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The Apparel Industry In Sri Lanka Economics Essay

The apparel industry in Sri Lanka rapidly developed in the mid 80’s after the implementation of the open economic policy. Industrialization was given first preference in order to move the economic structure from an agricultural base to an industrialized and service oriented structure by the government. As a result of this policy the apparel industry was given special preference and steps were taken to promote this industry amongst local and foreign industrialists.
The commencement of industrial development zones and export zones directly benefited investors and enabled them to easily set up their infrastructure needs. Apart from this, certain trade policies and agreements such as the multi-fiber policy, Indo – Sri Lanka Free Trade Agreement, the 200 Garment Factories Program and the recently offered GSP Concession etc. also directly influenced the boost in this sector.
Today as result of the above measures there are over 850 registered garment enterprises in Sri Lanka and there are over 1000 SME level garment enterprises that contribute towards the development of the local economy.
The present-day income generated from this industry exceeds over 42% (approx: $3 Billion) of the country’s export earnings (Refer appendix – 03. Export structure Breakdown) and, on average, contributes over 45% of industrial production and around 6% of the GDP, thereby converting itself to become the highest foreign income earner for Sri Lanka. It presently employs over 350,000 workers who account for around 15% of the country’s entire work force. Majority of these workers are females and therefore the industry plays a major role in women empowerment in Sri Lanka.
The Threat – Withdrawal of the GSP Scheme
Since early 2005 the local apparel industry has been facing various difficulties such as the withdrawal of the Multi Fiber Agreement in the year 2005, increased competition from low cost players such as China, Bangladesh, and India who are now more preferred as manufacturing destinations and the credit crunch which resulted in from the Global Economic Recession in the year 2008.
The GSP is a duty free export concession awarded to countries which fulfill the requirements set by the EU on good governance, compliance to international human rights conventions and labor standards.
On the 15th February 2010, the European Union (EU) decided to temporarily halt the GSP concession which was extended to Sri Lanka due to violations of the EU agreement and causing further difficulties for the local industry.
Necessity for Value Chain Improvements
The impact caused due to the withdrawal of the GSP concession towards the sustainability of the industry is high as it has led to an direct increase in the purchase price (due to the enforcement of duty and additional tax payments made upon exporting) and thus has made local garment exports much more expensive than other exporters to EU countries.
This situation has led towards the contraction of the industry and has also threatened the infant firms (SME) as they are unable to obtain orders from the EU market due to the uncompetitive prices offered as a result of the import duty imposed.
Due to the above issue, industrialists today are considering to withdraw from this sector as it is losing its attractiveness in terms of profitability, return on investment and due to various other macro factors such as lack of government support, tight economic conditions with high borrowing costs etc.
Therefore it is time that all relevant parties looked into this matter in order to rescue the industry by providing various facilities required and suitable for an industry vision for the future which is focused upon value chain improvements in terms of quality, lean costs, reduced lead time in production and sustainability.
Furthermore organizational restructuring in terms of technology, techniques and infrastructure will also have to be incorporated into the vision of the industry in order to stamp a presence in the global market.
Potential Publications
A case based on the above issue faced by the local apparel industry has been produced and would like to seek publication in the following industrial journals or magazines.
Sri Lanka Garments – A Journal Published by the Sri Lanka Apparel Export Association (SLEA) on an annual basis and has a reader base of over 4000 apparel industrialists and investors. The journal mainly features valuable insights of the apparel industry covering areas of the export market, industry issues, future developments and trends. The editorial policy of this journal mainly stresses on the fact that articles pertaining to the industry would only be published subject to a prior verification on the credibility of sources and facts used by the author.
LMD – Published by Media Service Pvt Ltd. Lanka Monthly Digest, a local business magazine published on a monthly basis and currently has a reader base of over 20000 corporate and individual clients within the island. This magazine mainly consists of articles which relate to the local business organizations, Colombo Stock market performances and also features special articles based on a particular theme.
Financial Times This is a Daily Business newspaper which is published by the Wijeya Newspaper Ltd and currently has a mass reader base covering over 28,000 households island-wide. This news paper mainly contains a comprehensive coverage of local and international business news.
