Dispute supporting institutions InvestmentClimate Assessment & Reform Strategy Page49 Chaoter 3 Diversification 3.5.1 Private-Led Value Chains Value chains are an important part o f private sector development in the East Asia and Pacific Region and should be seen as a type o f governance institution. As described at the outset o f the chapter, networked production i s a hallmark o f trade in East Asia, and the rules governing this trade are often set by supply chain participants. Large buyers - assemblers, retailers, and processors - have transitioned from vertically-integrated manufacturers to brand managers and supply-chain "orchestrators." While the automotive supply chain is perhaps the most evolved, value chain integration also takes place in the agro- industrial sector. Carnation, for example, provides technical assistance to coffee growers and dairy farmers inThailand in return for the security o fan adequate supply and quality of raw materials. In the absence of an enabling environment that encourages value added production, several companies such as Angkor Kasekam and Manhattan Textiles have established their own out grower1 contract farming schemes. These out grower schemes have effectively linked a wide range o f smallholder farmers in rural areas with processing facilities in urban areas to create an environment that fosters market segmentation and specialization, adherence to quality standards that reflect international norms, and contracting mechanisms that in some respects stabilize relationships inthe absence o f strong rule of law. Examples o f successful vertical integration o f local farmers and enterprises can be found in the poorest parts of the world such as Zambia and Central Kazakhstan, where enterprises have effectively integrated small local suppliers into a vertical supply chain. In Zambia, a number of enterprises in the high value horticulture sector have established out growers schemes, some covering over 1,000 local smallholder farmers, where output is sold through the world's top companies such as Tesco, Walmart, Saintbury, and McCormick Spices. Similarly, in Central Kazakhstan, the world's fourth largest steel company operates a supplier development program in the steel sector. In both examples, the country suffers from a poor enabling environment where the rule o f law is not observed, and the market is represented by an absence o f institutional capacity and support infrastructure. Such out grower schemes have been effective in vertically integrating rural smallholder farmers into a global supply chain, while at the same time creating an effective network and support infrastructure through which rural smallholder farmers now gain access to working capital to purchase inputs, cheaper access to input material, skills training, access to improved seed varieties and farming techniques, access to markets, and other services. These programs have broad spillover effects and can redefine industry standards. In Thailand, Royal Ahold/TOPS has created a supply chain development program that has upgraded post-harvest practices throughout the fresh produce industry. InvestmentClimateAssessment& Reform Strategy Page 50 Chapter 3 Diversification Box 3.1. TOPS/Royal Ahold Supply Chain Development Program: CatalyzingSupplier Upgrading In 1998 Royal Ahold, a leading global retailer, TOPS Thailand, a retail chain, Rabobank, Kasetsart University inThailand, SGS, TNT Logistics andthe Thai Departmentof Agriculture conducted a value chain project with the goal of improving the performance of the supply chains for perishableproducts in terms of efficiency (cost), dependability/continuity, flexibility, and quality including food safety. Prior to the program's establishment,TOPS had around 250 domestic suppliers of fresh h i t and vegetables, including growers and wholesalers. They suffered from an unstable supply, long lead times, uncertain quality, and high product deterioration (shrink) inthe 60 hours it took from the point produce was delivered to the back of TOPS stores to shelves. Farmers trading practices were primarily personal, agricultural production was simple and executed with poor quality equipment, there was an absence of grower associations, and a lack of trust which prevented effective standardization of product and a multiplicity of middlemen handling small volumes of product. The net result was an inability to offer a consistent quality to TOPS customers at a reasonableprice. TOPS invested in a distribution center to handle incoming product flow, and in parallel, a program of upgrading suppliers. Elements of the program included: A value chain analysis to identify bottlenecksand potential improvement areas; A preferred supplier program was developed to move from spot transactions among 250 suppliers to strategic relationships with a more limited number; A food safety and quality assuranceprogram for suppliers, which would be certified by athird party; Capacity building in good agricultural practiceswas provided to participating suppliers; Training by the Wageningen School of Management, which resulted inthe creation of the Kasetsart Supply Chain Managementprogram; While there were some difficulties, the 250 suppliers were eventually narrowed to 60 preferred suppliers. Suppliers were provided with operational criteria supporting the goals of cost, quality, flexibility, and dependability, and trained in integrated pest management and value-added post-harvest functions (pre-cooling, washing, sorting, grading, packaging). All 60 suppliers were eventually certified for food safety and quality practices and became capable of the necessaryvalue-addedfunctions and delivering ahigh quality of produce. In less than four years, the TOPS distribution center's service level reached98% of its maximum, and the fresh produce section of TOPS supermarkets is now among the best in Thailand and one its key marketing advantages. The key lessons learned: without selective incentives, there was little cooperation among suppliers, but suppliers respondedwell to capacity building clearly tied to increases in volume. Personalizedbusiness relationships were a threat to preferred supplier programs, and in general, there were substantial intercultural gaps in the measurement of performance, the role of standards, and the management of public-private partnerships. Despite these obstacles, the project has stimulated not only standardizationand quality among suppliers, but throughout the Thai fresh produce industry. Source: Business Case Description: TOPSSupply Chain Project, Thailand. Dave Boselie, KLICT International Agri Supply Chain Development. InvestmentClimateAssessment& ReformStrategy Page 5 1 Chapter 3 Diversification 3.5.2 From Rule of Bureaucracy to Rule of Law? Many of the investment climate issues result from the lack of a functioning legal system that secures property rights. Property rights -the right to use, control and benefit from a resource- are essential to investor confidence. Clear property rights depends on clarity in the role of the state, and withdrawal from roles better performed by markets. The intent of inspection processes is to ensure public safety and quality; hence a policy that depends on 100 percent inspections and licensing requirements, which are often ignored. Were the rule o f law to prevail, this would be entirely unnecessary, since buyer o f goods that violated legally-defined standards could simply seek satisfaction through the courts, and the likelihood o f such a decision being carried out and enforced would deter selling o f unsafe or expired goods. The burden of monitoring, detection, and enforcement shifts from an over-stretched civil service to the market, whereasthe state's role shifts from inspection to the definition of standards. An effective Civil and Commercial Code is particularly important since it encourages arm's length transactions, but only one-third of firms have confidence in the judiciary. The law is in draft form and being reviewed at time of writing. A recent review o f the Cambodian legal system suggestedthat there remain a number of severe challenges before the CCC is accepted, disseminated, understood, applied, and enforced. 61 Simply put, the Judiciary will need substantial capacity building to demonstrate a track record of impartial and effective judgments before this perception i s changed. Furthermore, the judiciary needs to rebuild public confidence and trust, especially given the widespread allegations o f corruption. All o f this can only be seen as a medium-term agenda, something that will emerge gradually. Clearly, an interimapproach is neededthat will enable more confidence intrade and investment decisions. 3.5.3 Complements to Formal Legal Institutions Given that establishing the rule of law will take considerable time, are there non-state alternatives? In de Soto's words, an essential part of deregulation "should include delegating functions and authority to those formal or informal private institutions which, as we have seen, are today operating better than the state."62 The Government's Legal and Judicial Reform Strategy seeks the establishment of a system o f arbitration and mediation to deal with commercial disputes and what are termed `minor disputes' at the community level. A draft Law on Commercial Arbitration is before the National Assembly, and an organization has been established. In addition, the promotion o f village level mediation would appear to be a more practical and helpful approach inorder to increaseaccess to means o f alternative dispute resolution. A legal empowerment approachfocusing on increasing awareness and demand for rights, but also utilizing alternatives to formal courts and lawyers, would seem relevant to Cambodia's private sector and a recognition that informal dispute resolution mechanisms do exist in absence of the formal rule of law. Defined as "emphasizing civil society, including legal services and development NGOs, as well as community-based groups; using whatever forums (often not the courts) the poor can best access in specific situations; encouraging a supportive rather than lead role for lawyers; cooperating with government wherever possible, but pressuring it where necessary; using community organizing or group formation; developing paralegal resources; integrating with mainstream socioeconomic development work; and building on community-level operations to enable the poor to inform or influence systemic change in laws, policies, and state institution^."^^ More needs to be understood about the effectiveness of this form of dispute resolution inorder to determine if it could serve the needs o f expanded trade. 6`World Bank (2003a), Cambodia: Legal and Judicial Sector Assessment, 62Hernando de Soto (1989), The Other Path: The Invisible Revolution in the Third World,pp. 249-25 1. 63Stephen Golub (2003), "Beyond the Rule of Law Orthodoxy: The Legal Empowerment Alternative," Carnegie Endowment Working Paper. InvestmentClimate Assessment& ReformStrategy Page 52 3.5.4 BusinessAssociationsAVembership Organizations BMOs are intermediary, networking, and self-regulative bodies. As such, they represent an increasingly important form of participatory development in countries such as Cambodia. Because o f their size, BMOs have extensive outreach capabilities and can contribute to improving the framework conditions for the private sector through facilitating a common understanding o f the formal rules o f commerce, taking collective action, delivering central services, and networking among members and other stakeholders. I t is this unique combination o f strengths that makes them effective tools to increase the growth o f firms in a given country. Social capital and networks are important to trade, specialization, and innovation. Business membership organization^^^ (associations) can play a critical role, but need to overcome an atmosphere of distrust in the private sector. Business associations can facilitate exchange by improving information flows and by facilitating learning through policy advocacy, through facilitation or direct provision o f demand-driven services, and through advocacy aimed at creating a better business environment. As described above, the private sector in Cambodia exhibits a dual structure - a few large, modern, capital- as well as import-intensive enterprises on the one end o f the spectrum and a majority o f micro- and small enterprises serving local markets with simple and traditional technologies on the other. The smaller firms face a number o f constraints, including resource endowments, economies o f scale, demand conditions, market size, as well as available technologies and institutions. There are additional constraints facing the private sector as a whole, such as bureaucratic complexity and a weak legal andjudicial system. BMOs in Cambodia are typically characterized by poor organizational capacity and technical skills, lack of proper accounting systems and governance, and lack of demand-driven orientation resulting in low levels of sustainability. Another characteristic o f Cambodian BMOs is that board members do not understand fully their role and responsibilities and do not realize that they work as representatives o f a community. Conflict o f interests can arise and board members do not spend the time necessary for this voluntary work. The most important areas for intervention are the development o f services, advocacy, and BMO management. MPDF is actively involved in helping to create well-functioning BMOs with professional staff and a board o f directors who understand their role and responsibilities. The indicators for measuring the impact o f these projects are: the growth o f membership/ membership retention; the variety o f business services to members; the self-sustainability o f the BMO; recognition by the Government and third parties as being representative o f a particular group; the solution o f at least two advocacy issues per year; the satisfaction rate o f members; and the participation rate o f members to the activities o f the association. 3.5.5 Government-Private Sector Forum The Government-PrivateSector Forum, designed as a bi-annual meeting of the Cabinet of the Royal CambodianGovernment and representativesof the private sector, is a usefulvehicle for public- private dialogue and enjoys considerable support of high-level officials and the private sector. It is essential that the Government and private sector engage in a constructive dialogue in identifying and overcoming the policy constraints to trade. In Cambodia, the Government-Private Sector Forum (PSF) i s a framework to encourage consultations between the private and public sector. The PSF meets twice a year and i s chaired by the Prime Minister. There are seven sector focused Working Groups (WG's) under the 64BMOs have to be defined as non-profit and democratically guided membershiporganizationsthat finance themselves by a mix o f membership dues, service fees, as well as subsidies from govemment or donors. There is no law regarding the regulation o f business enterprises associations in Cambodia. With the exception of a few BMOs, such as the Chamber of Commerce, which has been establishedby law; most BMOs simply declaretheir existencewith the Ministry o f Interior. InvestmentClimate Assessment & ReformStrategy Page 53 Chapter 3 Diversification PSF. They are: (1) Law, Tax & Governance, (2) Agro Business & Agro Processing, (3) Energy & Infrastructure, (4) Banking & Financial Services, (5) Tourism, (6) Manufacturing & SME's and (7) Export Processing & Trade Facilitation. The Cambodia Development Council (CDC) provided the Secretariat to the seven working groups. The International Finance Corporation (IFC) supports the Government-Private Sector Forum mechanism with the Coordinating Bureau. This position is effectively that of an honest broker and is a conduit between the private sector, government, and the donor community. The WG's are co-chaired by a government minister and a representative o f the private sector (e.g. the WG on Law, Tax & Governance i s co-chaired by the Minister of Economy and Finance and the President of the International Business Club and the Export Processing and Trade Facilitation WG is co-chaired by the Minister of Commerce and the President o f Garment Manufacture Association Cambodia (GMAC)). Recent Government-Private Sector Forum meetings have been postponed due to the political cycle and the anti-Thai rioting, but Working Groups have continued to meet both inthe private sector and with the Government and a substantive dialogue continues to take place. Although there have been achievements, including the high level o f consultation on the Law on Investment and Law on Tax, the introduction of private sector monitors within the Customs Department, and negotiations on cost reform at the Port of Sihanoukville, the private sector in general, nevertheless, feels a level o f frustration given the slow pace of reform. In particular, there i s dissatisfaction with the failure to meaningfully address issues o f law enforcement and corruption. The challenge is to encourage the government to undertake the neededreforms and to support the public-private consultation process by addressing substantive issues that are identified obstacles to private sector development in Cambodia. Strengthening the advocacy capacity of business will also make the Government-Private Sector Forum more relevant to the provincial business environment. The Ministry of Commerce has begun to implement a strategy to discuss WTO and its implications at the provincial level, in order to raise awareness o fthe need for an effective supply response. Investment Climate Assessment & Reform Strategy Page 54 Chapter 4 Public-PrivatePartnerships C h a p t e r 4: E n h a n c i n g the Role of the Private Sector in P u b l i c Services 4.1 I n t r o d u c t i o n As Chapter 2 makes clear, access to infrastructure in Cambodia is not only relatively poor compared to its neighbors and countries o f similar income levels, but also where it is available, services tend to be both extremely unreliable and expensive. The country's electrification rate i s one o f the lowest outside sub-Saharan Africa; reliable, widely available, and safe drinking water supplies are limited to Phnom Penh, even though 90 percent o f the population lives outside the capital; rates o f fixed and mobile telecom penetration are low by both regional and international standards at only around 1.91 per 100 inhabitants; and the country's road network is the least developed inthe region. Itis difficult to see how Cambodia can address these backlogs ina short period oftime using internal resources alone. Inadequate domestic revenue mobilization and skewed public expenditure allocations have kept Cambodia heavily dependent on foreign aid for financing the provision o f basic goods and services. A 2002 study revealed that the gap between the cost o f the required investments and the resources at hand is remarkable - with 65 percent o f the costs of all infrastructure projects to be undertaken between 1999 through 2001 remaining with no identified source o f funding.65More recent figures suggest that just rehabilitating and maintaining the existing road network with current resource availability reveals a shortcoming o f enormous magnitude, with Government resources able to cover less than one-third o f the total annual cost. External donor financing, though it will help close the gap, looks to be insufficient, at least over the medium term, to meet expenditure needs.66 This suggests that there is significant scope for the private sector to play a large role in bridging the gap between the enormous financing requirement and the equally large financial shortfall in available public funds for infrastructure provision. However, mobilizing private capital for the accelerated provision o f infrastructure, thereby reducing dependence on government budgets, is not the only or even the most important role for the private sector in infrastructure provision. Internationally, there is a growing recognition that the private provision o f infrastructure offers a number o f additional "efficiency" advantages over public service delivery, including faster implementation, reduced whole life costs, better risk allocation, better incentives to perform, improved quality o f service, enhanced public management, and sometimes even opportunities for the generation o f revenue. The need for efficiency in service delivery is a key driver for change, given Cambodia's lack o f tax revenue, its substantial reconstruction and maintenance needs, and the poor record o f public provision o f services. This challenge is not unique to Cambodia. While many governments have attempted to improve the performance o f public sector monopolies through corporatization and, in some cases, through the introduction o f more formal arrangements such as performance contracts, these 65 The World Bank and the Public-Prhate Infrastructure Advisory Facility (2002), A Country Framework Report; Private Solutionsfor Infrastructure in Cambodia. 66The World Bank and Asian Development Bank (2003), Cambodia - Enhancing Service Delivery through Improved Resource Allocation and Institutional Reform: Integrated Fiduciary Assessment and Public Expenditure Review. InvestmentClimate Assessment & ReformStrategy Page 55 Chapter 4 Public-PrivatePartnerships interventions have largely been uns~ccessful.~~fact, studies o f global experience comparing public to In private provision of infrastructure services have revealed that, by the early 1990s, the annual losses from inefficiencies and unsustainable pricing policies associated with public provision o f infrastructure were estimated to be nearly equal to annual investment (see figure below).68 Increased private participation in infrastructure (PPI) in Cambodia, under an appropriate institutional and regulatory framework, is likely to provide opportunities for augmenting budget resources and for improving efficiency. The benefits of the latter can be substantial, particularly when accompanied by pro-competitive reforms (or even monopolistic activities operating under an appropriate regulatory framework). The most thorough studies o f the impacts o f privatization have shown that well- designed schemes can bring about substantial increases in overall welfare. For example, private participation in water and sanitation lead to overall domestic welfare benefits o f $1.4 billion in Buenos Aires and $23 million in Guinea.69 Six cases o f private participation studied in detail in the telecom, power, and ports sectors also showed substantial welfare gains to the government, consumers, investors, and, often, workers. These studies have found that the main sources o f benefits were increased investment to bring service to new consumers, lower prices, and improved productivity and efficiency.70 FIGURE4.1 Global Public infrastructure Provision In early 1990s 200 - pz 150- - v) 100 -- - 3 50 -- - 0 , Source: The World Bank World Development Report. Infrastructure for Development. 1994 4.2 Relevance of PPI to Cambodia's PSD Strategy Governments have long recognized that infrastructure has a vital role to play in supporting a country's growth and development as well as in directly addressing poverty. Improving access to efficient and affordable water, electricity, transport, and telecommunication services can have major impacts on the living standards o f individual households. Efficient infrastructure i s also essential to sustain broader economic growth and industrial competitiveness. 67The World Bank (1995). Bureaucrats in Business: The Economics and Politics of Government Ownership, World Bank Policy ResearchReport. The World Bank (1994), WorldDevelopment Report. Infrastructure for Development. Shirley (ed.) (2002), Thirstingfor Efficiency: the Economics and Politics of Urban Water System Reform. 70Newbery and Pollitt (1997), "The Restructuring and Privatization of the U.K.Electricity Supply - Was It Worth It?," World Bank Viewpoint Note No. 124; Gala], Jones, Tandon, and Vogelsang (1994), Welfare Consequences of Selling Public Enterprises. Investment Climate Assessment & ReformStrategy Page 56 Chapter 4 Public-Private Partnerships Given this widely held view, and the description o f Cambodia's infrastructure "endowment" in Chapter 2 and above, it is somewhat surprising that infrastructure does not appear to rank highly among the key constraints identified by the 2003 investment climate survey sample. It would be misleading to derive from this that a lack o f access to reliable, efficient, and low-cost infrastructure and public services is simply not constraining in the Cambodian context. On the contrary, poor-quality, unreliable, and expensive infrastructure is a serious impediment to economic growth in Cambodia, and there are a number o f likely explanations for the supposedly low ranking o f infrastructure among the key constraints. These include the following: 0 Attribution. First, the infrastructure constraint may be associated with (and therefore "hidden" by) other constraints. For example, port inefficiencies may be attributed to corruption and customs delays, rather than to inefficient terminal operations. Corruption may also be perceived to be at the root o f other infrastructure failures. For example, the survey finds that 100 percent o f respondents indicated that an unofficial payment i s required for a mainline telephone and electrical connection. Similarly, the non-transparent and uncompetitive award o f long term concession contracts may be described as "corruption" or "anti-competitive or informal practices" (from the perspective o f utility firms), even though the consequences (high tariffs, inefficient services, etc.) are clearly "infrastructure" constraints. 0 Self-Selection. Second, the sample o f existing firms i s self-selecting, in the sense that businesses that are intensive users o f infrastructure services may simply be unprofitable in Cambodia, and so do not form a significant part o f the population. For example, the absence o f a substantial agro- processing industry may be attributed in part to inadequate roads, limited storage and warehousing facilities, and a very inefficient port. Similarly, manufacturing diversification and expansion may be inhibited by expensive power and unreliable water supply resources. It is worthwhile to note that the value chain analysis for six distinct commodities - rice, garments, cotton/textiles, motorcycles, tobacco, and canned milk - found high electricity and transport costs to be consistent impediments to competitivene~s.~~ 0 Relative Improvement. Third, major investments in infrastructure may make conditions appear much better by comparison than at any time in recent memory. For example, the availability o f mobile phones has substantially reduced the constraint imposed by the fixed line system. Cambodia i s the only country inthe world with mobile penetration rates more than double that o f fixed line penetration. However, this perception may be short term, inthe sense that there are real limits to the extent to which mobile services can substitute for basic telephony. Similarly, visible improvements to the airport terminals at Phnom Penh and Siem Reap do not necessarily mean that the government, airline companies, or passengers are getting good value for money from the concession arrangement. 