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Dual-currency economy of Cambodia: Just a Band-Aid?

In the last decade, several emerging economies experienced severe financial crises. This led to the acknowledgement of a need to revise exchange rate and monetary theory, taking into account more specifically the conditions under which these countries operate.

Topics such as dollarization, and balance sheet effects, have become central to the formulation and conduct of monetary policy and exchange rate regimes. In order to save the dying economies, transitions in the currency is a popular method. Cambodia is one of the low-income countries that have had a slow development path due to its historical record that also opted for dollarizing their economy to achieve output growth. The aim of this paper is to review the experience of dual-currency economy of Cambodia and analyze the main challenges faced by policymakers in formulating and conducting monetary policy. Cambodia, one of the richest countries in the 1960s, has now become one of the poorest countries in Asia. During the period of turbulence over 30 years prior to1998, wars, diseases and starvation killed multiple millions of Cambodians.

What is dollarization?
Dollarization can be defined as the holding significant share of assets, in the form of foreign currency-denominated assets. Usually, it is differentiated between official (or de jure), and unofficial (or de facto) dollarization. The former refers to the case in which foreign currency is given (typically exclusive) legal tender status. This implies that the foreign currency is used for purposes a currency may have, including as a unit of account for public contracts. De facto dollarization represents the situation of a foreign currency being used alongside the domestic currency as means of exchange (for transaction purposes) or as means of saving in hard currency (i.e., as asset substitution). A distinction is also made between domestic dollarization, in which financial contracts between domestic residents are made, and external dollarization, which covers financial contracts between residents and non-residents.

Cambodian Economic History

Current situation: Cambodia is a highly, but not fully dollarized economy: it is a multiple currency zone, where the Vietnamese dong (VND) coexists with the riel near the border with Vietnam, the Thai baht (THB) circulates in Western provinces, while the dollar of the United States (USD) commands the greatest share in domestic use.

Advantages of Dollarization

Dollarization has helped Cambodian economy grow due to several reasons; firstly, dollarization helped maintain the flow of money in the economy (which is one of the most important factors and determinant of the working economy). It helped the payment capacities in Cambodia as the riel; the locals, which had initially dried up the economy, did not use the local currency.

Secondly, dollarization stimulated growth as it encouraged savings. Introduction of dollar notes replaced the use of gold as means of transaction and storing of wealth. The use of gold was unproductive physical asset (why, because it cannot float in the economy). Hence, the use of dollar notes led to monetization, which in result caused the middle class to save money. Saving money leads to growth because a lot of infant industries borrow a lot of money (this money comes from savings) to boost the growth of their firms, which leads to business expansion, which leads to increase in employment and economic growth. Third of all, dollarization has protected Cambodia against contagion in the face of the Asian crisis (1997-2000). It sustained confidence of investors in their operations in Cambodia.

Lastly, dollarization actually helps stabilize the price levels. Stabilizing price levels. Since 1993, the balance of public finance has recorded a deficit of more than US$100 million. The Cambodian government has had to make up the deficit by foreign borrowings. If Cambodia were not a to solve the deficit problem instead of collecting more tax revenues or incurring all the difficulties of obtaining foreign loans.

Disadvantages of Dollarization

There are a lot of disadvantages of dollarization. The costs of dollarization include, seigniorage loss, loss of monetary policies, loss of foreign trade policies, and distortion of income distribution.

Firstly, the use of another currency translates to loss of some part of seigniorage, a profit made by government by issuing a currency, especially the difference between face value of coins and their production costs, as the use of another currency eliminates the printing of local currency in full scale. Whenever any economy grows, the volume of circulating currency also grows; however, due to dollarization, the amount of riel that can be printed and float around in the economy is restricted. For instance, the Cambodian economy grew by 6% in 2005; the volume of currency grew by 6% also. However, due to dollarization, instead of USD$ 53.2 million in riel, only US$12.2 million in riel was printed in 2005. Hence, USD$ 40 million of riel worth of seigniorage was lost. This hampers the implementation of monetary and fiscal policies (main macroeconomic policies used to stimulate the growth of an economy). This also prevents the execution of foreign economic policies through controlling exchange rates and the foreign exchange market. Hence, the use of foreign currency face huge losses in its economic and social independence.

Secondly, add that Cambodian government cannot implement this in Cambodia monetary policy cannot be implemented due to dual-currency status because outward and inward flow (in the economy) of USD is freely circulated. Hence, the Cambodian government cannot control the quantity of money through the use of monetary policy. In this way, dollarization in Cambodia prohibited the Cambodian government to support domestic industries with monetary policies. Dollarization hinders growth as monetary policies lead to stabilization of price level, (which eliminated inflation) and level of interest rates (which lead to savings). In Cambodia, the free circulation of USD causes the central bank of Cambodia to have uncontrolled supply of money in the economy. Uncontrolled money supply impedes economic growth as it the price level increases and results in inflation when the money supply increases faster than real output. Inflation retards growth primarily for 3 reasons because of a series a) it reduces the value of money. For instance; $100 in 1920 could have bought a lot of items, however, due to inflation, fewer items can be purchased by $100. High inflation reduces the incentive to save. (which has a negative effect on the economy. Reduced savings are bad), b) inflation destabilizes the economy as it becomes harder to make transactions due to fluctuations in prices and c) high inflation creates uncertainty which discourages firms from investing and can slower the rate of development.

Third of all, dollarization leads to increase in debt, which is not desirable (why, because of the trade balance). Dollarization leads to inflation, which leads to expansion of the economy, As a result; there is an increase of accumulated foreign debt.

Lastly, dollarization increases the disparity between the rich and the poor. There is a huge distortion between the rich and the poor in Cambodia because the rich receive their salary in US dollars and the poor in riel. Further, only a small proportion of the population fall under the high-income bracket. This (disparity) leads to high-income distribution because the exchange rate between US dollars and riel is 1 USD ($) = 10,000 riels. In such a case, the rich can afford a much higher quality of life and standard of living as compared to a middle class and lower class in Cambodia. Moreover, over the past years, the US dollar is appreciating which only worsens the situation because the value of riel decreases. For example; in 1995, the exchange rate between US dollars and riel was 1 USD ($) = 5000 riels and in 2013, 1 USD ($) is worth 10,000 riels. Hence, income of people earning in US dollars increased and the income of people earning in riel decreased. This phenomenon increases the disparity between the rich and the poor and creates more obstacles for the middle class and lower class to improve their quality of life and standard of living. In short, dollarization drives income disparities from bad to worse in Cambodia.

Miha Alam
Byrn Mawr College

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