Request for Publication
I personally believe that this article regarding the loss of the GSP Concession which I have forwarded for publishing would be a great value addition to your journal (Sri Lanka Garments) as this article explores a major issue which affects and threatens the industry. This article provides an alternate strategy on how the industry could recover from its current position as the country cannot afford to lose the revenue generated from this industry at a time when the economy is in a recession.
The following article features a significant issue which has emerged in our local apparel industry mainly due to political factors, and as a journal which analyses various issues regarding the apparel industry and the local market performance, this article would help market analysts to evaluate various issues pertaining to employment, trade condition, future demand and supply conditions etc in a more realistic manner which would enable them to explore the industry further.
Therefore, as a journal which is well known for its credibility, sound editorial policy and composition of a wide variety of articles pertaining to various apparel industry issues, I believe that my article merits publication as it addresses a significant threat relating to the industry in nature and needs to be communicated to all relevant stakeholders in the industry (Investors, Buyers, Government etc).
Word Count: 1067 words
The GSP Trade Concession
The GSP, also know as the Generalized Preference System is a special trade arrangement granted by the European Union (EU) where they are involved in providing special access to the EU market in forms of reduced tariffs and taxes.
The Generalized Preference System (GSP) is mainly provided to 176 developing nations for a period of three years and is an incentive that is granted with the objective of reducing poverty, providing sustainable development and to promote good governance. The total value of imports under the GSP amounts to around €58.6 Billion and the nominal duty loss is estimated at over €2.5 Billion as of year 2008.
Apparel and textiles, machinery items, minerals and gems, plastic and rubber items, footwear are the leading segments of imports which use the GSP scheme. (Refer appendix – 04. GSP preferential imports composition – 2007)
The GSP is provided to nations in three main forms,
Standard GSP: a general system which covers 6,244 products and provides a standard preferential treatment which is given in form of reduced duty tariffs that is provided to all 176 nations.
GSP : this trade preference is provided to vulnerable nations which ratify and implement international conventions relating to human rights, labor standards, sustainable development and good governance. This preference is currently provided to 16 nations (refer appendix – 01. Countries covered under the GSP Scheme) including Sri Lanka and provides concessions to around 6,336 products in terms of duty free coverage and reduced tariffs in specified taxes.
Everything But Arms (EBA): is a special quota and duty free concession provided to 7140 products except for arms and related items for the 48 least-developed nations.
Situation of Sri Lanka Sri Lanka (SL) is amongst those 176 countries which receive the standard GSP. However, in the year 2005, the EU decided to consider SL as a “vulnerable state” based on its criterion and awarded the GSP scheme (refer Appendix – 02.Vulnerable nations) as SL’s export portfolio was limited in terms of diversification (refer appendix – 03. Export structure breakdown) and due to increasing levels of poverty which was further aggravated by the 2004 Tsunami and the 30 year long civil war. This trade concession further expanded business opportunities available, especially in the apparel sector within the EU region. SL managed to grasp them using the GSP scheme and thereby turn into one of the top 5 beneficiaries of the GSP scheme.
In the beginning of the year 2008, the intensity of the civil war began to increase and the country geared itself up with an aim to bring this conflict to an end. This move made by the government caused significant uproar within the international community and many allegations were leveled at the SL government accusing them on violations of the following treaties listed under the ratification list of the GSP scheme. (Refer Appendix – 02.Vulnerable nations)
International Covenant on Civil and Political Rights (ICCPR)
Conventions Against Torture (CAT)
Convention on the Rights of the Child (CRC)
These issues prompted the EU to appoint a special committee in October 2008 to investigate the level of compliance and ratification of human rights as it is a key obligation which needs to be fulfilled in order to receive the GSP concession. According to the committee’s report, three major violations of human rights was identified in terms of civil and political rights, torture and child protection.
Even though the SL government blatantly denies these allegations based on the reported findings, the EU Regulation council decided on the19th October 2009 to temporarily withdraw the GSP concession for a period of 6 months in order to rectify these issues.
The suspension of GSP Preference has directly caused a dent in political ties and international relations especially between United Kingdom and the other EU nations and the impact of this issue has extended itself into bilateral trade relationships between these nations and SL. As a result, the apparel segment, the footwear exports industry and agricultural exports have directly been affected.