0 Substitution. A final reason infrastructure may not appear to be more constraining lies in the extensive investments firms make to substitute for weak public systems. As noted above, 39 percent o f all firms (and 63 percent o f large firms) own their own generator, and 44 percent o f all firms have their own well. Weak public systems appear to be particularly constraining for the garment sector, in which 67 percent o f firms auto-generate, and the agro-processing sector, in which 91 percent o f firms have their own water supply. While this substitution of public for private utility systems may assure a reliable supply, these expensive investments constrain financing available for expansion and upgrading. "TheWorldBank(2003~1,TowardsA PrivateSector-LedGrowthStrategyfor Cambodia - Volume I Value Chain Analysis. ' InvestmentClimate Assessment& Reform Strategy Page 51 Chapter 4 Public-PrivatePartnerships I t is thus reasonable to conclude that infrastructure service delivery is a critical feature of the investment climate. Encouragingly, there appears to be strong recognition of the benefits of private provision o f infrastructure in Cambodia, which unlike other countries at similar levels o f development, has significant experience with PPI, across all sectors- inurban electricity generation and rural electricity generation and distribution; provision o f rural water supplies; international, mobile, fixed line, and internet telecommunication services; highways and airports; and municipal waste collection and disposal services. Figure 4.1 summarizes the main PPI contracts to date in Cambodia, grouping them by sector; indicating the public entities (ministries, departments, and regulatory agencies) that are officially responsible for administration and approvals for each sector and those that were actually involved with each PPI contract; describing the form o f PPI contract deployed in each case; and where known, the capital value of the project. On the face of it, this is good news for Cambodia. There appears to be strong and widespread political will to entertain PPI. The value of this should not be underestimated, as this is often a serious impediment to sustained PPI in developing countries. Moreover, there appears too to be a good understanding o f the constraints, risks and opportunities from PPI contracts among some senior government officials. Infrastructure service delivery through PPI is also an important source of growth for providers. A number of international firms have already made substantial investments in Cambodian infrastructure, notably in electricity generation, telecommunication services, road transport, and airports. Moreover, the local private sector is entrepreneurial and innovating, and seemingly willing to take risks, for example, by contributing their own equity into PPI projects. Local participation is spread across almost all sectors, suggesting that there is a local market to respond at least to some of the PPI opportunities. Inthe power sector, for example, there is local ownership in one of the independent power producers (Jupiter Power - minority Cambodian shareholding), and among the small-scale power producers that provide about 60 MW of capacity, largely financed from their own funds. In the water sector, all the small-scale service providers in provincial and district towns and rural areas (16 intotal) are locally owned and primarily internally financed. In telecom, one o f the four mobile companies is partly owned by the Royal Group, a large Cambodian company. Lastly, in the transport sector, a Cambodian company, Meng Steang, is in ajoint venture with a Malaysian company to manage and operate two toll roads around Phnom Penh, while a second company, AZ Group, has the concession rights for tolling along National Road 4, the 220-km divided highway connecting Sihanoukville and Phnom Penh. Cambodia also has a small but developing expertise in local private PPI advisory services, and a number of local companies (particularly legal firms) have acted on behalf o f private service providers in negotiating PPI contracts with the RGC. Moreover, Cambodia has a tradition o f public-private dialogue. These characteristics suggest that Cambodia has some o f the ingredients necessary for a successful PPI program. The practice of PPI, however, does not reflect many of these apparent advantages, and in the absence of an appropriate legal, institutional, and regulatory framework, many of the benefits frequently associated with PPI have not been secured. Each and every contract listed in Table 4.1 has been directly negotiated with the private contractor, without competitive bidding, in line with the procurement method under Sub-decree 60, governing public procurement. In the power sector, for example, independent power producers have all negotiated power purchase agreements directly, and this has meant that projects were not necessarily commissioned on a least-cost basis nor met technical criteria that would limit the likelihoodof delivery failure. InvestmentClimate Assessment & Reform Strategy Page 58 0 i9 c 0 RC E $E 3 r5 .-C 8 B fu s '5 5 -0 5 .-P 0 3 PLO i i .-0 .-e0 n I ! - m 6 6 B m de j Chapter 4 Public-PrivatePartnerships Cambodia has similarly failed to reap all the benefits of competition and private involvement in service provision in the telecommunications sector. The key reason for this is that each private license that has been awarded or cooperation agreement entered into has been inthe form o f ajoint-venture between the operator and the Ministry o f Post and Telecommunications (MPTC) itself. The Ministrythus shares in the ownership of all mobile services, the fixed line network, and the international gateways. It also sets telecommunications policy and acts as the regulatory agency. The sector is characterized by a lack o f transparency in the process for awarding licenses, forced large-scale revenue sharing between private operators and the MPTC, and very little price competition between service providers. Inthe transport sector too, it is difficult to determine whether the RGC andor users are getting value for money from the airports, toll roads, and air traffic control concessions, since all the contracts were directly negotiated and the details regarding performance obligations and risk allocation are not publicly available. 4.3 The OverallRegulatoryEnvironmentfor PPI-Enablingor Constraining? I t is clear, therefore, that Cambodia's PSD strategy must consider infrastructure service delivery both as a feature of the investment climate, and as an important source of growth for providers. To support this effort, the World Bank is overseeing a project on behalf of the Royal Government of Cambodia's Ministry o f Commerce, funded by the Public-Private Infrastructure Advisory Facility (PPIAF)'*, to strengthen the regulatory, procedural and institutional framework for managing PPI transactions in Cambodia (in short, PPI Governance). The study will deliver a set o f practical tools (draft law, policies, and supporting regulations and guidelines) that together assist in strengthening PPI governance in Cambodia, thereby increasing the country's attractiveness to private infrastructure investors, both international and local. Enhancing the role of the private sector in infrastructure and public service delivery represents Cambodia's best option for addressing the substantial infrastructure backlogs and will play an important role in facilitating private sector growth and development. The PPI Governance Study was initiated with a "regulatory and institutional gap analysis", which entailed a review o f policy, legislation, and other relevant documentation; a review o f best practice and experience elsewhere; as well as a series o f in-depth meetings with senior government officials, private sector providers, and other key stakeholders. In comparison to practice and experience in other countries, the gap analysis identified several major issues in relation to the regulatory environment for PPI in Cambodia. First, there is a general lack o f transparency in the handling o f dealings between the public and private sectors, specifically in the negotiation and management o f specific contracts between government and investors, from the initiation o f a potential project through to implementation. Few if any concession agreements or negotiated contracts have been made available for review, publication, audit, or public scrutiny. Second, there are significant gaps in the legal framework in a number o f sectors, with over-arching sector laws still in draft for telecommunications, water supply, and transport (inland and water as well as civil aviation). Even where there are no gaps in the legal framework, there is persistent bypassing of laws and administrative process and rules. Third, scant respect is paid to examining and documenting contingent and ongoing liabilities taken on by the public sector via contracts negotiated by government with private sector parties for infrastructure projects. Fourth, planning processes across sectors are generally inadequate, and as a result private firms frequently present unsolicited offers independent o f sector plans or in conflict with previously negotiated concessions. Fifth, there appears to be little auditing o f concessions prior to or after implementation. The 2004 work plan o f the Auditor General has already been set and audits for concession agreements are not inthe plan. "The PPIAF is a multi-donor technical assistance facility aimed at helping developing countries improve the quality o f their infrastructure through private sector involvement. Cambodia:InvestmentClimateAssessment Page 60 Chapter 4 Public-Private Partnerships Finally, and equally importantly, there is considerable institutional muddle, including cases where the allocation of roles and responsibilities between institutions is unclear. In several sectors there are multiple agencies providing oversight, licenses, and permissions to operate, but there is no or limited coordination between them. Government agencies tend to compete with each other to enter into concession negotiations with private sector investors. In some instances officially designated roles and responsibilities have been over-ridden by more senior individuals, departments, and ministries in government. On the other hand, different investors have taken different points of entry and different negotiationand approvalpaths (e.g. individual line ministries, the CDC, and the CoM) for similar projects that shouldbe handled identically. The consequencesofthese problems include: non-bankableprojects, with investorsto date completelyunable to secure limitedrecourse or non- recourse project financing for infrastructureprojects in Cambodia - all investments have been fully equity financed, which drives up requiredreturnsand hence the prices to consumers; higher than necessary prices to consumers in the Cambodian economy due to the costs of administrativeinefficiency to investors and the extraction of bribes by individuals and government agencies involved inapproval, permitting,licensing, and concessionprocesses; unavailability of information on the value-for-moneyreceived by the public from infrastructure projects due to the inability of the public or third parties such as international development banks and agencies to assess the full value set o f risk and the distribution of revenues and profits in concessions. limited protection of the public interest - the lack of transparent, predictable, and enforceable laws and administrative procedures contributes to an environment where decisions can be made in an arbitrary or improper manner without due regard to the economy, efficiency, the long term sustainabilityofthe project, or the interests of consumersandthe wider public. 4.3.1 Weaknesses in the Legal Framework There are substantial gaps in the wider legal framework for PPI. Cambodia's legal framework i s still in the course o f development with many new laws being drafted, examined, and adopted. Over 50 laws are due to be adopted within the next 4 to 5 years as a requirement to Cambodiajoining the WTO. Many areas are not yet coveredby any laws or regulations. The backlogof laws to be implementedandthe slow speed with which new laws are adoptedalso has implicationsfor the extent to which the frameworkfor managingPPIcan be reformedby changesto laws or regulations. Gaps in the wider legal framework in Cambodia adversely affect the bank ability of infrastructure projects with private participation. Gaps include the lack of a security law (and, more specifically, laws clarifying the ability of lenders to take security over infrastructureassets, income streams, and contractual rights), bankruptcy laws, commercial contract laws, a business law, and the absence of developed anti- competitionlaws. Evenwhere laws have been enacted, those laws andregulations are not fully applied or are difficult to implement.This reflectsa lack of clear enforcementmechanismsinthe applicable laws and shortcomings in the legal mechanisms for enforcing laws generally, notably because the court system is unreliable. As Chapter 2 reveals, the courts are not only regardedby privatefirms as the least honest public body, but this perception appears to have worsened over time (when comparingthe 2003 ratingsto a parallel question in the 1999/2000enterprise survey, a higher percentage of firms rate thejudiciary as corrupt). The deficiencies in the wider legal framework are reinforced by problems in legislation that Cambodia: InvestmentClimate Assessment Page 61 Chapter 4 Public-PrivatePartnerships have specific relevance to various stages of a typicalPPIproject cycle. These include the following: Policy-making, planning and project identification. Current laws and regulations do not provide for any effective, coordinated process for agreeing policy on development o f PPI, nor for setting priorities across projects or sectors. The general legal framework provides for planning processes to be dealt with on a sectoral basis. However, it does not contain clear requirements to carry out such planning, so that even within sectors there is, in practice, little or no planning and pre-approved plans are often changed when unsolicited proposals are received. In addition, no detailed policy planning is provided for in sectoral laws and regulations and such planning (if done) is performed under the general duties provided in the laws or regulations establishing each ministry or government entity. The draft Sub-decree on Power Projects has sought to address this problem, for example, by detailing the policy planning process and forbidding unsolicited proposals. The approval process prior to award. Once individual projects have been identified, the 1993 Financial Budgetary Law requires all PPI contracts, regardless o f the sector, to be approved by the Ministry of Economy and Finance (MEF) prior to signing. However, this legal requirement is generally not followed and it is not clear that MEF has the capacity to carry out this function.73 The laws and regulations leave it unclear whether certain minimum risks, such as legal and regulatory risk, will (or may) be borne by the Government (as will usually be required by private investors), reflecting the lack o f understanding within the RGC of the importance o f the allocation of risks in PPI projects. The legal framework also fails to provide clear guidelines, conditions, and procedures for the approval o f governmental support to a project, particularly financial or performance guarantees. While the law requires guarantees to be approved by the National Assembly (either in an annual Financial Law or by a separate law), the procedure for taking a guarantee to National Assembly for approval and the criteria for approval are not set out inlaw. 0 Negotiation and award ofprojects. A number of cross-sectoral laws reflect the principle that contracts with the private sector should generally be awarded by competitive tender. However, these laws either have limited application to PPIs or are simply not followed. To date, most PPI contracts in Cambodia have been awarded without a formal biddingprocess. The sectoral laws also do not set out clear procedures for awarding and negotiating PPI projects. Furthermore, these sectoral laws or regulations do not address the applicability of cross-sectoral laws and regulations (such as Sub-decree No.11 concerning BOT projects) to PPI projects in each sector, particularly where conflict exists between these. The developing legal frameworks for most sectors (electricity sector excluded) also do not appear to address this issue. Finally, the existing laws do not clearly identify which governmental entity has the power to enter into negotiations and take decisions on all types o f infrastructure projects, notably with confusion existing between the powers of the Council for the Development o f Cambodia (CDC), line ministries, the MEF, and the Council o f Ministers (CoM), and between these o f the central government, the provinces, and the commune^.'^ 0 Project implementation. Once agreement has been reached with the Government on award of a project, private investors must begin the burdensome task o f requesting all necessary approvals, permits, consents, licenses, and authorizations from multiple governmental entities, including the Ministries of Environment, Social Affairs, Labor, Vocation and Youth Rehabilitation, and the Tax 73 Itshould be noted, however, that there appears to be at least one recent instance in which the Minister of Finance used the provisions of the 1993 Law to refuse to sign an implementation agreement for a power generation, transmission, and distribution contract; until such time as his Ministry has hadthe time to review the draft contract in more detail. 74The Law on Investment (LOI, 1994) established the Council for the Development o f Cambodia (CDC) as the 'one-stop' service organization for investors and supposedly the sole responsible organization for evaluating and making decisions on all investment projects, both rehabilitation and new. However, numerous contracts, including the National Route 4 Highway; the oil terminal and dry ports: and the airport concession were each negotiated directly with the CoM. Similarly, power purchase agreements with independent power producers in Phnom Penh and electricity projects in Battambang and Siem Riep were each negotiated with the Ministry of Mines and Energy (MIME) and the CoM in the presenceof ElectrictC de Cambodge (EdC). Cambodia:InvestmentClimate Assessment Page 62 Chapter 4 Public-PrivatePartnerships Department. Although the Law on Investment of 1994 sets out a process for identifying the required consents and streamlining the approval process, these procedures in practice are not followed. This largely reflects gaps inthe scope of the law and the absence o f suitable enforcement mechanisms. Given the lack of institutional capacity, the scope for legal solutions to these problems may be limited. Management of PPI contracts. The legal framework does not make provision for post award management o f PPI contracts. In particular, the law does not clearly identify the public authority responsible for monitoring construction and operation o f the project, or for enforcing the terms of the PPI contract. Issues such as principles for managing changes in tariffs project costs, auditing government spending under the contract and for extending the PPI contract on completion of its term are not dealt with in relevant laws or regulations. In practice, there i s little evidence o f effective project monitoring or management. Regulation of infrastructureprojects. Inmany sectors, the law is unclear as to which entity has the power to regulate projects of the kind contemplated by the particular PPI contract. Inmost sectors, the laws establishing the line ministries provide generally that regulation of the sector is the responsibility o f that ministry. There is, therefore, no separation between the authority approving and awarding the contract on the one hand and the entity responsible for regulating the project on the other, creating potential conflicts of interestand confusion where a project falls within the scope of more than one `sector' (under different line ministers). A further problem is the lack of clear distinction between the government party to a concession or other type o f PPI contract and the body that would regulate or resolves disputes arising under the contract on the other hand. In certain sectors (namely power and aviation), separate regulators have been established, though in the case of civil aviation the regulator is not independent. The procedures for making regulatory decisions are not set out in law or regulation, and there i s no requirement to make decisions available to affected persons or for those decisions to be challenged. 4.3.2 Institutional Weaknesses In Cambodia, the unstructured and informal nature of the PPI project process makes the construction of an institutional `road map' especially difficult, and largely irrelevant. It would appear from the gap analysis that none o f the successful concession agreements began with a line ministry and followed a clearly documented prescribed path to approval that involved the assigned line ministry, except as an implementing agency. It i s therefore not possible to describe a general approval path followed in practice by many or most PPI transactions., Several cross-sectoral institutionshave key if not clear roles in the PPI process. These include the following: The Council for the Development of Cambodia was established as a `one-stop shop' service organization for all investment in the country. After receiving a registration certificate from CDC, investors should be eligible for investment guarantees, tax incentives, and import duty incentives. CDC should also provide a conciliation service for disputes. The CDC automatically refers large projects with a value o f over US$50 million to the Council of Ministers, but even smaller projects have bypassed the CDC.75The amendment to the LO1 (2002) makes the granting of a registration "While the CDC has devised an `official' process for an investor to bring a project to the RGC through its various internal departments and ultimately to the CoM, more common routes entail projects being brought either directly to the Council of Ministersor indirectly to the Council ofMinistersthrough a `relationship broker'. Cambodia Investment Climate Assessment Page 63 Chapter4 Public-Private Partnerships certificate automatic, subject to investors meeting set criteria rather than the discretionary basis in the p a . ~ t The~amendment also makes the CDC responsible for obtaining on behalf o f the applicant . ~ all o f the licenses required from the relevant ministriedentities, and requires that the latter issue the documents within 28 days. The Ministry of Economy and Financehas, intheory, a fairly comprehensive role inthe oversight and approval o f key aspects o f the leasing or concession process. According to Order No30BB on Management o f State Property, MEF has a central role in the management, sale, and letting o f state property that is under the management o f ministries, provinces, municipalities, state, and public enterprises (called Trustee Authorities). As mentioned above, the 1993 Financial Budgetary Law requires all PPI contracts to be approved by the MEF prior to signing. In addition, while the MEF has a dedicated department to play this latter role, it lacks the capacity to do so effectively, or it i s simply bypassed. The Office of Public Procurement, established under the MEF, should theoretically review all public-private partnerships. However, it can be and is frequently bypassed if the proposed project does not require budget transfers or can bejustified as an emergency. The Audit Authority, established in terms o f the Law o f Audit 2000, is empowered to undertake audits on all state and government institutions, using its powers to gather information, enter premises, inspect records, and impose penalties on individuals. To date, the Authority has not undertaken an audit o f any o f the existing concession contracts, and has not planned to do so in financial year 2004. Sectoral institutions similarly lack capacity and clear institutional roles and responsibilities, although this is uneven across the sectors. The institutional framework is quite advanced inthe electricity sector, for example, both in the existence and roles o f organizations and in the ongoing proposals in the recently developed draft policy. Roles have been substantially clarified, with MIME as policy-maker, the newly formed Electricity Authority of Cambodia (EAC) performing the regulatory function, and the main utility EdC being the off taker for power purchase agreements and the major transmission and distribution player serving Phnom Penh and a number o f other urban areas inCambodia. The institutional framework is less advanced in the other sectors. The Ministry o f Post and Telecommunications (MPTC) is both the line ministry with policy responsibility and in effect the sector regulator, responsible for issuinglicenses for telecommunications operators. There is a draft law which may establish the Telecom Authority as independent regulator. An independent water regulator is proposed in the draft Water Supply Law. Overall, the institutional framework for transport is unclear and weak, with no clear legal framework and a tendency for sector projects to bypass the line ministry, the Ministry o f Public Works and Transport. 