1

A CURRENCY BOARD FOR CAMBODIA

Sophal Ear*
(Princeton University)
N
o
2
srie rouge, juillet 1997
* E-Mail : sophal@alumni.princeton.edu Website: csua.berkeley.edu/~sophal
Fax:(510)991-1514
1997 by CERIA
Case postale 2403 - 1002 Lausanne - Switzerland


2
EAR Sophal, A Currency Board For Cambodia, Les Cahiers du Ceria,
srie rouge, n2, juillet 1997.
ABSTRACT

Cambodia's monetary policy has been a marginalized academic issue in
the recent past, this paper tries to correct for some of this lack of
attention. This paper recommends that the Royal Government of
Cambodia convert the NBC to a currency board. First, the paper reviews
the literature on central bank independence, including empirical
considerations. This review is followed by a discussion of the advantages
and disadvantages to central bank independence in the context of a
developing country, followed by questions of instrument and goal
independence. The paper then outlines the major macroeconomic
constraints under which the NBC currently operates, with particular
emphasis on credibility in policies designed to fight dollarization and
introduce Treasury-bills. Finally, it recommends that even with current de
jure independence, the international financial community should push for
increased transparency in monetary policy and the adoption of a currency
board in Cambodia.
RESUME

Dans un pass rcent, la politique montaire du Cambodge n'a que peu
retenu l'attention des chercheurs. L'auteur de cet article se propose donc
de modifier quelque peu cet tat de fait. L'objectif principal de cette
contribution est de dmontrer en quoi le gouvernement cambodgien aurait
avantage transformer la BNC en un "currency board". Dans un premier
temps, l'article passe en revue la littrature consacre l'indpendance
des banques centrales en incluant des considrations empiriques, puis il
poursuit par un questionnement sur les avantages et les incovnients de
cette indpendance ainsi que sur ses instruments et ses objectifs. L'article
analyse ensuite les principales contraintes macroconomiques qui psent
sur l'action de la BNC. Il insiste tout particulirement sur la faible
dollarisation de l'conomie par l'introduction et l'mission de bons du
Trsor. En dernier lieu, l'article recommande que la communaut
financire internationale pousse la transparence de la politique
montaire et l'adoption d'un "currency board" au Cambodge, car
l'indpendance de jure de la BNC semble plus qu'insuffisante dans le
contexte actuel.


3
A CURRENCY BOARD FOR CAMBODIA
by Sophal Ear*
1. Introduction
Cambodia's central bank, the National Bank of Cambodia
(NBC), faces severe constraints as it formulates and attempts to
implement monetary policy. These constraints include wide-spread
dollarization in the economy, the lack of an interest rate of any
kind that is market determined, and foreign exchange reserves
that fell below International Monetary Fund (IMF) recommended
levels in October 1996 (Robinson 1996). This paper recommends
that the Royal Government of Cambodia convert the NBC to a
currency board. First, the paper reviews the literature on
central bank independence, including empirical considerations.
This review is followed by a discussion of the advantages and
disadvantages to central bank independence in the context of a
developing country, followed by questions of instrument and goal
independence. The paper then outlines the major macroeconomic
constraints under which the NBC currently operates, with
particular emphasis on credibility in policies designed to fight
dollarization and introduce Treasury-bills. Finally, it
recommends that even with current de jure independence,1 the
international financial community should push for increased
transparency in monetary policy and the adoption of a currency


4
board in Cambodia.
2. Why Central Bank Independence Matters
Central bank independence is one suggested solution to
solving the problem that governments may be tempted to inflate
after they have announced an inflation target. This may be due to
the government's setting inflation rates ex-post announcements,
creating a time consistency problem as presented in the Barro and
Gordon (1983) model. For instance, governments may want
unemployment to fall below the natural rate (perhaps because of
structural problems in labor markets, unemployment could be 10
percent, 20 percent or more). Policy-makers could discount the
effects of inflation and put a weight on the benefits of
employment in their objective function (Eifinjer and de Haan
1996). IMF First Deputy Director, Stanley Fischer, explains the
logic of central bank independence this way:
In a first-best world, monetary policy would be
perfectly coordinated and chosen, and there would be no
need for an independent central bank. But in the
imperfect world in which most central bankers ply their
trade, political systems tend to behave myopically,
favoring inflationary policies with short-run benefits
and discounting excessively their long-run costs. An
independent central bank, given responsibility for
price stability, can overcome this inflationary bias.
(Fischer 1996, 35)
It may also make sense for governments to partially default on
debt denominated in the domestic currency if the benefits to
doing so are greater than the costs. In that case, the socially