76The amendment has also reduced the size and scope o f some o f the incentives. Cambodia: InvestmentClimate Assessment Page 64 Chapter 4 Public-PrivateParfnerships Box 4.1. Permits, licenses, and consentsrequiredfor a typical power project Establishment Investment license and Investment Incentives (CDC) Registration o f the Company (Ministry of Commerce) TUX Master list import exemption (CDC/MEF) Licenses ConsolidatedLicense according to the Electricity Law b RGC to provide a Policy Directive to EAC for the grant o f the appropriatedistribution and retailing licenses to the Company inrelevant Provincial Towns b RGC to provide the principles and conditions for the grant of the appropriate SpecialPurposeTransmission Licenses to the Company Construction Construction permit for facility (Ministry of Land Management,UrbanPlanning, and Construction) Construction permit for smaller works (Ministry of Land Management,Urban Planning, and Construction) * Permit for water intakes (Ministry of Water Resources and Meteorology) b Permit to build pontoon structure on river where applicable (Ministry of Water Resources and Meteorology) Street excavation and use license for water/fuel piping and electrical (Ministry o f Water Resourcesand Meteorology, Ministry of Culture and Fine Arts, CambodianNationalPetroleum Authority, Ministry of Transport andPublic Works) Waste water and storm water discharge permit (Ministry of Water Resources and Meteorology) Right to extract water for use at the facility Transportation Permit for off loading of fuel at Port (Ministry of Transport and Public Works) Environment Agreement with Ministry of Environment (MOE") to regulatethe Company's compliance with environmental regulations in a form and substance satisfactoryto the Company Site assessment approval (MOE) Environmental Impact Assessment Report approval (MOE) Exportation of hazardouswaste (MOE, Ministry of Commerce and Importing Country Permit) Transportation of hazardouswaste (MOE) Dischargeor transportation ofwastewater (MOE Permit) Investmentof the treatment or incineration of hazardouswaste (MOE) Immovable Propevv Registration of title transfer (ifapplicable) Registration of easement (Ministry of LandManagement,Urban Planning, and Construction) Registrationof lease (Ministry of Land Management, Urban Planning, and Construction) Registrationof security interest in land (Ministry of LandManagement, Urban Planning, and Construction) 0 Registrationof security interest in i)improvements and ii)easement (Ministry of Land Management, Urban Planning, and Construction) I Cambodia: InvestmentClimate Assessment Page 65 Chapter 4 Public-PrivatePartnerships 4.4 Improvingthe PPI Framework-Key Drivers for Change WTO Accession. Cambodia has recently obtained agreement for WTO accession. Injoining the WTO Cambodia will be required to adopt and implement a range o f legislation and practices, which will promote better governance. Key among these will be government procurement practices that promote competition, accountability, and transparency. The pressure to adopt a multitude o f reforms i s likely to impact the institutional and regulatory environment for PPI in Cambodia directly, and there i s already evidence o f this in the telecommunication sector, which is in the process o f drafting a new Telecommunications Act. The Act will separate policy-making powers from regulatory and operational ones, which will have a profound effect on the current structure o f the sector, in which the Ministry has a role in all three functions. Similar reforms are anticipated for the water sector. The Changed PPI Environment. Globally, the PPI environment has changed dramatically in the past few years. The optimism o f the mid-1990s has now been replaced by widespread pessimism. Annual investment flows to private infrastructure projects in developing countries, which peaked at nearly $130 billion in 1997, are down (and by 2001 were only 44 percent o f the levels seen at their peak). Projects have been renegotiated and some have been re-nationalized or cancelled. Investor interest in private infrastructure projects in developing countries is also subdued, and the appetite for risk severely diminished. Many o f the traditional players are even trying to disinvest from countries in which the political and regulatory risks are considered to be extremely high. The Royal Government o f Cambodia will need to respond to this changed environment in a number o f important ways, such as by: Making immediate and fundamental changes to the current regulatory and institutional environment for PPI - focusing on transparency, predictability, competition, and accountability - to mitigate political and regulatory risk; Reinforcing government performance risk by using political risk guarantee instruments to protect foreign investors and lenders not only against war, currency transfer, and expropriation, but also against government breach o f contract risks; Using transition subsidies to full cost recoveringtariffs and connection subsidies to connect some o f the poorest households, employing private partners to ensure effective delivery o f subsidies; and Recognizing that at least some o f the investment to achieve build-out targets may need to be kick- started by public finance. This new reality has implications for both the RGC and for the international donor community. For the Government o f Cambodia, it means that failure to introduce early and meaningful reforms will severely restrict the number o f private operators and investors willing to participate in the PPI market inthe country, and may induce existing concessionaires to seek to renegotiate their contracts. For the donor community, it provides considerably more leverage to attach funding conditions for improved PPI governance to the projects with which they are associated, thereby increasing transparency in project award. There is already evidence that the donor community has begun to "flex its muscles" in this regard. In two recently signed infrastructure loans provided by the World Bank, for example, one for road transport and a second for rural electrification, the World Bank has incorporated conditions that require the Cambodian Government to publicly disclose (on appropriate government websites) relevant project information, including the name o f the awarded party; the value o f the contract; its location; duration; financing arrangements, and other non-proprietary commercial information. In a separate project, the Korean Government has publicly announced its intention to retract a commitment to fund a road transport project, based on its assessment that the procurement and selection process was fraudulent. Cambodia Imestment ClimateAssessment Page 66 Chapter 4 Public-PrivatePartnerships Box 4.2 The Importanceof Transparency Citizens, service providers, and governments would all gain from increased accountability and transparency. With easy access to published concession contracts, citizens would be better able to determine which party has responsibilities for a particular aspect ofthe project, such as maintaining service quality, improving infrastructure, collecting fees, connecting and disconnecting service, and a variety of other daily operations. This would enhance the accountability of both service providers and govemments to respondto citizens' issues and concerns. Inmany cases of troubled projects, governments and concessionaires simply exchange accusations without allowing citizens to directly establishliability. Transparency reduces the chances for, and perception of, of corruption. In Cambodia, many projects that were negotiated through closed, non-transparentconcessions are the subject of frequent allegations o f corruption, and are also often the subject of calls for renegotiation of tariffs paid by users. A norm of publication could reduce the suspicions that sometimes surround the awarding of contracts. This would be very valuable when projects are unsolicited and/or contracts are directly negotiated. With this in mind, the Mexican Government recently passed a Transparency and Access to Public Govemment InformationLaw making government contracts available to requesting citizens within 20 days. The new Mexican law also dictates that federal agencies must place contracts on government websites by mid-2003. Although transparency laws like Mexico's will not prevent all corruption, both government officials and companies would be less likely to engage in unethical behavior during the awarding phase ifthey know that their contracts will eventually be made publicly available. Transparency helps markets work better. Publication of contracts could facilitate the evolution of standards in infrastructure transactions. Governments could obviously benefit from access to privatization agreements from other municipalities, agencies, and countries. Widespread availability of contracts would also make it easier for consumers to benchmark tariffs and other service obligations with similar systems in other jurisdictions. Overtime, contracts for services in similar environments would become more in line with one another, thus lowering the number o f "sweetheart" deals. Published contractual information could facilitate easier and quicker market access to new entrants as well. If previous agreements are widely available as benchmarks, prior to bidding a potential concessionaire would have a much better idea of what terms to expect from a particular government. Transparency is consistent with WTO. In Cambodia's WTO Working Party Report Para 217, the Council of Ministers has committed to establish or designate an Official Journal dedicated to the publication o f regulations affecting trade. Furthermore, moving forward on an agenda o f transparent, competitive PPI indicates that Cambodia is on the way to implementing one of the so-called "Singapore Issues" on public procurement. I s contractual information confidential? Private providers will often dispute that certain information in a contract is property of the company and should not be publicly disclosed. For example, private operators may argue that concession agreements contain confidential information about technologies used, cost of capital, national security, or parent company finances. This type of information, however, rarely is central to the consumers and does not necessarily needto be in the concessioncontract. A key would be to accurately separate true confidential information from publicly acceptable information. The US Freedom of Information Act does allow for certain information to remain confidential, especially if it is relevant to national security. Governments may fear that companies will not participate in bidding processes if contracts are made public. If the terms that companies are willing to accept are so bad that they must be hidden from citizens, however, then the concession arrangement was probably not best for the community in the first place. Inthe long-term, governments may even adapt policies of circulating concession agreements for public comments before signing, which is often the case fnr l l r m 4.5 Conclusion In summary, the opportunities for realizing significant efficiency gains from current and future PPI transactions in Cambodia are severely constrained, for a number o f reasons. These include the fact that the vast majority o f deals are done at very high levels o f government, circumvent the institutional and Cambodia InvestmentClimate Assessment Page 61 Chapter 4 Public-PrivatePartnerships regulatory framework, undermine the ability o f line ministries to develop credible policy, and weaken the accountability of ministries. Finally, because the terms of these contracts are not released to either Parliament or the public, there is no way for citizens to know if terms are providing good value for their money nor a means for them to pressurefor terms which are more favorable. Inother words, these practices violate three basic principles: competition, accountability, and transparency. Since the service providers are granted long-term rights to manage monopoly assets, the only opportunity for obtaining the benefits of competition comes during the initial transactions. The lack of regulatory institutions that could bring a proxy for competition benefits to bear on tariffs and performance obligations also highlight the need for competition at the point o ftransaction. The PPI Governance Study is nearing completion and draft proposals have already been submitted to key Cambodian government officials and political leaders for consideration. Final proposals, to be reflected in a limited number o f key instruments (policies, legislation, and supporting regulations and guidelines), will be delivered by August 2004. The outlines of a reform program for PPI are discussed briefly in Chapter 5 below. Cambodia: Investment Climate Assessment Page 68 Chapter 5 Program of Reform CHAPTER 5: A PROGRAM OF REFORM Strategic objective. The objective, as defined in the NPRF' and through the public pronouncements o f the Government, is to enable broad-based private sector growth as a sustainable means o f poverty reduction. Given the limited public sector resources to develop, implement, finance, and monitor policies, question o f strategy i s about making best use o f limited resources in a way that has the greatest impact on the strategic objective. The core o f the strategy i s about removing administrative obstacles, strengthening essential trade-enabling institutions, and improving the enabling environment for the private sector's contribution to service delivery. The analysis informs a set o f principles that may help Government, Donors, and the private sector in prioritizing actions and reforms. Guidingprinciples Ease the burden on business: a shifi from a culture of control to a culture of facilitation. Streamline institutional overlaps, particularly in trade facilitation, and reduce the large number o f inspections and licensing requirements, particularly those related to ensuring quality. Empower markets and competition. The healthy development o f the private sector depends on removing policy distortions that prevent market signals from reaching the private sector and helping shape economic decisions. This includes elimination o f exclusive dealing arrangements. Do not go beyond the limited capacity of public institutions. Given capacity constraints, it is necessary to focus on non-state roles and streamline the role o f the public sector. The strategy should reposition the state to provide effective governance, accountable to the public, and focus where possible on enabling private service delivery. Focus on reforms that are empirically shown to relate to improving competitiveness and productivity. There is a range o f institutions and reforms that can help the private sector, but in consideration o f the survey and value chain analysis, few that impact productivity. Increasing labor productivity is the most sustainable way to increase job growth. Use private institutions to integrate rural and informal sectors. Integration means removing policy-related impediments, both formal and informal, that raise the cost o f doing business for firms that are now limitedto either informal or small-scale, local trade. This will be achieved by (1) reducing policy-based impediments, particularly in such areas as trade facilitation and business inspections and (2) reducing entry barriers, such as unnecessary licenses and the high cost o f registering businesses. Focus on institutions that reduce risk and transaction costs, While specific, sectoral interventions may be needed, institutions that reduce the risk and uncertainty o f trade are needed across all sectors. Where feasible, these should include sustainable alternatives to state or donor-funded measurement systems. Focus on institutional learning, given the early stage of private sector development. Explore the role of local business organizations, scaling up pilot work with rice millers and REEs. Cambodia: InvestmentClimate Assessment Page 69 Chapter 5 Programof Reform Introducing greater accountability in policy formulation and performance. No strategy or economic policy can have impact unless it i s monitored and there are consequences for objectives and milestones that are not achieved. In Cambodia, donors currently provide a monitoring role. This is inconsistent with a program designed to achieve sustainability. The strategy should strengthen private sector monitoring of public performance (including corruption) and capability to participate in policy dialogue - both to support Government-Private Sector Forum and rural areas. Reform Priorities Private sector development i s an evolving process, and successful reform can only emerge from continual effort to improve the investment climate. Based on the analyses conducted to date, the following eight reforms emerge as initial priorities supporting existing reforms underWTO commitments. 5.1. Streamline Trade Facilitation As part of WTO accession, Cambodia has committed to a new Customs Law." However, extending the benefits of WTO accession to the rural economy requires not just Customs Reform but comprehensive trade facilitation reform. For this reason, we have provided a detailed outline of a reform program that address several key requirements: 0 The solution should comprehensively address all stakeholders rather than Customs alone; 0 Decreasethe import and export transaction costs to the private sector; 0 Increase formal revenue flow to the RGC; Decrease unnecessary and redundant operational costs to the RGC to manage the trade process; 0 Decreasethe overall time it takes to import and export products; 0 Increasethe visibility and predictability o f the processwith respect to bothtime and cost; and 0 Comply with international commitments-most importantly WTO, but also APEC, AFTA and GMS. Reform Actions. Reform must start from a cross-agency perspective- rather than in agency silos. Currently, each agency pursues mandates independently and communication across agencies is insufficient. Since the CED and Camcontrol have overlapping approximately the same powers and responsibilities, their activities should be better integrated or possibly merged over time. Adopt a challenging, aggressive, and achievable trade facilitation mission statement that is supported by the senior members of the RGC in order to provide the framework and motivation for significant reform. The mission statement should (1) set the broad goals for the trade facilitation function, (2) establish Cambodia's performance objectives with respect to its competitors, (3) acknowledge the importance of trade facilitation within the larger societaUeconomic goals of the country, and (4) set a timeline for achievement o f stated goals. Set quantifiable performance goals - and measure progress. Agreement on a set of regularly tracked metrics is proposed, to (1) assess overall performance, (2) compare efficiency across departments and against competitors, (3) assess staff performance, (4) guide staffing and policy decisions by management, and (5) improve public relations with respect to process improvement. I 7Working Party Report, Para 84 and 93. Cambodia: Investment Climate Assessment Page 70 Chapter 5 Programo fReform Reengineer the Facilitation Process while Introducing a Single Administrative Document. The current "real" trade facilitation process contains numerous steps that provide little or no value in facilitating trade and significant opportunities for rent seeking among government agents. As such, basic process streamlining is required to drive cost and unnecessary processing time out o f the system by eliminating "non valued-added'' steps. The reengineering is designed to support the move from independent dealing by each concerned agency with a single, rationalized process facing the customer, which is the private sector export or importer. Such a process, based on improved information sharing across agencies, could usehlly start with the replacement o f the current multiple documents with Single Administrative Document shared by all agencies. Initially, streamlining should focus on improving the manual processes, but at the same time it will pave the way to automation.'* WTO entry requirements (valuation standards and the Harmonization System) should be incorporated. RationalizeRoles and ResponsibilitiesAcross RGC Agencies under a Single Window with Flat Fee for Service and SLAs. To increase efficiency and accountability, trade facilitation processes should be consolidated into a Single Window. The implementation o f a Single Window is a core step to improving overall customer service, reducing opportunities for rent-seeking and addressing the needs o f the legitimate private sector. The Single Window should consolidate all documentation and payment processing into a single customer interface for importers and exporters operating inCambodia. Introduce a Risk Management System to Reduce the Inspection Rate per Container. Current discretionary inspections should be replaced by a system by which inspections are selectively inspected based on risk parameters. The development o f risk parameters would take into consideration historical current communication path reform performance, and the perspective o f the various agencies involved inthe TF process. Automate the Process. To support the successful implementation o f other streamlining initiatives and to achieve the vast process efficiency improvements the technology has demonstrated, a comprehensive automation system should be deployed. An overall architecture across key agencies should be developed, followed by a phased implementation plan. HR Management Reform. Although it is unlikely that official salaries will ever match the full compensation that customs agents are currently making through official and unofficial payments, it is important to increase compensation to reasonable levels. An effective, comprehensive compensation program requires restructuring o f salary scales to increase formal base compensation, restructure positiordgrades to provide additional promotion opportunities and development o f a system o f tangible performance goals. To pilot new processes and automation within the trade facilitation process and to increase customer service, an "elite unit" within Customs should be established. 78The foundation for manual process streamlining has already been developed by the CEDIIMF. Initial focus should be on driving the implementation o f those initiatives. ~Cambodia InvestmentClimate Assessment Page 71 Chapter 5 Programof Reform Review support functions. While KAMSAB has improved the overall process for coordination of shipping activities within Cambodia since its inception, the introduction o f commercial shipping agents in the market eliminates the need for an official government shipping agent. While the current outsourced PSI program is not operating at an optimal level, immediatetransition o f PSI responsibilities to customs is not advisable in the near-term. Over time, however, placing all inspection responsibilities under an institutionally-strengthened Customs agency will reduce cost and processingtime.79To provide the RGC with additional funds and to introduce competition within the shipping agent industry, the privatization o f KAMSAB should be evaluated. Increase Enforcement to Deter Government Agent Malfeasance. To support other initiatives to reduce petty corruption among agents, an aggressive enforcement program should be adopted that attacks the problem of agent malfeasance at multiple levels. The core components of this enforcement program include the creation o f an independent arbitration panel to review cases o f agent malfeasance, enforcement of a "zero-tolerance" policy against petty corruption, and formalization of post- reconciliation audit to locate and punish fraud and increasedpenalties. Introduce Stronger Anti-SmugglingEnforcementMechanisms. A systematic review, evaluation and refinement of current enforcement mechanisms should be conducted. The role of and capabilities of the Intelligence unit within Customs Administration must be strengthened and cooperation between enforcement agencies increased." Focus also on private sector ethics. While in the short-run, more enforcement is needed, over the long term, a culture of trade facilitation by the public sector must be matched by a culture o f compliance by the private sector basedon ethics. Establish a trusted, transparent, dispute settlement mechanism. Cambodia has committed to establishing a dispute settlement mechanism within its WTO commitments." The mechanism should be independent, autonomous, and to the extent possible, include private sector participation. It should focus on specific technical issues such as nomenclature and valuation rulings, which have as their base, publicly disseminated information. FIGURE 5.1. SUMMARY OVERVIEW OF REFORM INITIATIVES Re-engineer process around Consolidate inspections under one automstlon and olngle window agency B create speclal unlt IntroduceSLA Eliminate Kamsab requirement Ratlonalize (Evaluate Privatization) Support Import Implement Risk Inbound Certification and Training PSI program, Management Clearance for CBIFF Increase skill process Committee Introduce SLAdFlat Fee transfer and technical Change AZ Reduce Port Service Formalize % of Unofficial Charges assistance; Group reimbursement Charges Establish "ellte Unlt" wlthln Customs transition to insourcina scheme (Evaluate Privatization) EstabllshSuPPortini Performance Targets Infrastructure Misslon and Ratlonalize Roles and Consolidate around Customs Increase Staff Remuneration Increased Enforcement Mechanisms Establlsh Transparent Arbitration Process Tie lncentlvec to Achievement of Goals 79Working Party Report,Para 93, 105. ''Working Working Party ReportPara 98. Party Report Para 99. ~~Cambodia InvestmentClimateAssessment Page 12 Chapter 5 Programof Reform 5.2. RemoveImpedimentsto Diversification Value-Chain Focus on Removing Impediments.The value chain analysis indicates that in order to improve the competitiveness o f locally produced products, particularly those targeted for the export market, a number of policy and market based reforms must be undertaken simultaneously. Isolated action by the government or the private sector to address either policy or market reform issues i s likely to have a limited impact on the overall competitiveness of the Cambodian economy, particularly as many of the critical barriers to competitiveness are cross-cutting issues that can only be tackled through a strong public-private partnership. No one Ministry has within its ambit the broad range o f strategic reforms required to remove these constraints. We therefore suggest forming pilot inter-ministerial task forces around key value chains, beginning with rice and cotton as pilot products. The composition o f these task forces should be determined by where the key constraints lie and who has authority to address them. The effort should be guided by market demand, and the task forces should also be informed by direct consultation with the private sector. Private sector input should be broadly coordinated by the Government-Private Sector Forum, but should incorporate the input of the relevant business association. The support o f MPDF, SME Cambodia, CDRI, and other technically competent organizations should be leveraged, possibly on a competitive basis. For example, looking at the rice value chain, key agenda items would include: 0 Addressing highfertilizer import costs and dilution o f fertilizer through opening trade;'* Strengthen access to rural financing by removing impediments to rural branch banking, improved land titling, and strengthening legal institutions for collateral and contract enforcement; 0 Address low productivity inplanting through agricultural extension and improved rural education; 0 Improve export competitiveness o f domestic mills through power sector reforms, competitive contracting of private roads, combating illegal roadblocks, and trade facilitation. Streamline business registration. As noted in Chapters 2 and 3, competition and economic dynamism in Cambodia are constrained by barriers to entry and a variety o f administrative and regulatory impediments to formal operation. This begins with business registration, a long and costly process estimated by the Doing Business evaluation to take 94 days and cost over 550 percent o f GNI per capita in 2002 ($280). A further minimum capital requirement requires a deposit o f over 18 times per capita GDP. Experience of other countries has shown that business registration can be substantially expedited even without any fundamental technological changes relating to the process. For example, the VAT can pre- approve registration numbers, which are then assigned by the Ministry o f Commerce upon the incorporation o f the firm in the commercial registry. Low-income countries often achieve registration within 30 days (e.g. Bangladesh, Ghana and India).83 0 Reducethe cost and time requiredto register the incorporation with the Commercial Register, which is maintained at the Office o f the Clerk o f the Commercial Court, and costs an average of $630 and 30 days. Registration as a corporate entity should be an administrative procedure and information should be conveyed from the Ministry o f Commerce to the Commercial Register automatically; 0 Remove the requirement to send a notification of the Ministry o f Labor to start hiring employees, costs $250 and 30 days to complete; 0 Automatically register the company for the VAT using the same form; and 0 Waive the minimum capital requirement, which can be eliminated as it does not, in practice, serve any function other than to make entry more expensive. 