5
optimal rate of inflation will be lower than the one set by the
government ex-post. It therefore makes sense for rational actors
with perfect foresight to set expected inflation to the true
level of inflation and thus cancel any real effects on the
economy.
The issue becomes one of credibility in monetary policy, and
central bank independence offers an avenue for solving this
problem. How then to design the blueprint of an optimal central
bank? When a central bank is independent, this means that
monetary policy is set not by the government in power, i.e., the
entity tempted to inflate, but by an entity precisely independent
from the government itself. This means handing the power of
monetary policy over to the central bank completely and
appointing a governor who cannot be fired for not following the
government's wishes. In so doing, monetary policy is set by
someone other than the government, preferably a conservative,
though not too conservative, central banker (Rogoff, 1985).
The issue of credibility in monetary policy in the case of
Cambodia, as will be seen, is of crucial importance. The NBC is
now trying to convince Cambodians to hold the local currency, the
riel, but this is exceedingly difficult given the high inflation
rates in 1973-1975, throughout the 1980s, and in 1992-1993, and
the fact that the exchange rate experienced excessive volatility


6
against the dollar, cumulatively losing more than half its value,
has made this task all the more difficult. This has forced
Cambodians everywhere to turn to the dollar, the Thai baht, and
other hard currencies for transactions. Central bank independence
should therefore be the centerpiece of any policy intended to re-
establish the NBC's credibility in issuing Cambodian currency,
the more so the better.
The available empirical evidence by Alesina and Summers
(1993) and Alesina and Gatti (1995) suggests that countries which
have independent central banks have lower inflation rates and
higher rates of growth due to risk premium reduction in interest
rates. However, because many of the radical changes to central
bank designs took place recently, and only because inflation was
high, there are too few years to draw a sufficient conclusion on
the effectiveness of central bank independence. Cukierman, Webb,
and Neyapti (1992) and Eifinjer and de Haan (1996) have found
sufficient evidence to conclude that central bank independence
results in lower inflation. For developing countries, the
evidence is less conclusive. It should be noted that central bank
independence is by no means a panacea, nor is it a pre-requisite
for low inflation. Many countries, including J apan, enjoy
relatively low inflation-though their central banks are only
moderately independent.2 On average, however, it appears that


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independent central banks do have more degrees of freedom to set
inflation low.
2.1 The Side-effects of Central Bank Independence in Developing
Countries
Special consideration should be given in the case of
developing countries as to the effect of central bank
independence on output. Although much is still unknown, one
theoretical disadvantage to low inflation is a resulting higher
interest rate. High interest rates are detrimental to investment
and hence to growth (Eifinjer and de Haan 1996, 13). The other
problem that might occur in the case of an independent central
bank is that having placed greater emphasis on maintaining price
stability, the central bank would be willing to sacrifice output
and cause recessions in the event of an unanticipated shock. In
theory, this would lead to a higher variance in output, and hence
uncertainty (Eifinjer and de Haan 1996, 14-15). Finally, with
central bank independence, policy coordination is impossible
(though that would have been an unrealistic first-best condition
anyway).
On the other hand, it is clear that allowing inflation to be
moderately high leads to increased variance in inflation which
also hurts growth. The inflation risk premium on interest rates
would increase, if the rate of inflation were higher. Uncertainty