82 Working Party Report Para 77 requires removal of Quantitative Restrictions (QRs) and establishment of WTO-consistent methods for registration and review. 83 See,for example Djankov et al.,"The Regulation of Entry", Quarterly Journal of Economics, 117, 1-37, February 2003. Cambodia: Investment Climate Assessment Page 73 Chapter 5 Program o f Reform 1 0 0 - 6 0 0 9 0 8 0 5 0 0 7 0 8D. 4 0 0 6 0 5 0 3 0 0 BE8 4 0 e 3 0 2 0 05 2 0 8 1 0 0 i o 0 0 1 2 3 4 5 6 7 8 8 I O 1 1 P rote d u r e Numbero f procedures 11procedures Time (days) 91days Cost (%of income per capita) 553.8 Yo Min capital (% of income per capita) 1825.8 Yo Source The World Bank, DoingBusinessDatabase 2003 Step 1: Deposit the legally required initial capital ina bank Step 2: Check the uniquenessof the company name Step 3: Pick up a company registration form Step 4: File the office registration with the Municipal Government Step 5: Make a company seal Step 6: Publish formation notice Step 7: Incorporate the company with the Commercial Register Step 8: Have registration documents stamped Step 9: Registerthe company for VAT Step 10: Notify the Ministry of Labor Step 11: Receive Inspection from Labor Inspector StreamliningBureaucracy Removal of obsolete licenses. Many licensing requirements currently serve little purpose, and are frequently ignored. For all products for which there has been no request for a new license in 24 months, the licensing requirement should be eliminated except in cases o f extremely risky business lines. Automatic Approval. All requests for Government approval of a license will be considered positive ifthere is noresponse within 30 days ofan acknowledged acceptance ofthe request. Ifcircumstances dictate a more lengthy review (such as a mining or natural resource investment with significant socio-economic impact), then the Government should respond within 30 days with a clear process and timetable. Flat fee for all sector licenses. To avoid artificial incentives, fees to obtain licenses should be waived or set at a minimal level that is equal for all products and sectors. Place the burden on the Government to share information. Multipleforms should be replaced by Single Administrative Documents that serve multiple agencies wherever possible. Agencies should be prohibited from requesting information that has already been provided to another institution during the same process. Cambodia: InvestmentClimate Assessment Page 14 ChaDter 5 Proeram of Reform 5.3. Strengthen Rule of Law Businesses identify the weak rule of law as critically and increasingly constrainingto their operation and growth. Weak rule of law adds to business costs and heightens the risk associated with investment. Cambodia has embarked on a strategy to complete its legal framework and strengthen its judiciary. In addition, Cambodia has committed to a substantial program o f law development within the context of WTO accession, including the passage o f a law establishing the Commercial The underlying substance of the reform program is currently being reviewed by a number of donors including the World Bank Group, and a Legal and Judicial Reform Assessment i s being prepared by the Bank with a donor working group, as well as the Law, Tax, and Governance working group of the Government-Private Sector Forum. Yet it is clear that certain key elements will characterize any approach to strengthening the rule of law. One is to complete the legal framework for markets, by putting into place the basic laws that together comprise a commercial code, starting with the Law on Business enterprise^.^^ Another is to make certain that laws and regulations are widely available, not only to judges and lawyers, but also to citizens and businesses, so that they better understand their legal rights and responsibilities. A third is to improve the functioning of the courts, potentially through technical assistance, training and administrative reforms, so that impartial and legally-based judicial decisions can underpin contracting and backstop alternative dispute resolution. Since establishing the legal framework, implementation capacity, and awareness among stakeholders will take considerable time; early and sustained progress is essential to building investor confidence. Meanwhile, as complements to the formal rule of law, it is important to note that stakeholdersto the legal andjudicial reform program can be empowered to actively promote rule of law and "demand side" reforms. This will involve both mainstream public education and outreach to the rural and informal private sector regarding legal rights and fair mechanisms to resolve businessdisputes. 5.4. Leverage Private Sector Value Chains to Develop Suppliers Encourage both FDI and supplier development programs. A key lesson from recent experience with globalization is that the value chain concept i s important because it represents a way the private sector can organize itself to deliver value. An increasing share o f world trade occurs through global value chains, or international production networks. In these value chains and networks, suppliers benefit from the technical and marketing expertise o f large buyers who set market standards for quality, cost, delivery and even responsible labor and environmental practices. This requires attracting foreign investors and leveraging the interest of both investors and suppliers in creating productive value chains. The key lesson from the TOPS and other value chain programs around the world is that private value chain participants, formally or informally, can address a number of institutional and incentive problems without relying heavily on public sector capacity. Private value chains are an effective complement legal and institutional reforms to support efficient markets. While legal institutions to support transparent, low-cost transactions are maturing, and while institutional support infrastructure is evolving in ways more responsive to the needs of the private sector, private value chains can play complementary role. There are a number o f donors involved in agro-industry, including ADB's Agricultural Sector Development Program, AusAID's AQIP, the Cambodian Australian Agricultural Extension Project, GTZ, French bilateral projects targeting a number o f specific products, the World Bank, and FA0 projects on the 84 Working Party Report Para 35. *'Working Party Report Annex I. Attachment Cambodia InvestmentClimate Assessment Page 75 Chapter 5 Program o fReform empowerment o f women and support to the Ministry of Agriculture, Fisheries, and Forestry (MAFF).86 To build on these, we recommend a complementary approachof developing private supply chains through: RemovingImpediments. To attract investment inthe critical transport, distribution food processing and market-making functions that are necessary for supply chains to function, sector-specific restrictions on investment should be eliminated, with regulatory processes focused on public goods such as environmental safety, rather than on controlling the market. Research in many countries around the world indicate that the regulations to protect traditional retail industry, for example, end up preventingthe emergence of efficient supply chains by limiting investment in modern logistic and distribution. This ultimately reduces the productivity and income o f farmers and other suppliers. Attracting investment. Creating an enabling environment where FDIthat is supply-chain sensitive -particularly modern-formatretailandagro-industrial processors-is interestedinCambodia. This means understanding sector-specific constraints of the investment climate most relevant to modern- format retail and addressing those impediments (including excessive licensing, inspections and registration). One such area i s efficient trade facilitation and logistics. 0 Building capacity of suppliers. Where FDI has located in Cambodia, the Government-Private Sector Forum can be used to encourage creative partnerships between NGOs, foreign investors, and donors working on rural development, and local educational institutions in order to expand the supplier base. The TOPS experience, a creative partnership between local and intemational institutions, provides an effective model. MPDF is moving inthis direction, and other donors should be encouraged to do so under the guidance of willing and capable investors. Aligning donor and civil society resources to scale up vendor development technical assistance to the private sector can address the "content" side o f capacity building on buyer's technical standards; it also addresses the scaling problem through a public-private partnerships; and addresses the "incentive" problem by ensuringthat firms who successfully complete capacity buildinghave a potential market. 5.5. Strategic Review of Camcontrol Shift to market-driven reporting, standards assurance, and prevention. Camcontrol has both a mandatory and a voluntary role in support of its mission, but focuses a significant effort on mandatory inspection. While this is a legitimate public interest, the law that provides for 100 percent inspections of commercialized products is obsolete and contributes substantially to the problems with Cambodia's investment climate described in Chapter 2. Inthe past, Cambodia was used as a market for expired goods by unscrupulous traders. Camcontrol's mandate, prepared during the Socialist period, enables the firm to inspect any traded good. However, the way this mandate is carried out places a high burden on firms with limited results. Camcontrol can more effectively achieve its objectives by formulating and implementing an import inspection program based on risk management and by upgrading and facilitating market and consumer reporting, providing a resource for adherenceto international norms and standards, and promoting awareness and knowledge both among consumers and producers of those norms. This will transform Camcontrol into a valuable asset both to the private sector and to consumers. The creation o f consumer associations would complement the facilitation o f the exercise. WTO accession means that domestic firms will now be exposed to international competition both in Cambodia and in foreign markets. As described in Chapter 3, the lack of non-garment exports is Gummen, Martin, Consultant to MAFF PRASAC 11, "Assessment of the Agro-Industrial Situation in Cambodia." February 2003, along with several interviews in which these projects were described. Cambodia:InvestmentClimate Assessment Page 16 Chapter 5 Program of Reform related to a lack of institutions to establish trust in Cambodia's ability to produce at agreed quality and price. The voluntary adherence of firms to international standards and norms in labor, quality, product labeling, and environment can help bridge that trust gap and help open up new market avenues in industrialized countries where compliance to international standards and norms are a must. Camcontrol, both with laboratory assets and a number of employees who are familiar with ISO, HAACP, GMP and a number of other international standards frameworks, can help build local compliance capacity. Without this, standards will act effectively as technical barriers to trade (TBT). Adoption of international norms can also facilitate investment and establishment of joint ventures with firms that already adhere to those standards. A clear example is the introduction, by 2005, of EUROGAP standards on all agricultural imports into the EU. Compliance to such standardswill demand that Cambodian farmers adhere to the use o f prescribed and registered agrochemicals. The elements of a modern quality assurance system -Metrology, Testing, Standards, and Quality assurance, are only partially in place. The Ministry of Industry is establishing an Office of Metrology with UNIDO support.87 The Ministry of Agriculture and Forestry (MAFF) also implements a sub-decree on material standards. Other institutions are needed along side the Office of Metrology in order for standards to have an impact in the economy, including testing and calibration laboratories and training centers. In Thailand, for example, the Thai Productivity Institute, a public-private partnership, plays an important role in raising awareness and adherence to quality processes both through training and consulting. While it i s important that Camcontrol not assume the role being played by the Office of Metrology, Camcontrol's laboratory assets could be put to good use as voluntary testing facilities for private companies wishing to meet international product standards. The Ministry of Commerce is, with EU support, developing National and International Trade Enquiry Points. Sharing of Information on Product Standards and Norms: Camcontrol may be effectively positioned to develop a database accessible by both suppliers and buyers on international standards. Reverting back to an earlier example of problems faced by farmers with diluted fertilizers, the proposed database on international standards and norms would give farmers leverage over fraudulent wholesale and retail agents, while at the same time place suppliers in a stronger negotiating position with buyers based not only on the quantity o f goods and services delivered, but also on its quality. Information on standards i s crucial for improving market transparency and competitiveness, but without support for compliance training, the proposed actions may have a negative rather than a positive impact on rural farmers and SMEs. Cross-Recognition of Quality Standards. One of the Government's more immediate tasks will be to cross-recognize quality standards from countries that invest in or trade with Cambodia, starting with ASEAN and then extending to all WTO members as agreed in the Working Party. There is no reason for Cambodia to focus its standards development process on products in which a regional ASEAN standard might be developed, or that have been certified by competent authorities in key trading partners." In most cases, quality is a marketjudgment and the public sector's role should be focused on public safety. Other potential roles for Camcontrol include potential conversion to a Food and Drug Administration or similar agency. 87 Consistent with WTO commitments. the Ministry of Industry Minesand Energy is also drafting a law on Industrial Standards and implementingregulations.Working Party Report, Table 10, para. 131. 88 Working Party Report, para 127. Cambodia:Investment Climate Assessment Page I1 Chaoter 5 Programof Reform 5.6. Strengthen Governance for Increased Private Participation in Infrastructure The key objective underlying the PPI Governance Study i s to create an enabling framework for PPI that i s sufficiently flexible to allow for unique sectoral requirements in contracting. At the same time, the regulatory, procedural, and institutional framework should be sufficiently robust and inclusive to ensure that all PPI transactions - regardless of the sector, source o f funding, or size o f the transaction - are conducted fairly, transparently, competitively, and in the public interest. Strengthening governance for increased private participation in infrastructure and public service delivery rests on four principlesthat are cornerstones of a sound, enabling environment for PPI: improvingpredictability via improvements to the legal and institutionalfiamework; assigning clear lines of responsibility within institutions; 0 ensuring accountability of those institutions responsible for applying the procurement processes according to the legalfiamework; and 0 improvingthe transparency and openness of government procurementprocesses. Based on these principles and on the institutional and regulatory gap analysis described in Chapter 4, PPI governance reforms will need to revolve around six themes (i.e. a convenient and rational grouping of measureshnterventions that reflect common elements in the identified problems, such as the stage in the project cycle, the institutions involved, or the solution instruments) that provide answers to three primary questions, namely: 0 What approvals are required; 0 Who contracts and monitors; and 0 How will government capacity be developed? The relationship between the various programs, the main focus o f the program components, and the primary questions they address are presented inthe summary table below. Program Addresses Substance 1.Clarify responsibility for The decisions on project go-ahead primary approvals What (can terminate a project) approvals 2. Clarify and streamline are required? The decisions on project details secondary approvals (has the potential to delay a project) 3. Establish responsibility for Clarifies which government entity granting contracts 1 Who should contract with the investor 4. Establish authority for contracts and Clarifies which government entities contract management and monitors? manage and monitor the PPI contract monitoring I 5. Build PPI capacity in Strengthens central ministries o n PPI functional ministries How will government project transactions 6. Build PPI capacity in sector capacity be Strengthens sector ministries to ministries developed? manage PPI projects Cambodia: InvestmentClimate Assessment Page 78 Chapter 5 Programof Reform Key objectives for eachtheme are as follow: Theme 1 Primary Approvals. The first step will be to clarify which cross-sectoral and sector - - specific laws or sub-decrees apply to a particular type of project and to recommend specific changes to legislation and regulations to ensure the primary approvals required for any particular project are clearly set out in the applicable legislation, while removing any overlap in types o f projects/approvals required or conflicts between legal instruments. The second step will be to develop appropriate criteria for determining when a particular project requires a specific approval, and to ensure the process reflects real public policy concerns. The third step is to clarify the timing of various approvals through the various stages. It will also be necessaryto ensure that the cross-sectoral rules reflect approaches being developed in the various sectors (and particularly in the electricity sector) so that there is no conflict. Theme 2 - Secondary Approvals, The first step will be to clarify the legislation pertaining to the secondary approvals, removing ambiguities, and simplifying wherever possible. The role of CDC as the `one-stop shop' for secondary approvals will be reinforced. The second step will be to support CDC, as part o f its role as an investment promotionagency (IPA), to prepare guidelines for investors, so that investors will understand what the specific requirements might be regarding both primary and secondary approvals. Theme 3 - Responsibility for Granting Contracts. The objective here will be to clarify the legal capacity of different levels o f government and government-owned entities to tender for, and act as contracting party to, a PPI project (including the relevant person authorized to bind that government or public entity). Where appropriate, changes to the legal capacity of different government entities will be proposed, so as to enable, for example, provincial and commune levels o f government to act as purchasing authorities. Theme 4 -Contract Management and Monitoring. The key objective here is to establish the legal responsibility for monitoring and regulatory roles, which will require new legislation. Key among these will be amendmentsto the Financial Budgetary Law and the Annual Financial Laws via additional provisions that make them sufficiently detailed with clear obligations on line ministries to comply with fiduciary requirements. It will also be important to define in law, with coverage o f all sectors, a regulatory role separate from the policy-making and PPI contracting roles in all sectors. Independent regulation will be supported by relevant legislation specific to the sectors in which the private sector participates. This including electricity, civil aviation, telecommunications, water and social sectors such as education. Theme 5 -Build Capacities of FunctionalMinistries. This will focus in particular on developing the capacities of 3 functional ministries,namelythe Council for the Development of Cambodia, the Ministry o f Economy and Finance, and the National Auditing Authority. Whereas developing CDC's role as an efficient investment promotion agency is an important aim in the long term, in the short term the program aims to improve its efficiency and effectiveness as a `one stop shop' as regards to acquiring secondary approvals for Cambodia's PPI investors. The primary support for MEF will be to perform its financial appraisal and monitoring role on PPI projects and to ensure that budgetary considerations are incorporated in all stages of PPI project development. Support to NAA will primarily be in the form o f the development o f tools and methodologies that facilitate auditing o f PPI projects to ensure compliance with contract terms, assess value for money and to analyze contingent government liabilities. Theme 6 -Build Capacitiesof Sector Ministries. The primary objective of this theme is to ensure that the technical, economic, and financial skills exist within the line ministriesto develop appropriate PPI sector strategies in terms o f the technical solutions utilized, taking into account project costs and financing barriers. This would focus on developing (i)strategy/planning skills, (ii) project appraisal skills, and (iii) understanding concepts of risk allocation and optimal project design within target line ministries. The benefit o f the effort would be to reduce the reliance on unsolicited PPI proposals and promote competitive tendering practices. Cambodia: InvestmentClimate Assessment Page 79 Chauter 5 Programof Reform It is important to understand that the themes represent the package of critical reforms that will be required to create an enabling environment for PPI in Cambodia. However, it is not reasonable to presume that all the reforms can be introduced in a short time period. Nor will it be necessary. While private investors will require certain fundamental reforms to be in place, particularly in the current environment for PPI, and to see visible and demonstrable evidence of a clear commitment to reform, experience elsewhere suggests that private investors are willing to invest in relatively risky markets, as long as the rewards are commensurate to the risks, and political risk mitigation instruments are available. In confronting the more urgent areas of reform required in the immediate term, the World Bank team has developed, with the Government, a set o f practical proposals inthe form of policy and legislation: 0 PPI Policy. The PPI Policy sets out the roles and responsibilities of the various parts of govemment with respect to PPI projects, as well as specific policy proposals for managing the PPI process throughout the typical PPI project cycle, with various aims to address inter alia several serious concerns with respect to: the lack of transparency inthe handling o f dealings between the public and private sectors particularly in the selection, negotiation and management o f specific contracts between government and investors; more systematic control over the contingent and ongoing liabilities taken on by the public sector under PPI contracts; and improvements to supervision of the performance of PPI concessions during project implementationand operation. 0 ConcessionLaw and Sub-decree on Concessions. These pieces of draft legislation embed the key policy recommendations underlying the draft PPI Policy in the law. Prior to the World Bank- managed PPI Governance Study, UNIDO was commissioned to assist RGC to develop a Law on Concessions, the intention of which is to replace the BOT Sub-Decree and to supersede the relevant provisions o f Order 30BB on the Management o f State Properties. Te RGC asked the World Bank team to work with UNIDO to ensure overall consistency with the approach being proposed in the draft PPI Policy. The World Bank team has also drafted a Sub-decree on Concessions, which expands on the key provisions inthe Law in greater detail. 0 Policy Guideline Documents,dealing with: o Financial Management of PPI Projects - setting out a range of policy options and guidelines for managing government's fiscal exposure through PPP projects; o Policy for Dealing with Unsolicited Bids - setting out guidelines and suggestions for managing the trade-offs involved in balancing the advantages o f encouraging private sector initiative to come forward with sensible project ideas with the potential loss in transparency and efficiency gains of a well-conceived competitive tender process; o Contract Design Issues - setting out some recommendations for ensuring that contract design is consistent with encouraging private sector participation; the parties responsible for management and monitoring are involved in contract negotiation; and that contracts transfer the appropriate risks to the private sector, while being flexible enough to deal with material changes to the context in which to operate; o Policy for Contract Publication- setting out some recommendations on how best to make public the contractual terms for PPI projects, to maximize transparency and enhance public confidence and trust inthe integrity o f the procurement process; o Policy on Decentralizationof PPI Project Governance - setting out some guidance notes on how to ensure that initiatives to improve the PPI governance that are appropriate to the requirements of large national or large provincial-level projects do not have the undesirable side-effect o f suffocating small scale infrastructure development. Capacity buildingprogram to support implementation. Cambodia: InvestmentClimate Assessment Page 80 5.7. Strengthen InstitutionalLearningthrough BusinessAssociations Increasing the effectiveness of institutional learning. Since Cambodia i s at early stage of formalization and specialization the most important consideration may be the ability o f local institutions to learn - to acquire information and experience that is an essential part o f the process o f technology adoption. Cambodia does not have the benefit of a national innovation or deep extension system. Yet there have been good experiences in building the skills of, for example, the Rice Millers' Association through a visit to Thailand and exposure to different milling techniques." While this particular bilateral intervention was highly productive, this can be costly and its impact i s limited to one sector. First, it is important that the range and depth of businessmembership organizations be expanded, and more producers become organized through them. Secondly, the capacity building process needs to be made more scalable. This could be achieved through research and apprenticeship partnerships - both bilaterally and with international organizations - focused on exposure to the particular sectors. ICT i s particularly well suited for this task, and an increasing number of telecenter projects are emerging, which may provide sustainable access to communication throughout the country. Given high illiteracy rates, it is inevitable that learning will also involve demonstration on site. But the targeting of learning would be more cost effective when combined with research partnerships that draw on the resources of, for example, international textile research institutions or textile producer associations in other countries. It is important that these research partnerships be focused in the private sector; a public institution-centered approach allows public organizations to become the center o f technological learning but diffusion to the private sector i s absent. Furthermore, it is important that these activities take place through industry groups to strengthen trust and stimulate innovation in the sector. Increase Access to Market Information. The value chain analysis suggests at least three types of information are critical for improving the bargaining power of suppliers, reducing monopolistic market behavior, and improving the overall competitiveness o f enterprises operating in Cambodia: legal and regulatory information; information on prevailing market price of goods and services; and information on requirements to meet and comply with international standards and norms. As real time data and information i s paramount for improving market transparency, the introduction of an IT strategy with accessibility even to rural farming communities could play a significant role in improving competitiveness of enterprises operating in Cambodia. I t i s anticipated that the Government-Private Sector Forum and more specifically the industry working groups would serve as a platform for establishing various public-private partnerships to develop and manage information access points (or "access nodes") for their respective constituents. Buildingprivatesector policy monitoringand advocacy capacity. No party has a larger stake in a successful reform than the private sector, which is directly affected by the quality o f the investment climate. As such, building local capacity to monitor reform is more likely to be sustainable, and more consistent with a strategy that calls for maximum use of private, non-state resources. To enable long-term private sector monitoring and evaluation, the Bank Group (IDA, MPDF, IFC) can identify one or more private institutions to monitor reform and build capacity through the following actions. Agree on a common set o fbenchmarks to monitor, relevant to each portion of the strategy. Build capacity with regard to the underlying analytical techniques and content areas (investment climate, value chain analysis, trade facilitation, private participation in infrastructure). Support preparation, World Bank review, and an annual monitoring report ("The Cambodia Competitiveness Report ") on the reform program in eacho f these areas. Support the Government-Private Sector Forum, to disseminate the monitoringreport. 89 Tony Knowles, SME Cambodia, interview. Cambodia Inwstment ClimateAssessment Page 81 Chapter 5 Program of Reform 5.8. Accelerate Leasing and Access to Finance Demand for formal credit appears to be low, but this would likely change quickly if other impediments are removed. Because of long and detailed work required to build a sound financial system and credit culture, early action needs to be taken to be prepared for an expected increase in demand. As a cash-based economy, the scope of potential private sector transactions is severely limited. Cambodia has committedto a number o f actions inthe financial area through the WTO processg0and through the Government's financial sector blueprint prepared by ADB.9'Untilthese are established and enforced, the risk o f secured lending will make costs to the private sector very high. '* There is no shortcut around the difficult and detailed work required to build the policies, laws, institutions and skills that a modern financial sector demands - particularly for term finance. Cambodia has committed to legal reforms including a Secured Transactions Law, a Leasing Law, and a legal framework for insolvency. These will be particularly important for private sector firms that require capital equipment and other long-term assets. While the foundation for basic credit delivery is being developed, the analysis suggests two focal areas may produce more rapidresults. Lease transactions, because they do not require a change in title, are less dependent on a robust legal framework for secured lending and in fact do not require borrowers to secure loans with collateral. Leasing companies retain title, and in case o f default on lease payments by the user o f the equipment (lessor), the leasing company typically does not need a legal judgment to repossess the equipment. Furthermore, the rights and obligations under a leasing contract are relatively easy to transfer to third parties. In a default situation, often the leasing company and the lessor can find another user for the equipment who i s willing to take over the equipment and the lease, which keeps the equipment in productive use. Representatives from Cambodian industry associations said that the associations would both encourage repayment and would assist with locatinganother member who would take over the equipment and lease incase o f default. Basic differences between a bank loan and lease are as follow: BANK LOAN FINANCIAL LEASE O\r cership during lease term Borrower Lessor (Leasing Company) Onnership aier Isax tcrm Borrower Lessee (User of Equipment) \longdge and collaterdl needed' Yes No Default remedies Uncertain, multi-year process to foreclose Various options, including finding another user to on collateral take over use of equipment and rights and obligations under original lease agreement 6 months to 1 year inCambodia 3-5 years. Dependson: Useful life ofequipment Credit risk of lessee Cash flow oflessee Whether equipmentis multipurpose Collateral value I1Value and importanceof equipment to business In Cambodia, only property is acceptable Leasedequipment such as: collateral for a bank loan. harbor operations(cranes) transportllogistics (trucks) fishing boats textiles (spinning, weaving, dying, printing) garments (stitching) 90 Working Party Report Services Schedule: Financial Services. 9'Chun, Zhang, et. A1(2001), Financial Sector Blueprintfor 2001-2010. 92 Working Party Report Annex Iincludes commitments on Insolvency, Secured Transactions, and Leasing. Cambodia:Investment Climate Assessment Page 82 ChaDter 5 Programof Reform 5.9. Moving Forward Progress in private sector development is closely tied to further progress on public sector reform. Improvements in tax collection, streamlining the civil service, introducing performance-based competitivewages, and building public sector capacity would significantly increasethe success ofthe reform program cited above and the likelihood of building a diversified, productive private sector. Again, many of the required reforms fall outside the scope of this study, with the exception of the trade and investment- supporting agency reformsdescribed. Completing the transition of the Council for Development of Cambodia's FDI function to an effective Investment Promotion Agency (PA). Recommendations 2 and 3 above on leveragingprivate sector mechanisms to build a responsive supplier base would be significantly facilitated by new foreign investment. While international experience suggeststhat foreign investment is responsive to improvements in the investment climate by addressingthe very problems identified inthe investment climate review, many countries actively promote foreign investment through investment promotion agencies. The Council for Development of Cambodia (CDC)'s Cambodian Investment Board (CIB) currently serves a number of administrativeand regulatoryfunctionsthat are affectedby the Amendment to the Law on Investment,which was approved by the National Assembly in February 2003. The Amended Law on Investment explicitly movesthe CIB toward serving as a facilitative and promotionalagency, with many evaluativeandregulatory functions replaced by automatic systems. This new role will create a need for a corporate strategy to be developed,defining the new agency's goals and objectives, the strategies and resources it will useto achieve these and the performance measurements by which it will assess its progress and success. The planning process can also be expected to yield an action plan and help to define the organizationalstructure that the agency would need to implement the strategies and actions chosen. FIAS has recommended a strategic review ofthe functions and structures o f the CambodianInvestmentBoardto address their appropriateness in the light of the explicit amendment inthe Law on Investment designedto movethe Boardfrom a regulatory agency to a facilitative and promotion agency and the problems in the overall investment environment and emergingchanges inthe global competitiveenvironment. More analytical work will need to be done at (a) the interface of the enabling environment for private sector development and agriculture; (b) a deeper understanding of the role of social capital, particularlytrust, in buildingtrade-supportinginstitutions; and (c) morework and possiblyaction research on formalizing or scaling up traditional or informal institutions, including dispute resolution. As this second generation set of reforms is set in motion, Cambodia will quickly need to move to a third-generation of reforms-those that focus on higher quality skills and a morecompetitivefinancial sector. Strategy development is a continual process, and private sector development strategy is in its early phases. Since many of the reforms are questions of political will, it is hoped that this analysis contributed to a frank and factual dialogue between the Government, private sector, and development partners. Cambodia: Investment Climate Assessment Page 83 Chapter 6 Actions and Commitments Chapter6: GovernmentActions and Commitments The Government has recognized that combating poverty requires fundamental improvements in governance. This will ultimately require a change in mindset from one focusing on short-term gain to a focus on long-term development based on a strong moral foundation and work ethic. Better regulation can contribute toward realization o f this vision by improving the reward for legitimate entrepreneurship. By taking on the more difficult challenges o f the investment climate, the Government demonstrates its commitment to realization of this new vision. 6.1 SpecialInter-ministerialTask Force onTrade Facilitation& InvestmentClimate The investment climate survey findings were presented to the Government in February 2004, and were discussed in a series of Cabinet-level meetings. These Cabinet level discussions resulted in Prime Minister's Decision No. 1212004, to form a Special Inter-Ministerial Task Force on Trade Facilitation and Investment Climate, Chaired by the Minister of Economy and Finance and Vice-Chaired by the Minister o f Commerce. KINGDOMOF CAMBODIA Nation Religion King No.: 12 SSR DECISION ON The Establishment of Inter-ministerial SpecialTask Force for Investment Climate Improvement and Trade Facilitation ----- The Royal Government of Cambodia -- Having seen the Constitution of the Kingdom of Cambodia Having seen the Royal Decree No. NSIRKTI1198i72 dated November 30, 1998 on the Organization of the - Royal Govemment of Cambodia Having seen the Royal Kram No. 02/NS/94 dated July 20, 1994 that stipulates the use of the Law on the - Organization and Functioning o fthe Council of Ministers Having seen the Royal Kram No. 03/NSi94 dated August 05, 1994 that stipulates the use o f the Law on Investment of the Kingdom of Cambodia and the Royal Kram NS/RKM/0303/009 dated March 24,2003 that stipulates the Law on the Amendment of the Law on Investmentof the Kingdom of Cambodia - Having seen the Sub-decreeNo. 70 ANKriBK datedJuly 27,2001 on the Organization and Functioning o fthe - Council for Development o f Cambodia Having seen the Decisions No. 44 SSR dated August 03,2001 and No. 41 SSR dated August 12,2001 on the - Formation of SectoralWorking Group Based on the spirit of the plenary meeting o f the Council of Ministers dated February 27, 2004 on Implementation Program to carry out Cambodia's Obligations within the Framework of the World Trade - Organization Basedon the spirit of the Inter-ministerial plenary meeting on March 18, 2004 Cambodia: InvestmentClimate Assessment Page 84 Chapter 6 Actions and Commitments DECIDES Article 1: Form a Special Inter-ministerialTask Force (SITF) to improve investment climate and trade facilitation. SITF is comprised o f H.E.Keat Chhon Senior Minister, Minister of Economy andFinance Chairman H.E.Cham Prasidh Minister o f Ministry of Commerce Vice Chairman H.E.Suy Sem Minister of Ministry of Industry,Mines, and Energy Member H.E.Chan Sarun Ministerof Ministry of Agriculture, Forestry,andFisheries Member H.E.Proum Sokha State Secretary o f Ministry of Interior Member H.E.Pen Siman Delegate ofRGC inchargeofCustoms andExcisesDepartment Member H.E.Lou Kim Chhun Director General of SihanoukvillePort Member Mr.HongTha Director of Tax Department Member Mr.Suth Dara Director of CamcontrolDepartment Member Mr.SeangBunLeang First Deputy Director of EconomicPolice Member H.E.Sok Chenda Secretary Generalofthe Councilfor DevelopmentofCambodia Secretary Article 2: To improveinvestmentclimate and trade facilitation, SITF shallhave immediateresponsibilitiesas follows: First- Raiseand implement measuresto reducecash paymentson intermediariesrelatedto export-import Second-Raiseand put into implementationmeasuresto reduce procedures or cancel duplicatingprocedures in the managementoftrade process. Third- Raiseandput into implementationmeasuresto reducetime delays for goods exportand import. Fourth- Raiseand put into implementationall measures that would increase nationalbudget. All the measures of the above responsibilities one, two, and three are only part of Cambodia's obligations being member of the World Trade Organization that the Ministry of Commerce has been leading and complyingwith a decisionmade by the Councilof Ministers datedFebruary27, 2004. Article 3: The aboveresponsibilitieshaveto be achievedand computable in digit term Article 4: SITF shall regularly report to the Head of RGC all the measures initiated by itself. In case where some measuresare beyond its capacity, SITF shall report and request for guidance and decisionfrom the Head ofRGC. Article 5: The Chairman o f SITF may invite the Leaders of line ministriesiinstitutions to participate in conductingthe work. Duringthe absence of the Chairman, SITF can conduct meetings ledby Vice Chairmanor Representativebased on delegating power of the Chairman. Article 6: If deems necessary, SITF may collaborate with donors andor private stakeholders in order to efficiently achievethe above responsibilities. Article 7: SITF shallhave the right to usethe stamp ofthe Councilfor Developmentof Cambodia Article 8: The mandate of SITF will be ended when the mechanism of RGC on the implementation of strategy to develop private sector and the program to improve investment climate in Cambodia is determined. In this context, SITF shallshortly submit its proposalsto the Headof RGCuponthe mechanism. Article 9: The Minister in charge of the Council o f Ministers, Ministero f Ministry ofEconomyandFinance,Minister o f Ministry o f Industry, Mines and Energy, Minister of Ministry of Agriculture, Forestry, and Fisheries,Co-Ministers, Ministers, State Secretaries o f line ministries and those as stated in Article 1 shall implement efficiently this Decision from the date of signature. Phnom Penh, March 22, 2004 Prime Minister cc: - Signedand sealed ----- The Ministry of Royal Palace General Secretariat of the Senate General Secretariat ofthe National Assembly HUNSEN The Cabinet of the Prime Minister Similar to Article 9 Archives Cambodia InvestmentClimate Assessment Page 85 Chapter 6 Actions and Commitments 6.2 Twelve Point Plan: GovernmentCommitmentsto Improvethe InvestmentClimate andTrade Facilitation The Special Task Force as defined in 6.1 has defined, and discussed with the Bank, an integrated ` program o f reform to address the most urgent impediments in trade facilitation raised in the document Towardsa PSD Sfrafegy. At its June 7,2004 meeting, the Task Force (TF) discussedthese steps and agreed upon a number of actions to be taken as described below. The reform measures agreed - establishing a cross-agency reform team, consolidating inspection mandates across agencies and introducing selective inspections based on risk, implementing a Single Administrative Document and Single Window process, automating information flows across agencies, streamlining business registrationprocedures and recognizingethical behavior inthe private sector -will be initiated in July 2004 be implemented on an urgent basis by December 2005. These reforms address some o f the key causes o f high costs and delay and strongly complement Cambodia's entry into the World Trade Organization. Actions Agreed by Special Inter-Ministerial Task WTO Working Party Actions Agreed by WB Force (SITF) on Investment Climate & Trade Report Reference -___-.._-- Facilitation 1. Establisha Cross-AgencyTrade Facilitation/Investment Climate Reform Team The TF agreed to form a team consisting of eight to Working Party Report The Bank agreed to work with ten members representing the Ministries of Para 39 defines inter- the CDC to develop TORs for the Economy and Finance, Commerce, Agriculture, ministerial coordinating change managementteam. Labor and Social Welfare, Interior, Industry, the committee. CDC, and the Port Authority of Sihanoukville to oversee the change measures in trade facilitation. This team will make reform recommendationsto the SITF and support operational work toward on the reform. The SITF assigned CDC to identify the members, prepare the TOR and initiate the team by July 1, 2004. 2. Establish A System Of Transparent Performance Measurement including Private Sector Monitoring The SITF agreed to establish a performance The Bank is already working on monitoring system to monitor progress accurately, a methodology for performance engender trust of all stakeholders inthe reform, and measurement, to be introducedas to report progress to the public. This system will for the consideration of the report the time and cost o f importing and exporting reform team July 1. The Bank product, and include monitors from the private further agreed to work with the sector. The first "baseline" measurements of the CDC on developing TORs and current process will begin in July 2004 and coordinating with related continued each month. The SITF asked the Bank initiatives as appropriate. and CDC to work together to develop a TOR on the details of establishing the system and the modalities and extent of private sector involvement. This should includethe Chamber of Commerce. Cambodia: InvestmentClimate Assessment Page 86 Chapter 6 Actions and Commitments 3 . The trade facilitation process, including all licenses, procedures and documents, will be reviewed to remove overlaps and unnecessary approvals. Following the reengineering, a Single Administrative Document will be implemented and other documents progressively eliminated. Currently over 45 documents are required to export Working Party Report The Bank agreed to coordinate a shipment, each of which adds time and cost to the Table 7 Paragraph93. with the efforts already trade facilitation process. To enhance sharing of underway, including within information, to reduce cost and to pave the way for Single Administrative ASEAN and GMS. The Bank automation, Cambodia will implement a Single Document is a step toward will contact other members of the Administrative Document by December 1, 2004. automated customs donor community, which are All other documents currently in use to support processing as described in currently considering a potential trade facilitation will be progressively eliminated. Working Party Report Sector Wide Approach (SWAP) The SITF agreed that the reengineering process Table 7. to coordinate assistance. should occur on an accelerated basis so that it can precede the Single Administrative Document. 4. Introduce an overall risk management strategy to consolidate and rationalize all examination requirements of the different control agencies. The TF agreed a risk management strategy was The Bank agreed to help necessary and asked for the Bank's help in develop TORS. developing a TOR for this work. A matrix of inspection requirements by categories o f goods will be drawn by all the relevant agencies, and will be progressively applied to shipments, with a view to consolidateall inspectionsunder one session. 5. A strategic review of the role of CamControl will be launched to more productively deploy the organization's unique knowledge of quality control processes and make optimized use of inputs and resources from other agencies, such as the CED. The SITF recognizes that the role of CamControl The Bank agreed to discuss may need to be modernized and updated in light of possibilities for such support the maturity o f the economy, the private sector's with other donors involved inthe ability to determine quality and its trading relations. PSD SWAP discussions, and The Government will conduct the strategic review respond to the TF's request as of CamControl including several options: retaining soon as possible. the existing profile, merger with CED (following cross-training) or establishment of a new entity such as a Food and DrugAdministration. 6. A Single Window process to manage trade facilitation will be piloted in the Port of Sihanoukville by December 2005. The Trade Facilitation process, once streamlined, will be automated by December 2005. The TF agreed to these timelines, and said that Working Party Report The Bank agreed to provide the every attempt would be made to complete this work Table 7 Paragraph93 flowchart but noted that grant by end 2005. The TF also agreed that the assistance had to be discussed Government will initiate a comprehensive within the context of the automation project by October 2004. The process upcoming CAS discussions. will start, as soon as possible, with the design of an overall architecture that incorporates all agencies into a seamless network. Within this overall architecture, implementation will be undertaken in phases. The TF asked if the Bank could provide grant support for the hardware required for automation as well as provide a flowchart of the Cambodia,InvestmentClimate Assessment Page 87 Chapter 6 Actions and Commitments automationprocess. 7. The Government will introduce a WTO compatible flat fee for service, and the service will be defined by a service-level agreement. The fee structure will be public. The TF agreed that the Single Window should be The SITF asked the World implemented in conjunction with a flat fee-for- Bank to provide technical service compensation mechanism that enables the inputs to the TFRT. The Bank private sector to pay once for all customsclearance agreed to do so. processing. They also agreed that this fee should be tied to publicly stated and enforced SLAs that clearly outline the level of service provided to the customer in exchange for the fee paid, and arefund should be allocated to the customer should the agency fail to provide service within the terms outlined in the SLA. The Trade Facilitation Reform team will determine the appropriate fee structure. Licensing and Registration 8. Streamline the process and reduce the cost o incorporating with the Commercial Register, a..ich is maintained at the Office of the Clerk of the Commercial Court, and costs an average of $630 and 30 days. 9. Streamline the process notification of the Ministry of Labor to start hiring employees, which costs $250 and 30 days to complete. 10. Harmonize registration for VAT, income tax and company registration using the same form and resulting in the same number. This would enable a unique identifier and facilitate information sharing across agencies. The SITF endorsed the goal of streamlining The Bank agreedto consult licensing and registration to decrease the share of with other donors such as the companies that operate informally by making Asian Development Bank, formal registration and hiring workers as easy and MPDF and FIAS. inexpensive as possible. The SITF noted that the changes proposed in Item 12 may require changing existing legislation and agreed that reform team would present proposals after taking into consideration ongoing reform efforts. In one such effort, the Ministry of Commerce is in the process of decreasing incorporation fees to $295 and the number of days to 10 days. Private Sector Governance 11. Implement a national award to promote good corporate citizenship and governance in the private sector. Improving govemancecannot rest on public action The Bank agreed to work with alone. Any strategy to fight corruption, build IFC, MPDF and other donors better institutions, introduce transparency inpublic to design and possibly fund contracting must also rest on efforts to strengthen suchaprogram. codes of ethics and standards of govemance that are developed and enforced by the private sector Cambodia InvestmentClimateAssessment Page 88 Chapter 6 Actions and Commitments itself. The TF agreed that the Government will encourage, through the Government-Private Sector Forum, adoption of a Code of Ethics by the private sector. The Government also will try to introduce a national award for corporate govemance, which will depend on an assessment against objective governance criteria. Publicizing the criteria is expected to raise awareness o f corporate govemance. 