8
about inflation makes contracts more difficult, and impedes
growth. Even with indexation to the inflation rate, this
uncertainty could never be completely removed (due to timing
considerations).
2.2 Instrument and Goal Independence
With central bank independence comes another question:
should the independent central bank have goal or instrument
independence or both? Goal independence means that the central
bank is free to choose what it wants to do with respect to
monetary policy. For instance, the goal of the future European
central bank is price stability. Other goals could be minimizing
unemployment, or maximizing seignorage, or monetizing debt. On
the other hand, instrument independence refers to how the central
bank achieves its goal. Examples of instruments include targeting
the price level, or an inflation rate, or a monetary target or a
nominal anchor like an exchange rate. Fischer (1995) argues that
instruments independence is preferable to goal independence, and
Fischer (1996) recommends inflation targeting over price-level
targeting because the latter actually creates more short-run
variance in inflation (Fischer 1996, 36). While it was possible
to target the money supply during the 1970s, there has been
increased volatility in money demand due to innovation in the
financial sector (from automated teller machines to money market


9
accounts), making it an increasingly difficult proposition
(Fischer 1996, 36).
3. The National Bank of Cambodia: Which Way to Go?
Though this was not always the case, the National Bank of
Cambodia today suffers from a severe lack of credibility. Before
1970, the riel was "one of the most stable currencies in
inflation prone Indochina." (UPI 1990) The NBC was founded in
1955, then shut down in 1975, after the Khmer Rouge took power
and banned money. It was re-established in the aftermath of the
Vietnamese invasion of Cambodia on Christmas day, 1978, as a
socialist institution designed to collect foreign exchange and
pay State liabilities to foreign governments. After the Paris
Agreements of 1991 that paved the way for the peaceful resolution
of a 20 year-old war, the NBC was again re-incarnated. Today, the
NBC is an independent institution-in so far as it "is different
from [other] government institutions.. [and] conducts its
operations independently,"3 according to the Second Prime
Minister. It currently uses inflation targeting as its main
monetary instrument,4 and facilitates policy consultants from the
New Zealand Reserve Bank to the World Bank in its offices. The
inflation target for 1994, according to the NBC Deputy Governor
was nine percent, but ended at 26.1 percent. In 1995, inflation
was only 3.5 percent, while annualized inflation for 1996 held


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steady at slightly over 7.5 percent.
There are several reasons as to why people may not give the
NBC the credibility it needs to introduce new currency.
Certainly, Cambodia does appear to have the capacity to sustain a
local currency, but after years of inflation and conflagration,
the National Bank of Cambodia is once again trying to re-assert
influence over the economy, as a lender of last resort and a
source of liquidity. The dollar, which came into prevalent use
before 1991 as a store of value, has dominated the economy since
then. Several reasons for dollarization are plausible, first, the
NBC is a very young institution (since the formation of the Royal
Government of Cambodia in 1993). Despite a rebirth, people have
not completely forgotten that in the three years prior to 1975
every riel continuously depreciated in value against the dollar
and lost purchasing power due to massive inflation. From 1975
until 1979, the riel was banned as legal tender and thus made
completely worthless.
In the days preceding the UN-sponsored general elections of
1993, exchange rate volatility in the riel ended with a massive
overshooting depreciation that cut its value in half. At the same
time, inflation exceeded 100 percent as the economy went into
mayhem with fundamentals, politics, and expectations gone wild.
The result was a complete loss of confidence in the riel-or at


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least for half of every riel-and the permanent re-alignment of
the currency to a new exchange rate level. Merchants now use the
dollar, especially for large volume transactions, in which price
volatility can make a big difference. Land sales are made with
gold bullion. Though the riel is accepted at restaurants, menus
are more often printed with dollar-denominated prices.5
To combat dollarization, the NBC has issued new currency in
larger denominations. The 500 riel note which once could have
purchased a bowl of noodles (now upwards of 2500 riels), can only
pay a motorcycle taxi fare (20 cents). The NBC has issued bills
200 times that value to create a store of wealth that is at least
as significant as a 50 dollar bill. The exchange rate, which had
stabilized at 2500 riels to the dollar, has gradually depreciated
by about eight percent against the dollar recently, to 2700
riels. In a dollarized economy, this means a loss of eight
percent in purchasing power against the riel, but not the dollar.
In addition, the NBC also plans to issue Treasury-bills which
will reveal a nominal interest rate (Wallengren 1996). This would
be an improvement over the prevailing private interest rates that
banks charge. Savings accounts interest rates are low, but these
are not market-wide. Few Cambodians actually resort to banks to
save money or borrow, since they are unlikely to be given a loan.
The market is one that is severely segmented, primarily for the