12. Monitoring and Reporting The TF agreed that the private sector, through Working Party Report IFC, AusAID business associations, will monitor and evaluate Paragraph 217 requires progress toward reform objectives. Progress transparency on trade- reports will be provided to the Government- relatedregulation. Private Sector Forum. 6.3 The Government'sTrack Recordof Reform inPrivate Sector Development While the reforms required to facilitate private sector development are substantial, the Government has not been complacent in the past. The following i s a compendium o f reforms introduced by the Government in five areas: trade policy and integration, private sector development policy, banking and finance, tax and customs. It is clear that the government has engaged heavily in policy reform. Implementation o f these reforms will continue to be deepened over time, complemented by the new commitments cited above. 6.3.1 Integrationinto the World Economyand Trade PolicyDevelopment,2001-2003 2001 e Government reduced maximum tariff rates from 120 percent to 35 percent and reduced the number o f tariff bands from 12 to 4. Structure o f the 4 tariff bands are 0%, I%, 15% and 35%, o f which about 95 percent o f the tariff lines are under three bands: 7%, 15% and 35%. e Average un-weighted tariff rates were lowered to 16.5 percent from 17.3 percent in 2000 and 18.4 percent in 1997. e The Government imposed an absolute ban on exports o f logs and an export quota on rice. Five items are subject to export licensing requirement: (i)processed wood products, (ii)garments, (iii) weapons, (iv) all vehicles and machinery for military purposes and, (v) pharmaceuticals and medical materials. e Most non-trade barriers were eliminated. 2002 e The Government i s moving forward with its tariff restructuring program by planning to reduce the un-weighted average tariff rate to below 15% in2002-2003, e The Government initiated a Triangle Economic Cooperation strategy between Cambodia, Vietnam and Lao PDR, focusing on (i)Commerce, (ii)Industry, (iii)Public works and Transportation, (iv) Tourism. 2003 e The Prime Minister asked the Ministry o f Commerce, Ministry o f Public Works and Transport and other concerned institutes to conduct a detailed feasibility study on the promotion o f sea ports mainly in areas o f K o h Kong, Sre Ambel, Keo Phus, Kampot and Keb into international seaports. e Cambodia become 147'h WTO member at Cancun 5Th WTO Ministerial Conference following Cambodia: Investment Climate Assessment Page 89 Chapter 6 Actions and Commitments successful five rounds o f working party negotiations with its multilateral and bilateral market partners. Failed ratify its WTO membership by deadline March 31, 2004. A formal extension request was send to WTO secretariat and new ratification deadline is extendedto September 30, 2004. Under the ASEAN-China Free Trade Area's Early Harvest scheme signed in July 2003, China has granted to Cambodia, effective from January 1, 2004, a special preferential tariff (SPT) treatment for 297 agricultural products at zero percent tariff rates. Under the ASEAN Integrate Special Preferential (AISP), Thailand has agreed to provide Cambodia a special and preferential tariff treatment for 249 products, Lao PDR 150 products and Myanmar from 300-400 products, effective from this year in 2004. Cambodia-Canada Memorandum O f Understanding signed by the two countries in March 2003 has given Cambodia, along with other least developed countries, a quota and duty free access to all its markets except banana. I t s exported goods must meet the rule of origin which is contained at 25% Cambodia's added value. Under the ASEAN agreement, raw materials importing from ASEAN countries are also considered local origin. Meanwhile, Japan expanded its duty and quota free treatment for LDCs to 496 agricultural and fishery products in 2003 and Cambodia is also eligible for this treatment as an LDC. Japan-ASEAN Comprehensive Economic Partnership signed in 2003 has provided Cambodia a broad-based liberalization o f trade and investment promotion. The Japan-ASEAN Comprehensive Economic Partnership has focused on regional trade and investment promotion with other facilitation measures, including, customs procedures, standards and conformance, financial services, information and communications technology, science and technology, human resource development, small and medium enterprises, tourism, transport, energy and food security. Summit for Economic Cooperation Strategy between Cambodia, Lao PDR, Myanmar and Thailand that was held on November, 2003 in Bagan-Myanmar. The Bagan Declaration for Economic Cooperation Strategyg3among the four countries has a 10-year timeframe from 2003-2012 with focused areas on Trade and Investment Facilitation, Agricultural and Industrial Cooperation, Transport Linkages, Tourism Cooperation and HRDevelopment. Sources: Reports of CambodianAuthorities. 6.3.2 Reform Progress Made in Private Sector DevelopmentPolicy,2000-2003 2000 Established seven publidprivate sector consultative working groups: (i)Banking & Finance Working Group, (ii)Export Processing & Trade Facilitation Working Group, (iii) Manufacturing & SME Working Group, (iv) Agriculture & Agro-business Working Group, (v) Energy & Infrastructure Working Group, (vi) Law, Tax & Good Governance Working Group, (vii) Tourism Working Group. Held seven public forums chaired by the Prime Minister in the past two years to discuss issues raised at the working groups; Removed most import and export licensing requirements; Removed the monopoly o f CAMINCO and introduced new legislation facilitating the entry o f foreign insurers. To date (June 2003), four fully licensed insurance companies are under operation (one i s state-owned); Entered into a new two year agreement in October 2000 with SGS to conduct Pre-Shipment Inspections on goods imported into Cambodia; Required agencies operating at border checkpoints to co-ordinate their activities and subject traders 93The Bagan Declarationwas later called "Arrewady, Chaopraya, Mekong Economic Cooperation Strategy" (ACMECS). Cambodia:InvestmentClimate Assessment Page 90 Chapter 6 Actions andCommitments to only one inspection; 0 Attempted to streamline procedures for issuing Certificates of Origin to garment exporters; 0 Established visa-issuing facilities to individuals entering Cambodia at the major land border checkpoints. 2002 0 The Ministry of Commerce set its mission statement as " Year o f Decentralization and Deregulation" to mainly reduce paperwork procedures in dealing with their export activities and introduced computerized system in coordination with the US Customs Department for monitoring garment exports. 0 Law on Commercial Enterprises was submitted to the National Assembly for Approval; 0 Law on Patents, Inventionsand Industrial Design was adopted; 0 Law on Trademarks and Dishonest Competition was adopted; 2003 0 Amended Law on Investment was adopted (February) to make the investment climate more conducive to growth. 0 Law on Copy Rights was adopted (January); 0 Draft Law on Industry Management was sent to the National Assembly for approval; 0 Draft Law on Industrial and Export Processing Zones was sent to the National Assembly for approval. Sources: Cambodian .4uthorities 6.3.3 ReformProgress MadeinMonetaryand BankingPolicies2001-2003 0 National Bank of Cambodia (NBC) established a clearinghouse for dollar-denominated checks. 0 NBC Adopted a financial blueprint for the next ten year so called "Vision and Financial Sector Development Plan for 2001-2010". 2002 0 The Government completed the re-licensing programs under the LBFI (in April), 15 banks were closed due to inability to meet the new minimum capital requirement set at US$13 million. As of December 2002, Cambodia's banking system consists o f 17 banks: one state-owned, three foreign bank branches, nine locally incorporated commercial banks and four specialized banks. 0 Draft law on Negotiable Instruments and Payments Transactions was submitted to the Council of Ministers and expected to submit to the National Assembly in 2003. The law aims to improve payment transactions, eliminate legal uncertainties and reduce payment system risk. 0 The Government pursued a flexible market-based exchange rate policy with the spread between official exchange and market rates limited to 1%. 0 NBC (in September) lowered commercial banks liquidity ratio requirement from 100 percent to 80 percent inresponse to appeals from banking community. 2003 0 Announced policy to privatize and seek potential investors to runthe state-owned FTB. 0 A uniform Chart of Accounts (COA) was made available to all commercial banks. 0 This international based Uniform Chart o f Account is expected to be fully completed by the end of 2004 for all commercial and specialized banks. 0 Draft Law of Negotiable Instrument and Payment System was passed by the Council of Ministers and submitted to the National Assembly for approval. 0 Issued complete procedures on off-site surveillance and on-site inspection. 0 Completion of on-site inspection for six commercial banks. 0 NBC expanded two additional provincial branches to a total of 20 provincial branches covering major cities throughout the country. Cambodia:InvestmentClimate Assessment Page 91 Chapter 6 Actions and Commitments Adoption o f a Prompt Corrective Action system (PCA) for commercial banks to ensure that central bank can effectively deal with problems at an early stage. Issued Prakas on Procedure for Identification o f Money Laundering. 0 Established Committee for InternationalReserve Investment. The Committee would be in charge of formulating the intemational reserve investment policy. By the end of 2003, 5 licenses was issuedfor Micro-finance Institutions. ACLEDA Specialized Bank was licensed to become a commercial bank effective December, 2003. a The central bank with support from the Asian Development Bank prepared an IT development plan with objective to automate key operations. Introduce CAMELS ratings to access and boost public confidence on commercial banks. Draft o f Bankruptcy Law was reviewed among the concerned line ministries. 0 Law on Secured Transaction has been drafted for consultations. Source: National Bank of Cambodia Reform Progress M a d e by the Ministry of Economy and Finance in Tax Policies Treatment of diesel sales as final sales for VAT purposes; Introducedvisa sticker to avoid tax loss from visa revenues; Introduced stamp system for tax collection on cigarettes; Expanding VAT on real regime (self-assessment system) to additional 150 firms (following the 2000 expansion by 500 companies); Introduced 10% excise tax to be levied on entertainment services; The minimum profittax o f one percent was eliminated on investment project; Established large taxpayer unitto cover about 500 large taxpayers; Strengthening tax audit. Improving exchange information with department o fMEF and other government agenciesto support tax audit program such as: Custom Department, Treasury Department, Procurement Department, CDC, Ministry of Commerce, etc. Raised additional tax on petroleum products, 2 cents per litre for gasoline and 4 cents per litre for diesel. Expanding real tax regime (real tax regime means taxation is based on accounting statement) to cover additional 5 provinces (it was previously applied to 5 provinces only)94. Raising excise tax on beer from 10% to 20%. Law on Corporate Accounting, Audit and the Accounting Profession was promulgated (in July). Applied a 15% withholding tax on interest earnedby bank depositors. Submitted anew Customs Code to the Council o f Ministers (inJuly 2002). It is subjected to be in line with the WTO. Reviewing the contract o f ticket sales to Angkor Wat complex (Siem Reap province) with Sokha company, to increaserevenue sharing to state coffer and collect VAT. The share of garment export quotas to be auctioned was increased from 10% to 20%. 94The real regime tax system was expanded in 2000 to five provinces: Sihanoukville, Koh Kong, Siem Reap, Kompong Cham and Battambang. In 2002, the real regime system has been expandedto another five provinces: Kandal, Svay Rieng, Kampot, Kompong Speu and Kompong Chhnang. Cambodia:InvestmentClimateAssessment Page 92 Chapter 6 Actions andCommitments e An Inter-Ministerial Commission (Intelligence Unit)on anti-smugglingwas established and regular reports will be submittedto the Council o f Ministers. e Strengthening the pre-shipment inspection program for imports by using reconciliation procedures to resolve valuation differences, and reducingto no more than 10% the number o f sealed containers subject to re-inspection by any government agency based on principles o f risk management. Penalties for firms that by-pass the pre-shipment inspection (pre-shipment inspection o f imports introduced in October 2000). e Introduced Medium Term Expenditure Framework 2003-05. e Streamlining the system for controlling refunds and develop risk management techniques for the verification and approval o f VAT refundclaims. e Development and implementation o f streamlined customs clearance procedures to enhance trade facilities and improve effectiveness o f operations. 0 Establish a single operational structure o f government bank account in the National Bank o f Cambodia under government control. e Establish a structure for a Chart o f Accounts (COAs) at the nationaltreasury. e Introduced direct payment o f large taxpayers to the National Bank o f Cambodia. e Strengthening collection enforcement measures to taxpayers who had tax arrears, for example: froze bank account, stopped import-export; CDC not to permit import materials, treasury department to freeze account, .etc. 2003 e Applied the VAT on imported and domestically produced agricultural product equally. e Issued Treasury Bill for an amount o f 50 billion riels. e Amended Law on Taxation was discussed many times between government and private sectors and then adopted by the National Assembly (Feb.) in responding to the five main thrusts o f the tax law reform initiative: (i)systematic reform which links the respective amendments to the Law on Investment and Taxation, (ii)Increase revenues to support increasing expenditures, (iii)simplify and clarify Cambodia tax system, (iv) align the tax system with international tax standards in order to attract foreign investors and (v) strengthening provisions aimed at collection tax arrears. The main points o f these amendments are as follow: Change exemption period Introduce 40% special depreciation for Qualify Investment Project (QIP) that not elect to use exemption period Introduce new depreciation schedules (declining balance method). Introduce additional profit tax on dividend distribution Reduced withholding tax on payment to non-resident from 15% to 14% Reduced withholding tax on interest payment from bank to resident taxpayers from 15% to 6% and from 5% to 4%. Increased rate o f salary tax for non-resident taxpayer from 15% to 20% Eliminate 1% o f turnover o f minimumtax and pre-payment o f profit tax on QIP Strengthening collection enforcement e Applied decree on Public Procurement to all ministries on budget expenditures chap. 11 and 13, except Defense and Interior ministries and the Royal Palace. e A new agreement signed with the Sokha Company on new formula for the sharing o f revenues from entry fees into the Angkor Complex and VAT payment. e Expansion the coverage o f Medium Term Expenditure Framework (MTEF) to (i)Ministry o f Agriculture, Forestry and Fisheries, (ii)Ministry o f Rural Development, (iii)Ministry o f Public Works and Transport and possibly to (iv) Ministry o f Justice and (v) Ministry o f Women's and Veterans' Affairs. e The Prime Minister's circular, orders the Ministry o f Economy and Finance not to sign new payment orders without sufficient cash in the national treasury. The payment orders must not accumulate in the national treasury over a total value o f one twelfth o f annual current revenue and Cambodia InvestmentClimate Assessment Page 93 Chapter 6 Actions and Commitments as the total value reaches threshold, the Ministry o f Economy and Finance shall temporarily suspend issuance o f new payment orders untilthe cash flow is settled. 0 Penalty charge was applied for delay or non-payment on leases o f state assets. 0 Completed review o f telecommunication operations was done to ensure funds are transferred properly to state budget. 0 Completed inventory process at ministry level on leases o f state assets. 0 New restructured tariff with an un-weighted rate o f less than 15% is applied from January 1,2004. 0 MEF financial controllers were transferred to Ministry of Education and Ministry of Health with clear TORSand responsibilities. 0 Established Kampuchea Institute o f Certified Public Accountants and Auditors (KICPAA) to ensure promotion o fthe accountancy and auditing professions. 0 The government would approve the ASYCUDA system to automate the customs-related services to reduce risk o f leakages o f revenues. 0 The government reviewed and reduced tax exemption provided under the amended Law on Investment. 0 Increased excise tax rate on beer from 20% to 30%. Increased excise tax on service: air transportation and telecommunication from 2% to 10% and broadening tax base to cover both domestic and international and introduced some new excise taxes. These above excise taxes were implemented in 01 January 2004. 2004 0 The Ministry of Economy and Finance put stiffer pressure on government's private debtors and set January 3 1, 2004 deadline to all vehicle owners to pay tax or confiscated. 0 The government reduced import tax on luxury vehicles from 230% to 50% beginning January 1, 2004 with expectation that the reduction intax would prompt and encourage people to pay it. 0 The government, in February 9, 2004 issued an order to all owners o f their unused land in Phnom Penh city to pay tax by March 10,2004 or be confiscated as state property. The government has put a squeeze on its tax debtors in response to the concerns o f widening budget shortage. Set up a working group to take action on collection non-tax revenues and arrears particularly in telecommunication services and leases o f state assets. Sources: Cambodian Authorities. Cambodia: InvestmentClimateAssessment Page 94 a' a a 4 . a..... , Q L e e . . 2 2 Lo e . . . d . N e d . d 0 N . N . e e e .d d . u z> . . N . a N . e . N . m n m m . r e . . . . Annex I Cambodia at a Glance Annex I:Cambodia at a Glance East Aaill 8 LOCI- Patclfl': iti<:oitw 12d 1938 2.496 ?81? 4.30 3.5 1740 1.072 2.2 10 1.9 2.i. 1 2 2.3 3F8 18 38 30 51 59 $IC1 33 81 45 15 30 '6 7i; 31 13 37 110 1lJ'j $45 I17 105 103 103 106 E37 1932 2001 200.2 2.I:! 3 4 3.7 ",8 17 0 13.7 53 2 tj,9 5,R T . I t. 4.7 -3 1 0.0 $3 1 0.2 92 4 7'33 7'3.1 17 (575 1 3 3 X 200.1 2002 2602-Qf d.3 4 s 4.2 2 t 14.ET 196.2 1492 2001 ,. 47.9 3i;.g ., 132 2 1.B B.1 39.1 41.2 ,. 83.6 84 2 9.5 6.Cl ,, 18.6 131.3 2001 3.3 15.5 2.5 2.2 13.1 .. ~ L? 3 1 12.13 I ,. . .. . ..,.,. ,.,,. . ,." . . .. 1892 2002 IljflatiNt?\.j *k 75.4 3.1 lj.5 -3.0 3 . 3 1,332 2002 265 12 25 3.51 193.2 2002 33?3 14 651 0 14 JJ.3 B 1.2i6.6 3.CilZ 1 1992 2002 I.831 2.P07 0 0 0 306 13 21 Cl CI 0 L 03 0 156 0 Q 33 0 0 30 0 47 0 0 (1 47 0 2 0 45, Cambodia: InvestmentClimateAssessment Page99 Annex I1 Skills Annex 11: Worker Skills andthe CambodianEconomy Background Cambodia has made significant progress over the last Figure 1: Literacyand illiteracy rates,15+age group, bysex, decade in expanding educational 1999 opportunities, particularly since 1999, which coincides with the scaling up of 100% the government's Education Sector Support Program (ESSP)/Priority 80% Action Program (PAP). Yet despite 60% -1 the improvement across generations, 0Sem-literate 40% standard educational attainment i 0Illiterate ~ indicators for Cambodia are among the 20% lowest in the region. The mean years 0% o f schooling o f the adult population kle Female Bothsexes aged 25 and over in 2001 was only 3.8 years.95 Child labor interferes with schooling and as such jeopardizes the future supply of skills. The labor force Figure2 Illiteracyrates,ASEANcountries,age 1524&I*, 1999 participation rate o f children aged 10- 14 is significant (21.2 percent), and children comprise 5.5 percent of the labor force. Government expenditure in education has increased significantly in recent times, both in absolute terms and as a percentage of the GDP and total public expenditures. Illiteracy rates in $ m g A gO n zE :g Z g9 za s& f e$ Cambodia are far higher, both for the % -= E ; 15-and-over population as a whole and 0$ 2 2 2 v) for the 15-24 age group, than in all o f I i t s ASEAN neighbors (UNDP 2001) except Laos (Figure 2). There has been a remarkable improvement in enrollment rates in recent years. However, coverage remains low, particularly in post-primary education. Repetition and dropout rates in primary school remain very high. Although teacher quality has improved, the shortage of teachers and classroom has recently become more acute. The labor force participation rate increased between 199314 and 2001 as Cambodia was makingthe 95 This information is based on the most recent Labor Force Survey (LFS 2001), which covered 500 sample villages or a total o f 5000 sample households nationwide. Cambodia InvestmentClimate Assessment Page 100 Annex I1 Skills transition to a market economy, from 58 percent to 72 percent. The current demand for skilled and educated workers in the labor market is low, which results in an overall adequacy o f skills supplied and skills demanded. Unpaid family labor is still the largest single category of employment status (42.8 percent) which, along with the low proportion o f paid workers in wage employment (28.4 percent), indicates the relatively early stage of development of the Cambodian labor market. Women have a significantly higher incidence of unpaid family work than men. Table A3.1. Sector of primary employment (YO) Total employment Self-employment Wage employment Agriculture, hunting, forestry 66.04 63.11 20.01 Fishing 4.18 6.04 2.68 Mining, quarrying 0.22 0.09 0.95 Manufacturing 8.73 7.77 26.44 Electricity, gas, water 0.06 0.00 0.37 Construction 1.51 0.61 7.55 Wholesale/ retail trade 10.32 16.72 2.28 Hotels, restaurants 0.17 0.09 0.78 Transport, storage, communications 2.71 3.91 6.65 Financial services 0.10 0.05 0.45 Real estate, renting, business act. 0.26 0.21 0.84 Public administration, defense 2.39 0.04 14.56 Education 1.42 0.03 8.63 Health, social work 0.40 0.17 1.96 Other services 0.89 1.09 2.22 Private households 0.44 0.06 2.59 - International organizations 0.16 0.00 1.01 Total 100.0 100.0 100.0 Source: Labor Force Survey In spite of the limited demand, there are positive, sizable and increasing retumsto schooling inthe labor market both in terms o f wagedearnings and employment-related outcomes. A probit analysis of the 2001 Labor Force Survey data indicates that the returns to schooling in terms o f paid employment are very sizable. Having primary school completed increase the chances of working for pay by 12 percent with respect to no school level completed. Wage returnsto schooling increase with school level, but this is more accentuated at the lower and upper ends of the wage distribution. These returns reflect shortages in the supply of educated workers and reflect, at least in part, differences in productivity. There is some evidence that labor rigidities may restrict the returns to schooling in such sectors as garments and public administration. Although the current supply of skills does not pose a serious constraint to the current economic model in Cambodia, the development o f new sources o f economic growth will. The development of a modern and diversified agricultural sector and industrial development strategy. While the most cost- effective way to improve the stock and quality of human capital in the long run is through the school system, the low rates of literacy and numeracy in the adult population also call for a more short runtype of approachbased on adult education and formaljob training. Overall, only 6.57 percent o f firms report the supply o f skilled and educated workers as a major or severe constraint to the operation and growth of their business, while the majority of firms (37.17) do not deem as a constraint at all (Table 18). The garment industry, which accounts for 42.5 percent of workers in Cambodia Investment Climate Assessment Page 101 Annex I1 Skills the I C s sample, appears to be the most affected by the skills constraint. Yet even here the percentage o f firms reporting major or severe constraint is only around 13 percent. Hence, most firms inthe survey deem the skill and education composition oftheir workforce as adequate for their business. While the impact o f rigid pay policies in adjusting to the observed supply shortage o f educated workers in general, but we know that at least labor market rigidities do not prevent more educated workers from earning more than less educated workers. In an attempt to examine how pay policies distort the price o f schooling, we estimated wage returns to schooling for 4 major sectors separately: agriculture, manufacturing, construction and public administration and defense.96 The highest returns to schooling correspond to the construction sector, followed by manufacturing, agriculture and public administration. Civil servants get paid less formally than equally educated workers in other sectors, On the other hand, we saw previously that the average educational attainment inthe public administration is actually higher than in the other 3 sectors, and wages are lower. First, it appears that public pay policies distort the price o f schooling and thus generate inefficiencies. Furthermore, it is well documented that widespread corruption augments formal compensation for many o f these public sector workers. Although survey responses indicate that labor regulations are a major institutional constraint for only a small percentage of, a closer look at the data i s revealing. Only 5.94 percent o f firms in the sample deem the constraint from labor regulations as major or severe obstacle, yet these firms represent 42.5 percent o f the workers in the sample. However, most o f these firms are in the garment sector (57.14 percent), which is the biggest employer in the sample and includes the biggest firms (an average of 1297 workers per firm in contrast with an average o f 22 workers per firm inthe other sectors). Finally, the difference in the returns to schooling between construction and manufacturing may also be due in part to the difference in the intensity o f labor regulations. In particular, data from the enterprise survey shows that 25.81 percent o f firms in the garment sector deem the constraint from labor regulations as major or severe, while only 2.8 percent o f firms in the construction sector do. Furthermore, while the average percentage affiliation o f workers to trade unions is 82.89 percent, this figure is only 0.40 percent for construction firms. This evidence indicates, again, that labor rigidities may distort the price o f schooling in some sectors o f the economy. Do differences in wages by school level reflect differences in productivity or i s education simply used as a credential or signaling device? To this end, we estimated the relationship between productivity per worker at the firm level and the proportion of workers with upper secondary scho01.