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use of expatriates and well-to-do locals.
The efforts of the NBC, though valiant, have been limited in
their success. Multilateral lenders like the IMF and the World
Bank recently suspended 46 million dollars in disbursements
because of unsatisfactory transparency in accounting for forest
logging revenues. This setback for the Government came one week
after a letter by the NBC Governor warned that Cambodia's foreign
exchange reserves had fallen below minimum levels recommended by
the IMF. Though a currency crisis could easily trigger an
overshooting of the exchange rate, the reserves came back to
recommended levels soon thereafter. Perhaps the fact that there
was no speculative attack shows how much anyone cares about this,
or has power to make money from it. In late August, the exchange
rate depreciated to 2900 riels to the dollar, but then returned
to 2700 riels.
The NBC is also rumored to have irked the World Bank when
money that was transmitted to it from the Bank was later missing
for at least 24 hours. There is clearly insufficient leverage or
will on the part of the NBC Governor to control the operations of
the central bank, and it is clear that political factors even if
they are currently dormant, can resurrect themselves. In 1995,
after a commercial banking scandal in which the NBC lost three
million dollars to a domestic bank that folded, the Governor was


13
immediately rumored to be next-in-line for dismissal. This did
not happen, instead one of Cambodia's two prime ministers stated
that "The National Bank of Cambodia is different from [other]
government institutions. The bank conducts its operations
independently, although it has to join various government
institutions in implementing the RGC's [Royal Government of
Cambodia's] monetary policy and in stabilizing the macro
economy."6 Furthermore, he stressed that removal of the governor
required the consent of both prime ministers. In a twist on Hibbs
(1977), the Royal Cambodian Government has both opposing parties
in power simultaneously, sharing the prime ministership and some
ministries, while the remainder is divvied-up.
It is evident that even with a legal interpretation of NBC
independence, the rule of law is so lacking in Cambodia that this
would be meaningless. Legislated central bank independence per se
is therefore not sufficient to achieve this credibility. One
option the NBC could follow would be to convert to a currency
board (more on this later). In addition, the NBC could use a
fixed exchange rate nominal anchor to preserve price stability
which it somewhat does already with a dual parallel market.
The NBC needs credibility to succeed in de-dollarizing the
economy. One source of this credibility could arise from being
made even more independent from the government and completely


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transparent. This is why a currency board is needed in Cambodia.
4. Conclusion: Alternatives to the Status Quo
Observers of this dollarization problem may also consider
the possibility of using a currency board, since there is already
so much dollar utilization. A currency board holds fractional
reserves of hard currencies and issues more local currency only
if it possesses the reserves for it. The advantage to a currency
board is immediate exchange rate convertibility and stability
which promotes economic growth and reduces uncertainty. However,
there are theoretical limitations to a currency board, some of
which are discussed next.
As with any fixed exchange rate regime, a currency board
means the permanent loss of monetary independence. To maintain a
peg, the currency board must enact the same monetary policies
that the United States Federal Reserve enacts. This must be done
to maintain the peg. Also, as during the waning years of Bretton
Woods, when the US dollar was overvalued, the country pegging to
the dollar imported US inflation. Likewise when the US dollar
weakens in a free-float, the country pegging risks importing US
inflation.
Moreover, foreign exchange speculative attacks, i.e., a
currency crisis would simply translate to a banking crisis when
high-powered money leaves or when money demand changes, say in