~'The results show that the higher the percentage o f workers with upper secondary education, the higher the productivity per worker. I s the current supply of skills a constraint to the development of new sources of growth (as opposed to current sources of growth)? The current sources o f dynamism in the economy, garment and tourism, are likely to do little to increase the overall demand for skilled workers in the labor market. Godfrey (2002) argues that Cambodia enjoys a current comparative advantage in natural-resource-based production, initially involving relatively unskilled labor, rather than in the non-agricultural labor-intensive activities for which countries like the Philippines and Vietnam, with high skill levels and labodland ratios, are better suited. A key constraint to the development o f an increasingly modern and diversified agriculture sector is the low proportion o f arable land under irrigation, both in comparison with other ASEAN countries and in relation to its potential.98Even if the economy adopts the path dictated by its underlying comparative 98These resultsare available upon request. 91 The model was estimated by OLS and also included the proportion of skilled workers as well the variables in Table 17, geographicalarea dummies, and sector dummies. The data used for the analysis come from the enterprise survey describedearlier. These results are available upon request. 98Another key constraint is the poor state of the road network, which also applies to other sectors. Cambodia InvestmentClimzie Assessment Page 102 Annex I1 Skills advantage, the supply of skills is likely to be a constraint as the use of irrigation and modern farming technologies require skilled workers. This strategy is certainly at the core of the government's Economic Action Agenda for 2003-2008. However, the current supply of skills i s inadequateto these proposed developments, so to be able to follow this path successfully the stock and quality of education mustbe improved. School coverageremains low, particularly in post-primary education, repetition and dropout rates inprimary school remainvery high, and the shortage o f teachers and classroom has become more accentuated. In response, two new programs were introduced since 1999. The Education Quality Improvement Project (EQIP) has been providing grants to primary schools for quality improvements, while emphasizing and supporting school management and teacher training. A new wave of educational reforms at the primary school level, known generically under the name PAP (Priority Action Program), started in 2000. These included school grants for routine operating expenses, the abolition o f school fees, village-based remediation programs. The resulting improvements in enrolment and flow rates in primary school will pose a serious pressure to the supply of secondary school facilities and teachers in the near future unless actions are taken in that respect. In response to this concern, the government's Education Sector Support Program Plan (ESSP) i s considering an integrated approach of demand and supply side interventions at the secondary school level: (1) Targeted school construction; (2) Improved utilization o f existing facilities through double shifting of teachers; and (3) Scholarships for girls and the poor. However, even if all these recent and planned education programs and reforms point in the right direction, increasing the stock and quality o f education in the labor market does not create demand for skilled workers. If the labor market and the economy does not keep up in terms o f generating enough economic opportunities for educated workers, two problems may emerge. First, the observed returns to schooling in the labor market would be reduced. Second, there would be skill mismatch in the labor market. The two key demand-sidedistortions that may be subjectto public policy reform appear to be: 1) At present, in part due to international agreementsdesignedto quality Cambodia for import quotas in the US market, wage rates are artificially high in the garments sector. With WTO, the incentive for this policy will diminish. The challenge will be either to find higher value-added activities that can maintain high wages for organized workers in this sector, or to address workers' potential disappointment and needto flexibly respondto changing demand. 2) It is clear corruption revenues in the public sector are attracting some higher-skilled workers to public service for the wrong reasons. On the one hand, civil service reform should address the wage distortions that create the mismatch between public employee skills and formal compensation. On the other hand, a serious and well-enforced anti-corruption program is required, so that Cambodia's most skilled workers are channeled by markets to productive activities, rather than diverted to rent-seeking. CambodiaInvestmentClimate Assessment Page 103 Annex 111 PICS Methodology Annex 111: Methodology: Productivity and Investment Climate Survey Survey Rationale Investment climate assessments represent a World Bank Group global initiative to systematically analyze conditions for private investment and enterprise growth. Improving the investment climate i s recognized as a key pillar o f World Bank Group work to promote economic growth and reduce poverty in developing countries. Investment climate assessments are envisioned in the World Bank Group's Private Sector Development Strategy as a systematic meansto allow: Better identification o f the features of the investment climate that matter most for productivity and hence income growth, Tracking of changes inthe investment climate within a country, and Comparison of countries and regions within countries ICAs provide a standardized way of measuring and comparing investment climate conditions in a country, replacing a number of varying methodologies of the past. These assessments highlight the microeconomic and institutional conditions inhibiting constraining productive investment. They identify priority problems whose improvement would yield the greatest and most immediate gains. To this end, ICAs look in detail at impediments (including policy ,regulatory and institutional factors) that constrain the effective functioning of product markets, financial and non-financial factor markets, and infrastructure services. ICAs utilize a set of tools and analytical framework to identify reform priorities in a country's investment climate, by linking constraints to firm-level costs and productivity. Underpinning all ICAs is a standard core investment climate survey instrument covering a variety of topics including financing, regulation, supplies and marketing, labor relations, technology and training, conflict resolution and governance. Surveys provide unique, micro-level information on the constraints and performance of firms as experienced by enterprise managers in a local context. Using a standard survey and consistent methodology facilitates comparability among countries. Integrating the survey with other information sources balancesthe private perspective o f businesses with broader policy concerns. ImplementingICAs in partnership with local partners and other donors deepens capacity and ownership. Survey Execution The survey was contracted to Indochina Research Ltd., a leading Cambodian Market Research company. It followed the following steps in survey implementation. Sample Coverage. The sampling was drawn from a wide range of commercial sectors (as agreed with WBG) that were considered to be representative of Cambodian economy and market interms of sector activity in each survey location: Phnom Penh, Siem Reap, Kampong Cham, Battambang and Sihanoukville. Cambodia Investment Climae Assessment Page 104 Annex 111 PICS Methodology Selection Process. Respondents were randomly selected from 1"s company and SME database, business association membership lists and the WBG in the case of electric power providers' list. IRL staff also made field visits when contact lists were depleted / insufficient to gain the required number of respondents. This occurred most for gaining contacts in the construction materials and services and agro- processing sectors. Respondentscontactedto arrange interview time and place. First contact was made by phone and repeatedon average four times before a successful interviewappointment was made. Pilot Interviews. The content and form of the questionnaire was tested using a "pilot" survey using experienced interviewers to conduct face-to-face interviews with 5 randomly chosen SMEs. This pilot survey ensured that the final questionnaire used in the actual survey was as accurate and efficient as possible. Quality Control. In order to ensure the best quality data collection possible, experienced supervisors managing the fieldwork carried out quality control of the survey results. These staff are experienced in a range of survey methodologies, quality control and procedural aspects o f such research projects and will work closely with IRLmanagement, to monitor the performance of interviewers. Productivity and Investment Climate Dataset and its Purpose The PICS productivity datasetbrings together survey data on firm-level performance by combining andprocessing key productivity questions o f World Bank surveys carried out in different countries during the past years. Its main purpose is to support the work of the Investment Climate Unit by making comparative productivity information readily available to colleagues participating in the elaboration o f Investment Climate Assessments. Rather than being a comprehensive gathering of Survey questions, this database builds upon a few key questions by (i)adding extra information crucial for cross-country comparisons and (ii)harmonizing questions across surveys from a "productivity" perspective. The dataset also contains a group of "derived concepts" so that the user can work directly with central variables like labor productivity, capital intensity, unit labor cost, investment ratios, weighted growth rates, and others. Additionally, unique firm identifiers are included so that the user can link other datasets to this one. The sections below describe the structure of the dataset and discuss some issues related to firm- performance assessment using the dataset. Structure of the Dataset The datasethas athree-part structure as indicated below: Part 1: Firm-level variables Part 2: Economy-level variables Part 3; Derived-concept variables The dataset contains information on multiple years (3, 2, or 1 depending on the survey). The structure of the data is such that different years of a same variable are counted as different variables, where the suffix "-lag#" inthe variable name was introduced to denote "# years ago". Naturally, one can always reshapethe dataset to stack different years of a sane variable into one single variable indexed by time. CambodiaInvestmentClimate Assessment Page 105 Annex I11 PICS Methodology The first part contains firm-level information directly extracted from the original surveys. Unique variable names (e.g. Sales, Fuels, etc) were assigned to common questions across surveys and the information was stacked producing one column for each variable spanning all firms and countries in the sample. At this stage, no outliers were removed. All "value" questions of block 1 are in local currency units (Cambodia is the only exception since the survey is already in Dollars) and they are normalized so that the numbers indicate thousands of LCU. Sectoral breakdowns are kept as they come in the original survey. This issue is further discussed on the sectoral alignment section ahead. Missing observations in the dataset indicate that a certain variable was not available in the respective survey. This is a problem for indirect cost and inventory variables in some countries, directly affecting value-added calculations. This issue is further discussed inthe conceptual adherenceversus sample validation section. The second part contains country-specific variables that are usefulfor conducting international level productivity comparisons. As o f now, only nominal exchange rates (average o f the period) and expenditure- based PPP are reported. These are used to convert LCU to a common currency. In the near future, real and nominal GDP figures will also be included so that the implicit GDP deflator can be calculated and used for inter-temporal comparisons. The issue o f whether to use nominal exchange rates or PPP when comparing international productivity levels is further discussed in a separate section below. The third part contains key productivity concepts derived from Parts 1 and 2 (for instance, partial factor productivity, capital intensity, and unit labor costs). EstimatingProductivity Gaps Across Countries The calculation of productivity gaps was based on the estimation o f a production function pooled across countries (China, India, Bangladesh, Pakistan, Poland, and Cambodia) and sectors (Garment, Food Processing, and IT Electronics) where ordinary least squares combined with White correction for heteroskedascity were usedto fit an augmented Cobb-Douglas technology. The specification usedwas: In(Output,)=cons p,, In(Material,) p,In(Labor,) p, In(Capital,) SectorDumies + + + + + n=l Where i indexes the firm, n the country where the firm is located, and J denotes the number of countries. India and Food Processing, respectively, were chosen as bases for country and sector dummies. ' Productivity gaps expressed in relative percentage terms were retrieved from the estimated coefficients on the country dummies as follows: Productivity Gap for country n = [ exp ( pn)- * 1] 100, for any country n other than India (2) The tables below report estimation results for equation (1) and country productivity gaps as calculated inexpression (2). Productivity Gaps -India as Base Country for Productivity Gap Cambodia InvestmentClimate Assessment Page 106 Annex 111 PICS Methodology ' S Productivity Gaps Across Countries (NominalExchange Rate, base country: India). Error Bars denote 95 % confidence interval Productivlly GapsAcrorrCountries(PPP, base country: India) Error barsdenote 9 5 %confidence interval CambodiaInvestmentClimate Assessment Page 107 Annex I11 PICS Methodologv Performance Gaps (Nominal Exchange Rate, base country: India) UTFP Gap Labor Productivity Gap ' Performance Gaps (PPP, base country: India) Percentage Gap oTFP Gap Labor Productivity Gap 1 Probit Analysis of Impact of Investment Climate improvements on probability of firms creatingemployment. In order to better understand how investment climate variables relate to firm level performance, several econometric models and specifications were tried. Due to imperfections in data and comparability across countries, the strongest indicator of firm performance for which data was broadly available was determined to be employment growth. This indicator is a satisfying one, in that Cambodia faces a Cambodia InvestmentClimate Assessment Page 108 Annex 111 PICS Methodologv fundamental challenge of creating employment for its rapidly growinglabor force, and employment growth links intuitively to poverty alleviation. A number o f indicator variables were identified in parallel for severalcountries, defined as follows: Variable description: LaborGD: Stands for Labor Growth Dummy. It assumes the value one when there was positive labor growth, and zero otherwise.This is the dependentvariable of the Probit. (Regressors) Labor lag1: Measuresthe employment level at the base period.The significant indicates that the likelihood o f observingfirm growth increaseswith the labor force. Age: How many years of existence the firm had at the time ofthe survey. ForOwn:Percentageofthe firm that is foreign owned. Export:Percentageof firm's sales that is directly or indirectlyexported MIC-Number-n: Investmentclimate variable measuredas the number of inspections averagedby country. MIC-BribeTax: Investment climate variable measuredas the percentage of sales made in illegal payments averagedby country MIC-Access-n: Investment climate variable measured as the proportion (within country) of firms saying that Access to financing is a major or severeobstacleto the operation and growtho ftheir business. MIC-Legals-m: Investment climate variable measured as the proportion (within country) of firms answering that they tend to agree with the statement that "they are confident that the judicial system will enforce contractualand propertyrights" A probit modelwas specified to determinethe influenceof changes ineach indicator variable onthe probability that a firm's employment had grown in the previous year. Below are the results of the model employed. Labor-lag1 1 . 0 0 0 5 9 @ 7 . 0 0 0 2 8 7 8 2 . 0 5 0.040 . 0 0 0 0 2 6 5 , 0 0 1 1 5 4 9 Age 1 -.(IO24903 . 0 0 6 9 6 2 9 - 0 . 3 6 0 . 7 2 1 - . 0 1 6 1 3 7 4 . 0 1 1 1 5 6 8 ForOwn 1 . 0 0 7 5 4 7 2 . 0 0 2 0 2 3 9 3 . 7 3 0.000 . 0 0 3 5 8 0 4 .(I115139 E x p o r t P 1 - . 0 0 @ 3 3 3 1 . 0 0 0 9 3 2 8 - 0 . 3 6 0 . 7 2 1 - . 0 0 2 1 6 1 4 . 0 0 1 4 9 5 2 MIC-Number-n I - . 0 1 6 0 2 6 1 . 0 0 2 1 6 7 1 - 7 . 4 0 0.000 - . 0 2 0 2 7 3 4 - . 0 1 1 7 7 8 7 M I C - B r i b e T a x 1 - . 0 7 5 0 5 2 3 . 0 1 2 3 9 8 9 - 6 . 0 5 0 . 0 0 0 - . 0 9 9 3 5 3 7 - . @ 5 @ 7 5 @ 9 MIC-Access-n I , 6 4 5 8 3 9 6 , 4 1 2 9 2 0 4 1 . 5 6 0 . 1 1 8 - . 1 6 3 4 6 9 5 1 . 4 5 5 1 4 9 MIC-Legals-m 1 , 2 4 6 6 2 9 3 , 0 7 0 2 7 7 3 . 5 1 0 . 0 0 0 . l o 8 8 8 8 9 . 3 8 4 3 6 9 7 - _ _ _ _ _ _ _-_c-o_n- -s- _ _I _ _ _- _ _ _ _ _ _ _ _ . 3 9 1 9 6 0 4 . 0 5 8 6 0 4 5 - 6 . 6 9 0 . 0 0 0 - . 5 0 6 8 2 3 - . 2 7 7 @ 9 7 7 When interpreting the magnitudes of the coefficients, it is usually a good idea to implement a transformation mapping the slope coefficients above (which capture effects over the quintiles of a normal Cambodla InvestmentClimze Assessment Page 109 Annex 111 PICSMethodology distribution) into probability changes (normally evaluated at the mean point o f the data). Using a STATA software transformation designed for this purpose yields the table below: R o b u s t LaborGD dF/dx S t d . E r r . 2 P > l z l x-bar [ 95% C . I . 1 --------- __----_------___________________________---------------------------- Labor-- 1 .OC02102 .0001025 2 . 0 5 0 , 0 4 0 1 7 9 . 7 4 4 9 . 3 e - 0 6 . 0 0 0 4 1 1 Age - . 0 0 0 8 8 6 . 0 0 2 4 7 6 6 - 0 . 3 6 0 . 7 2 1 1 1 . 9 3 3 2 - . 0 0 5 7 4 .OO3968 ForOwn . 0 0 2 6 8 5 . 0 0 0 7 1 8 6 3 . 7 3 0 . 0 0 0 8 . 6 7 7 9 1 . 0 0 1 2 7 7 . 0 0 4 0 9 3 E x p o r t P - . 0 0 0 1 1 8 5 . 0 0 0 3 3 1 9 -0.36 0 . 7 2 1 3 3 . 3 1 9 7 - . 0 0 0 7 6 9 .000532 M IC-Nu- n - . 0 0 5 7 0 1 5 , 0 0 0 7 6 8 6 -7.40 0 , 0 0 0 2 4 . 0 9 7 7 - . 0 0 7 2 0 8 - . 0 0 4 1 9 5 M IC-Br --x - . 0 2 6 7 0 0 9 .OC44286 -6.05 O . C O 0 2 . 6 4 6 1 6 - . 0 3 5 3 8 1 - . 0 1 8 0 2 1 This table brings the same model as the first one, but it reports the change in probability for a infinitesimal change in each independent variable (that is, it carries out the transformation Ialluded to above). For example, choosing the Bribe Tax, one would interpret the coefficient -.0267009 as indicating that on average, a 1 point worsening of the BribeTax IC measure will reduce the probability ofjob creation by approximately 2.6 percent. On the other hand, the worsening o f the IC inspection measure is 0.57 percent. The IC measures for Credit Access and Legal System are categorical, and must be interpreted accordingly. That is, for example, ifthe average expressedview of thejudicial system enforcing contractual and property rights shifts from "tend to disagree" to "tend to agree", this should be associated with an average increase in the probability of a firm creatingjobs o f almost 9 percent. CambodiaInvestmentClimaae Assessment Page 110 t- I I 0 0 0 0 0 9 9 $ 0 0 W h m Z?? I r a r I a6~e7 I iapodxg 0 0 0 0 g g z z ( Japodxg w b - - a6~e7 pajsanul -UB!aJoj c + + 0 0 0 L( ' P E P s c c m m m 1 n a a c i * I , r N I I Annex IV: DoingBusinessin2004 CambodiaCountryProfile - Monitoring, Analysis and Policy Unit InvestmentClimateDepartment World Bank Group Doing Business Country Profile Cambodia -pg. I17 Introduction A vibrant private sector-with firms investing, creating jobs, and improving productivity- promotes growth and expands opportunities for poor people. That is why governments around the world have implemented wide-ranging reforms, including macro-stabilization programs, price liberalization, privatization, and opening to foreign trade. In many countries, however, entrepreneurial activity remains limited, poverty high, and growth stagnant. And other countries have spurned orthodox macro reforms and done well. How so? Although macro policies are unquestionably important, there is a growing consensus that the quality of government regulation o f business and the institutions that enforce this regulation are a major determinant o f prosperity. Hong Kong (China)'s economic success, Botswana's stellar growth performance, and Hungary's smooth transition experience have all been stimulated by a good regulatory environment. But there is little work measuring specific aspects of regulation and analyzing their impact on economic outcomes, such as productivity, investment, informality, corruption, unemployment, and poverty. The lack of systematic knowledge prevents policymakers from assessing how good their legal and regulatory systems are and how to design and sequence reforms. Doing Business in 2004: Understanding Regulation is the first in a series of annual reports investigating the scope and manner of regulations that enhance business activity and those that constrain it. New quantitative indicators on business regulations and their enforcement can be compared across more than 130 countries--from Albania to Zimbabwe-and over time. The indicators are usedto analyze economic outcomes andidentify what reforms have worked, where, and why. The indicators presentedand analyzed inDoing Business emphasize domestic, small and medium sized companies, which comprise the vast majority of firms, investment and employment in developing countries. Two types of indicators are constructed. First, measures of actual regulations-for example the number o f procedures to register a business or an index of employment law rigidity. Second, measuresof regulatory outcomes, such as the time and cost to register a business, enforce a contract, or go through bankruptcy. The methodology is based on detailed assessments of laws and regulations, and surveys of in- country government officials, lawyers, legal consultants, and other professionals involved in administering, or advising on, legal and regulatory requirements. This methodology offers several advantages. It i s based on factual information. The data collection process i s transparent and easily replicable. I t allows multiple interactions with the local respondents, ensuring accuracy by clarifying possible misinterpretations of the survey questions. It is relatively inexpensive to administer and as a result the data can be produced for a large sample of countries. And because the same standard assumptions are applied in collection, the data enable valid cross country comparisons and benchmarking. Most importantly, the analysis has direct relevance for policy reform. Two features facilitate this. First,Doing Business studies the effects of the indicators on economic and social outcomes. This enables policy makers to understand better how particular laws and regulations affect employment, access to credit, the size of the informal economy, entry o f new firms, corruption, Doing Business Country Profile Cambodia -pg. 118 and poverty. Second, beyond highlighting the areas for policy reform, the analysis provides guidance on the specific design of reforms. The data provide a wealth of detail on which specific regulations and institutions enhance or hinder businessactivity, what the biggest bottlenecks causing bureaucratic delay are, and how costly compliance with regulation is. Each indicator set i s supported by a library of current laws, and a file specifying what regulatory reforms are underway. After reviewing their country's Doing Business indicators, governments can identify where they lag behind and understandwhat to reform. The initial data covered in the database and included inthis country profile are: Starting a Business:Entry Regulations Hiring and Firing Workers: Employment Regulations Enforcing a Contract: Court Efficiency Getting Credit: Creditor Rights and Credit Information Closing a Business: Bankruptcy A full set of topics will be built over a period of three years. New topics will include business licensing and inspections, corporate governance, property rights, taxation and law and order. Once published, each topic will be updated annually. The initial data are benchmarked to January 2003. The data set covers over 130 economies. The sample includes up to 22 high-income OECD economies as benchmarks, 34 from Africa, 13 from East Asia and the Pacific region, 27 economies from Europe and Central Asia, 21 from Latin America, 17 from the Middle East and North Africa and 6 from South Asia. The sample covers every economy with a populationgreater than 1.5 million, except for six economies that are not members o f the World Bank or are inactive International Development Association borrowers. Inclusion o f economies with less than 1.5 million population may be considered on a case by case basis upon request by Governments or World Bank departments. The following pages present the summary Doing Business indicators for Cambodia. Further information is available in a new annual report entitled Doing Business, which presents the indicators, analyses their relationships with economic outcomes and recommends reforms. The first report Doing Business in 2004: Understanding Regulation, published by the World Bank and Oxford University Press, will be launched in Fall 2003. The data is also available online at http://rru.worldbank.org/doinabusiness andwill be publishedinan annualreport. Doing Business Country Profile Cambodia -pg. 119 Summary of Indicators CAMBODIA REGION: East Asia & Pacific Economic Characteristics EntryRegulations Income oer caoita 280 Number o f orocedures 11 a 1 Legal origin French Time (days) 94 Informal economy (YOo f income) Cost (YOof income per capita) 553.8 Population 12,265,220 Min. capital ( O ho f income per capita) 1825.8 Labor Regulations Contract Enforcement Flexibility of hiring index 33 Number of procedures 20 Conditions of employment index 81 Time (days) 210 