15
the case of increased deposit withdrawals. If bank runs are still
systemically possible, the Diamond and Dybvig (1983) problem
remains.
Yet this may not be so large a risk in Cambodia, where few
Cambodians hold money in banks. Of the nearly 30 banks now
operating in Cambodia, many are foreign owned and operated.
According to official statistics, these banks are controlled by
majority shareholders of the following nationalities: two
Cambodian, 11 Thai, four Malaysian, three Hong Kongese, three
Singaporean, one Australian, one English, one French, and one
Taiwanese. In theory, Fischer argues that "A currency board would
be much easier to operate if all banks were foreign, supervised
by the monetary authorities of their countries, and with access
to their lender-of-last-resort facilities." (Fischer 1996, 37) Of
the seven foreign banks operating in Cambodia, all are supervised
by their central banks: two in Malaysia, six in Thailand, and one
in France (Fitzgerald 1995).
As for the exchange rate, Cambodia's current use of a dual
parallel rates system makes possible the introduction of the
currency board. As a nominal anchor, a fixed exchange rate
provides stability to a currency and makes it more attractive.
Given that the board essentially pegs the currency, with gradual
modification as needed, as in the case of Hong Kong, the riel


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could achieve remarkable stability in a short period of time,
thereby preserving its value.
REFERENCES
Alesina, Alberto and Roberta Gatti. 1995. Independent Central
Banks: Low Inflation at No Cost? American Economic Review 85
(May): 196-200.
Alesina, Alberto and Lawrence Summers. 1993. Central Bank
Independence and Macroeconomic Performance: Some Comparative
Evidence. J ournal of Money Credit, and Banking 25: 151-162.
Barro, Robert J . and D.B. Gordon. 1983. Rules, Discretion and
Reputation in a Model of Monetary Policy. J ournal of
Monetary Economics 12: 101-121
Cambodia Could Gain from Developments in the Region. 1995.
Newsletter Database, J une 1.
Cukierman, Alex, Steven B. Webb and Bilin Neyapti. 1992.
Measuring the Independence of Central Banks and its Effects
on Policy Outcomes. The World Bank Economic Review 6: 353-
398.
Diamond, Douglas and Philip H. Dybvig. 1983. Bank Runs, Deposit
Insurance, and Liquidity. J ournal of Political Economy 91:
401-419.
Eijfinger, Sylvestor C. W. and J akob de Haan. 1996. The Political
Economy of Central Bank Independence. Special Papers in
International Economics 19 (May), Princeton University
International Finance Section.
Fischer, Stanley. 1995. Central bank Independence Revisited.
American Economic Review 85 (May): 201-206.
Fischer, Stanley. 1996. Maintaining Price Stability. Finance &
Development (December): 34-37.
Fitzgerald, Tricia. 1995. United Press International, J uly 11.
Hibbs, Douglas A. 1977. Political Parties and Macroeconomic
Policy. American Political Science Review 23: 1467-1488.
Hun Sen Denies Report on National Bank Governor's Dismissal.
1995. Reaksmei Kampuchea (in Cambodian). J une 28.
Robinson, Katya. 1996. Cambodian Foreign Reserves Drop, Riel
`Volatile'. Reuters Asia-Pacific Business Report, November
14.
Rogoff, Kenneth. 1985. The Optimal Degree of Commitment to an
Intermediate Monetary Target. Quarterly J ournal of Economics
100 (November): 1169-1189.
United Press International, August 15, 1990.
Wallengren, Maja. 1996. Cambodia to Launch First T-Bill this
Year. The Reuter Asia-Pacific Business Report, August 22.


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_______________________________
* Sophal Ear is Master's candidate concentrating in economics
and public policy at Princeton University's Woodrow Wilson School
of Public and International Affairs. He will graduate this Spring.
1 The rule of law is so weak in Cambodia as to make this
meaningless.
2 The Bank of J apan falls under the control of the Ministry of
Finance. The MOF is itself famed for its bureaucratic
independence from the Government.
3 As quoted from "Hun Sen Denies Report on National Bank
Governor's Dismissal." 1995. Reaksmei Kampuchea (in Cambodian),
J une 28.
4 "Cambodia Could Gain from Developments in the Region." 1995.
Newsletter Database, J une 1.
5 This in itself is part of the inflationary burst that overtook
Cambodia in 1992-1993 when 22,000 United Nations Peacekeepers
came to Cambodia. Since U.S. coins are not used, the smallest
U.S. currency unit is the one dollar bill. This makes it
convenient to price beverages, for instance, at 1 dollar or
multiples thereof.
6 As quoted from "Hun Sen Denies Report on National Bank
Governor's Dismissal." 1995. Reaksmei Kampuchea (in Cambodian),
J une 28.