Flexibility of firing index 49 Cost (% o f income per capita) 268.5 Employment laws index 54 Procedural complexity index 18 Credit Markets Bankruptcy Public credit registry ooerates? No Time (in years) no practice Public registry .coverage (borrowers11000 no practice capita) n. a. Cost (YOof estate) Pu-blic'registry index 0 Absolute priority preserved index 100 Private credit information bureau operates? N o Efficient outcome achieved index 0 Private bureau coverage (borrowerdl000 capita) n. a. Goals-of-insolvency index 25 Creditor rights index 0 Court-powers index 67 Notes EmploymentRegulations Indices are scored between 0 and 100, with 100 representingthe highest level of regulation. The employment regulation index is the average ofthe flexibility of hiring, conditions of employment and flexibilrty of firing indices. Contract Enforcement The procedural complexity index is constructed by averaging six sub-indices. It varies between 0 and 100, where higher values indicatemore complexity in cottract enforcementprocedures. Credit Markets The creditor rights index is calculated by assigning a value of 1 for a "yes" response on each of four types of creditor rights and summingthe total score across all four variables.A minimum score of 0 represents weak creditor rights and the maximum score of4 represents strong creditor rights. The public registry index measures how well the public credit registry rules are designedto support credit transactions. This index is a simple average of four sub-indices (collection, distribution, access and quality) and its values can range from 0 to 100, where higher values indicate a more extensive registry. Bankruptcy Abso1uteprrorit);preserved index measures the order in which claims are paid in the bankruptcy process. Scores rangefrom 0 to 100. Higher values imply stricter observance of priority for secured lenders. A 100 on Absolute Priority Preserved means that secured creditors are paid before court costs, labor claims and tax claims. A 67 means that secured creditors get paid second, and 33 means they get paid third. A 0 on Absolute Priority Preservedmeans that secured creditorsget paid after all court costs, labor claims, and tax claims are satisfied. ESficrent outcome achieved index measures the success of the bankruptcy regime in reaching the economically-efficient outcome.A score of 1 indicates the efficient outcome is achieved 0 otherwise. Goals-ojinsolvency index is calculated as the simple average of the cost of bankruptcy (rescaled from 0-100 where higher scores indicate less cost), time of bankruptcy (rescaled from 0 to 100, where higher scores indicate less time), the observance o f absolute priority of claims, and the efficient outcome achieved. The total goals-of-insolvency index ranges from 0 to 100, with higher values indicating more efficiency. Court-powers index measures the degree to w,hich the court drives bankruptcy proceedings Scores range from 0 to 100, with higher values indicating more court-powers. Doing Business Country Profile Cambodia -pg. 120 Starting a Business:Entry Regulations When an entrepreneur draws up a business plan and tries to get underway, the first hurdles that needto be overcome are the bureaucratic and legal procedures to incorporate and register the new firm. Economies differ significantly in the way in which they regulate the entry o f new businesses. In some economies the process is straightforward and affordable. In others, the procedures are so burdensome that entrepreneurs have to bribe officials to speed upthe process or they would rather runtheir business informally. The entry data is based on a survey in 133 economies, which investigates the required procedures that an average small-medium sized company needs to go through before starting operation legally. This includes obtaining all necessary permits and licenses, and completing all the required inscriptions, verifications and notifications with all requisite authorities to enable the company to start operation. The survey calculates the costs and time necessary for fulfilling each procedure under normal circumstances, as well as the minimum capital requirements to operate. The assumption is that information i s readily available to the entrepreneur and that all government and non-government entities involved inthe process function efficiently and without corruption. To make the data comparable across countries, the indicators track the procedures for a standardized, hypothetical company to register a business formally. Detailed assumptions about the type o f business are applied. Among these, it is assumed that the business: is a limited liability company conducting general commercial activities in the capital city; that it i s 100 percent domestically owned, with start up capital o f 10 times income per capita, turnover of 100 times income per capita and between 5 and 50 employees; and that it does not qualify for any special benefits nor dos it own real estate. Similarly detailed assumptions about the type o f procedures are made, including that: procedures are only recorded where interaction is required with an external party; the founders complete all procedures themselves; voluntary procedures are not measured by mandatory shortcuts are; and that industry specific requirements and utility hook-ups are not measured. Across countries, cumbersome entry procedures are associated with more corruption, particularly in developing countries. Each procedure is a point of contact-an opportunity to extract a bribe. Empirical analysis shows that burdensome entry regulations do not increase the quality o f products, make work safer, or reduce pollution. They hold back private investment, push more people into the informal economy, increase consumer prices and fuel corruption. Doing Business Country Profile Cambodia -pg. 121 CAMBODIA egulations Number o f procedures 11 Time (days) 94 Cost (% o f income per capita) 553.8 apital (% o f income per capita) 25.8 Cambodia 100 - 600 90 80 70 v) z 60 'El f 50 40 30 20 10 0 1 2 3 4 5 6 7 0 9 10 11 Procedure Deposit the legally required initial capital in Publish formation notice a bank Incorporate the company with the Check the uniqueness o f the company name Commercial Register Pick up a company registration form Have registration documents stamped File the office registration with the Register the company for VAT Municipal Government Notify the Ministry o f Labor Make a company seal Receive Inspection from Labor Inspector Source: Doing Business Database. Doing Business Country Profile Cambodia -pg. 122 Benchmarking-Entry Regulation Cambodia-Compared to Global Best / South EastAsia Average / Selected Other Countries Time to Start a Business (Days) Australia Singapore Malaysia Thailand Philippines South East Vietnam Cambodia Indonesia Asia Average Cost to Start a Business (% of income per capita) Denmark Singapore Thailand Indonesia Philippines Malaysia Vietnam South East Cambodia Asia Average Source: Doing Business Database. Doing Business Country Profile Cambodia -pg. 123 Hiringand FiringWorkers: EmploymentRegulation Every economy has establisheda complex system of laws and institutions intendedto protect the interests of workers and to guarantee a minimum standard of living for its population. This system encompasses four bodies of law: employment laws, industrialrelationslaws, occupational health and safety laws, and social security laws. DoingBusinessexamines governmentregulation inthe areas o f employment laws. An employment regulation index is an average of three sub-indices: flexibility o f hiring, conditions of employment, and flexibility of firing. Each index takes values between 0 and 100, with higher values implying more rigid regulation.Flexibility of hiring covers the availability of part-time,fixed-term, and family members' contracts. Conditions of employment cover working time requirements, including mandatory minimum daily rest, maximum number of hours in a normal workweek, premium for overtime work, and restrictionson weekly holiday; mandatory payment for non-workingdays, which includes days of annual leave with pay and paid time off for holidays; and minimum wage legislation. Flexibility of firing covers workers' legal protections against dismissal, including the grounds for dismissal, procedures for dismissal (individual andcollective),noticeperiod, and severance payment. The indicators on employment regulations are based upon a detailed study of employment laws and industrial relations laws. Data are also gathered on the specific constitutional provisions governing these two areas. In most cases boththe actual laws and a secondary source were used to ensure accuracy. To make the data comparable across countries, a range of assumptions about the worker and the company are applied. Among others, assumptions on the worker include that he is a non- executive full-time employee in the same company for 20 years, has a non-workingwife and two childrenand is not a member of the labor union(unlessmembership is mandatory). It is assumed that the company is a limited liability manufacturing corporationthat operates country's most populouscity. It is 100 percent domestically-owned, and has 201 employees. Although most employment regulations are enacted in responsesto market failures, it does not mean that today's regulations are optimal.Analysis of the indicatorsacross countries shows that while employment regulation generally increases the tenure and wages of incumbent workers, strict regulatory intervention has many undesirable side-effects, including less job creation, longer unemployment spells and the related skill obsolescenceof workers, less R&D investment and smaller company size-all of which may reduce productivity growth. And with fewer job opportunities inthe formal economy, the expansion of an unofficial sector becomesinevitable. Doing Business Country Profile Cambodia -pg. 124 Benchmarking-Employment Regulation Cambodia-Compared to Global Best / South East Asia Average / Selected Other Countries Flexibility of Hiring index Czech Cambodia Malaysia Singapore Vietnam South East Philippines Indonesia Thailand Republic* Asia Average *Other countries which offer the mostflexibility globally include hrigeria,Papua New Gurneaand China. Condition of Employment Index Hong Kong Singapore Malaysia Cambodia South East Vietnam Thailand Philippines Indonesia (China) Asia Average Source: DoingBusiness Database. Doing Business Country Profile Cambodia -pg. 125 Benchmarking-Employment Regulation Cambodia-Compared to Global Best / South East Asia Average / Selected Other Countries Flexibility of Firing Index Hong Kong Malaysia Cambodia Singapore Vietnam South East Indonesia Philippines Thailand (China) Asia Average Employment Laws Index Hong Kong Singapore Malaysia Cambodia South East Vietnam Philippines Indonesia Thailand (China) Asia Average Source: Doing BusinessDatabase. Doing Business Country Profile Cambodia -pg. 126 Enforcing a Contract: Court Efficiency Contract enforcement i s critical for businesses to engage with new borrowers or customers. The institution that enforces contracts between debtors and creditors, suppliers and customers is the courts. In many countries around the world, courts are slow, inefficient, and even corrupt. The evidence here tracks the differences in the efficiency o f contract enforcement, looking at simple transactions o f relevance to the average business ineveryday business activity. The indicators on contract enforcement are constructed assuming a hypothetical case o f a payment dispute over 50 percent o f income per capita in the country's most populous city. The data track the procedures to recover the debt through the courts. I t is assumed that the plaintiff has fully complied with the contract (plaintiff is 100 percent right) and files a lawsuit to recover the debt. The debtor attempts to delay and raises opposition to the complaint. The judge decides every motion for the plaintiff. There are no appeals or post-judgment motions. The data are derived from reading o f the Codes o f Civil Procedures and other court regulations, as well as administering surveys to local litigation attorneys. The respondents are members o f the Lex Mundior Lex Africa association o f law firms, with at least two lawyers participating in each country. Based upon the survey responses, four indicators o f the efficiency o f enforcement of commercial contracts are developed. The first indicator is the number o f procedures, mandated by law or court regulation, that demand interaction between the parties or between them and the judge or court officer. The second indicator o f efficiency i s the time-in calendar d a y s - o f dispute resolution. Time i s measured as the number o f days counted from the moment the plaintiff files the lawsuit in court, until the moment o f settlement or, when appropriate, payment. This measure includes both the days where actions take place and waiting periods between actions. The third indicator is the official cost o f going through court procedures. The cost includes court costs and attorney fees. Finally, an index o f the procedural complexity o f contract enforcement is built by scoring countries on how heavily regulated the dispute resolution process is. Companies that have little or no access to efficient courts must rely on other mechanism-both formal and informal, such as credit bureaus, trade associations, social networks, or private information channels-to decide whom to do business with and under what conditions. Companies may also adopt conservative business practices and deal only with repeat customers. Transactions are then structured to forestall disputes. Whichever alternative i s chosen, economic and social value may be lost. The main reason to regulate procedures in commercial dispute resolution is that informal justice is vulnerable to subversion by the rich and powerful. But heavy regulation o f dispute resolution has negative consequences. Across countries, the more procedures it takes to enforce a contract, the longer the delays and the higher the cost. Moreover, higher levels o f complexity in the procedures to enforce a contract are associated perceived unfairness, corruption, inconsistency and dishonesty inthejudiciary. The indicators make clear that contract enforcement in Cambodia is very expensive in comparison to many other countries inthe region, and five times the regional average as measured by percent o f per capita income. In terms o f time, contract enforcement appears on a par with Thailand and below the regional average. However, other nearby countries, including Singapore and Vietnam, resolve conflicts in much less time. Doing Business Country Profile Cambodia -pg. 127 Contract Enforcement This table provides a summary list of four indicators o f performance on contract enforcement: number of procedures, duration, cost, and a procedural complexity index (including its six sub- indices and their components). Tot, of Form Bottom o f Form Bottom of Form Professionals or Laymen 0.67 Written or Oral 1.oo Legal Justification 0.67 Statutory Regulation o f Evidence 0.38 Control of Superior Review 1.oo Other Statutory Interventions 1.oo Notes: Sub-index components are score between 0 and 1. with 1 reuresenting :highest level of complexity. The procedural I complexity index is coikucted by averagingthe six subindices and multi'plying by 100.It varies between0 and 100, with highervalues indicating more complexity in ccntract enforcementprocedures. Sub-indexes: Professionals or laymen index measuresthe requiredlegal expertise ofthe person settling the dispute Written or oral index measureswhether the stages of the process are normally carried out orally or inwritten form Legaljustfleation index measures the level oflegal formalism ofthe documentationfiled during the enforcementprocess Statutory regulation of evidence index measuresthe levels of formality when introducing evidence during the enforcement process. Control of superior review index measures how the enforcementprocess is affectedby appeal proceedmgs Other statutory intevventions index measuresthe review role exercisedby the courts during thejudicial process. Doing Business Country Profile Cambodia -pg. 128 Benchmarking-Contract Enforcement Cambodia-Compared to Global Best / South East Asia Average / Selected Other Countries Cost to Enforce a Contract (YOof income per capita) I Jordan Vietnam Singapore Malaysia Thailand South East Philippines Cambodia Indonesia Asia Average Source: Doing Business Database Getting Credit: Creditor Rights & Credit Information Access to credit i s consistently rated by firms as one o f the greatest barriers to operation and growth. Two sets o f issues, credit information registries and creditor rights, are covered by the database. Access to credit may be expanded significantly by credit registries - institutions that gather and disseminate information on credit histories. The information sharing role o f credit registries helps creditors to assess risk and allocate credit more efficiently, which means that entrepreneurs don't need to rely on only personal relations when trying to obtain credit. The indicators report whether public credit registries or private credit bureaus operate in surveyed countries and the amount o f credit information they cover. An index o f the extent to which the rules o f credit information registries facilitate lending i s constructed on the basis of: scope o f information collected; scope of information distributed; ease o f access to information and quality o f information. The data were obtained from surveys o f public and private credit registries. Effective regulations on secured lending or collateral are another institutional solution to credit - - constraints. With collateral, a lender can seize and sell the borrower's secured assets upon default o f a loan, which limits the potential losses o f a lender and acts as a screening device o f borrowers. Therefore with effective collateral law, systems and enforcement, one may expect increased access Doing Business Country Profile Cambodia -pg. 129 to credit and better allocation o f credit. DoingBusinessreports an indicator of creditor rights, which measuresthe powers of secured lenders inbankruptcy. The creditor rights indicator is an index that measures four powers of secured creditors in liquidation and reorganization laws. First, whether there are restrictions, such as creditor consent, on entering into reorganization proceedings. Second, whether there is no automatic stay (or `asset freeze') on realizing collateral upon bankruptcy. Third, whether secured creditors are satisfied first upon liquidation, and finally whether management is replaced by a court or creditor appointed receiver in reorganization. Data for the variables were obtained from an examination of bankruptcy laws and legal summaries, verified through a survey of bankruptcy lawyers and cross checked with data gathered for the Doing Businessbankruptcy project. These two measures are important indicators of well functioning credit markets. Across countries, stronger creditor rights and more information sharing are associated with deeper credit markets and lower default rates. The presence of credit registries is also associatedwith a lower spreadbetween lending and deposit rates. Firms in countries with information sharing are less likely to report obstacles to obtaining finance and evidence of credit constraints. Countries with stronger legal creditor protections have larger debt markets, and higher rates o f capital investment and productivity growth. Evident in the tables below, Cambodia clearly lacks essential structure in both fields- creditor rights and information sharing. There is neither a debtor-oriented rehabilitation procedure in Cambodia nor institutions that assure credit information sharing. The decision to rehabilitate i s made by a creditor meeting, once insolvency proceedings have commenced and foreclosure is stayed throughout this process. Direct liquidation i s the most likely procedure to be used in the case of insolvent debtor firms. Doing Business Country Profile Cambodia -pg. 130 Getting Credit: CreditorRights & Credit Information This table shows two measures: indicators of the presence and structure of public and private registries, and a creditor rights index measuring the powers of secured lenders. To relate these indicators to outcomes the table lists three credit market outcomes. TODof Form Bottom of Form PCR Access Index 0 PCR Collection Index 0 PCR Distribution Index 0 PCR Quality Index 0 Restrictions on enteringreorganization No No automatic stay on enforcing security No SecuredCreditors are paid first No Management does not stay during reorganization No Private credit (% GDP) 0.1 Five bank concentration ratio (YO) Interest rate spread (%) 10.8 Note Scores for each of the public credit registry indices on coilechon, distribution, access, quality can range from 0 to 100 The total public credit registry index is the simple average of the collection, distribution, access and quality indices, and ranges from 0 to 100 Higher lalues indicatethat the rules of the public credit registly on collection, distribution, access and quality are better designed to support credit transactions The creditor rights index is calculated followingthe methodologyof La Porta et al (1998) by first assigninga value of 1 for a 'yes" response on each of the four types ofcreditor rights and then summingthe total score across all four variables A minimum score of 0 represents weak creditor rights and the maximum score of 4 representsstrongcreditor rights Doing Business Country Profile Cambodia -pg. 131 Source: Doing BusinessDatabase. Benchmarking-Creditor RightsIndicator Cambodia-Compared to Global Best/ South East Asia Average / Selected Other Countries Most Protection- Global Legal Creditor Rights Index I Hong Kong Singapore Thailand Indonesia South East Malaysia Philippines Vietnam Cambodia (China)' Asia Average * Other countrieS whlch offer the most protection globally include Kenya, Lebanon, New Zealand, Nicaragua, Nigeria, Panama, Zimbabwe, and the UK Source: Doing BusinessDatabase. Benchmarking Credit InformationIndicators - Cambodia-Compared to Global Best / South East Asia Average / Selected Other Countries The table shows the coverage of credit registries in Cambodia and selected benchmarks with indicators on the number of registered borrowers per 1000 inhabitants. Source: Doing Business Database. Doing Business Country Profile Cambodia -pg. 132 Closinga Business: Bankruptcy Recent economic crises in emerging markets, from East Asia, to Latin America, to Russia and Turkey, have raised concerns about the design o f bankruptcy systems and the ability o f such systems to help reorganize viable companies and close down unviable ones. In countries where bankruptcy is inefficient, unviable businesses linger around for years, not allowing assets and human capital to be reallocated to more productive uses. Most often, the bottlenecks in bankruptcy are associated with the inefficient judicial process, and hence the unwillingness of banks and other lenders to pushfor a formal bankruptcy resolution. Inthis set of indicators, the focus is on identifying weaknesses inthe existing law, as well as the main procedural and administrative bottlenecks in the bankruptcy process. In many developing countries, bankruptcy i s so inefficient that creditors hardly ever use it. In such countries, policy reform would best focus on improvingcontract enforcement outside o f bankruptcy. The indicators are derived from questionnaires answered by attorneys at private law firms and bankruptcy judges. Most respondents are members o fthe International Bar Association. The data track the step by step procedures for a hypothetical company to go through the bankruptcy process. It i s assumed that the company i s a domestically owned limited liability corporation, operating a hotel in the most populous city. The company has 201 employees, 1 main secured creditor and 50 unsecured creditors. Detailed assumptions about the debt structure and future cash flows are made. It is assumed that the company becomes insolvent on January 1. The case is designed so that the company has a higher value as a going concern-that is, the efficient outcome is either reorganization or sale as a going concern but not piecemeal liquidation. Six indicators were constructed from the survey responses: the time and cost to go through the bankruptcy process, a measure o f whether absolute priority for secured lenders is preserved throughout the process, a measure o f whether the efficient outcome is achieved in the hypothetical case. An aggregate "goals o f insolvency'' measure was built by averaging the scores on time, cost, priority, and whether the efficient outcome is achieved. Finally, an indicator o f court powers inthe bankruptcy process was constructed. Countries with ill-functioning judiciaries are better off without sophisticated bankruptcy systems. There is a general misperception that bankruptcy laws are needed to enforce creditor rights. In practice, the laws usually exacerbate legal uncertainty and delays in developing countries. Private negotiations o f debt restructuring under contract law, the efficient enforcement o f secured debt contracts outside insolvency under collateral law, through summary judgments and private enforcement will do better. Bankruptcy law i s often oriented to closing down unviable companies. But sometimes the bias toward discontinuing the business may lead to the premature liquidation o f companies in temporary distress-and a loss o f value to society. There is no law on insolvency or liquidation in Cambodia. The Draft Law on Insolvency, introduced in July 2002, has not been enforced yet, but is the most likely basis for future practice. Iffact, inthose areas of business where the only legislation is draft legislation, the governmental authorities and the courts tend to use such draft legislation as practical guidance pending the enactment o fthe legislation. Given its recent nature, the Draft Law on Insolvency has not been in Doing Business Country Profile Cambodia -pg. 133 existence long enough to provide reliable statements about the development of practices and procedures guided by the draft law itself. The court with bankruptcyjurisdiction, TOLAKA KHET/ KRUNG, I s plagued by work overload. Further, the lack of civil procedure legislation makethe use of delayinglitigationextremely easy for partieswishing to do so. Doing Business Country Profile Cambodia -pg, 134 Benchmarking-Ban kruptcy Cambodia-Compared to Global Best / South East Asia Average / Selected Other Countries Time to go through Insolvency (Years) Ireland Singapore Malaysia Thailand South East Philippines Indonesia Cambodia Vietnam Asia Average Cost to go through Insolvency (% of Estate) Norway* Singapore South East Indonesia Malaysia Philippines Thailand Cambodia Vietnam Asia Average *Finland and Colombia also have cost equal io 1% of estate value. 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