The Loss of GSP : Impact on the Apparel Sector
Industry nature The apparel sector in SL constitutes around 1850 large, small and medium enterprises (SME) and currently employees over 350,000 people directly and over 250,000 indirect workers in terms of support services. The industry in SL has positioned itself as a core manufacturer and middle man in terms of value addition because the industry has specialized itself in carrying out manufacturing of the garment, whereas the buyer has to get the designs, fabric and all other input separately done. At present around 85% of the industry are in the export market business and the US, EU, Australia and Canada are some of the main clients of the industry.
The apparel industry attractiveness at the moment is on a declining phase due to increased competition, increased costs of raw materials, reduced government backing etc (refer – Appendix 6. Industry Analysis). This situation has been further aggravated by the removal of the GSP preference scheme due to various external factors explained above.
Impact Currently around 50% of the apparel export is purchased directly by the EU and SL at present holds around 1.6% of market share of the total EU market. China dominates the market with over 46% of share and is followed by Bangladesh which holds around 13% of the EU market (Refer – Appendix No 7.EU Market share analysis). Therefore, due to the suspension of the GSP preference scheme, the local apparel industry is directly faced with a threat of losing its market share to other competitors in the EU market.
“If GSP were to go away, it is this excellent and compliant industry that will be hurt very badly. The effects would see the rural economy facing hardships and women employment and empowerment would greatly be damaged” – Mr. Kumar Mirchandani. President – SL Apparel Exporters Association.
The re-imposition of the trade tariffs would directly make the SL manufacturers apparels more expensive to the EU market and thus would directly place the SL apparels at a competitive disadvantage. At present, SL is the highest priced EU apparel exporter (refer Appendix – 5.Average Prices of garment imports to the EU) and due to this situation apparel exports to EU within the 1st Quarter of this year has declined by 18% and thus paving the way for global competitors such as China, Bangladesh, Vietnam who are well known for their lower priced apparels with an opportunity to directly benefit through this situation.
The limited diversity of the SL apparel exports in terms of markets have also contributed adversely to this situation. At present the revenue generated from this industry is estimated around $3.4Bn and 90% of this turnover is generated through the US (44%) and EU (46%) markets. Thus an increase in prices within the EU would be an extreme sensitive issue as it would directly contribute towards a decline in turnover levels and thus result in a loss of market share.
Furthermore when considering the necessity to increase prices, SL manufacturers pose little or no power in terms of bargaining mainly due to the market structure which dominated by strong competition. (Refer – Appendix 6. Industry Analysis)
Therefore, the withdrawal of GSP alongside the other industry problems such as increased labor costs and regulations, energy costs, reduced government facilitation and increased financing costs have made this industry a difficult one to operate in with many uncertainties which need to be addressed promptly.
Value Chain Improvements
Since a price increase would be detrimental to this sector, most of the SL apparel manufacturers will have to face the GSP challenge through considering options on internalizing the increase in tariffs with specific changes to their value chain through cost and margin improvements.
Special emphasis needs to be placed on the SME segment because in an industry where SME constitute the majority, it is imperative to ensure the sustainability of these firms as they are directly connected to the rural economy of SL and are also key players in empowering women. SMEs also play a vital role in the industry by providing various support services for large firms and thus indirectly ensuring their sustainability.
However it is this segment that faces most of the adverse consequence since their ability to manage change is limited.
In order to overcome this situation, all firms should focus more on their primary functions specially relating to manufacturing and logistics segments which could be vastly improved using technological innovations and infrastructure support. Investments in these areas would enable firms to increase their margins as they will be able to benefit from economies of scale, increased efficiency and reduced overhead costs.
Ex: Adopting the usage of a Computer Aided Design (CAD) system in the process of cutting fabric. Remove capacity bottlenecks by investing on latest machinery and equipment.
Larger firms would view this option more feasible due to their strong financial background where as the SME sector will face difficulties in coping up with this move due to financial constraints.
MAS Intimates – the leading apparel exporter in SL opened its first custom built ECO – Factory for Lingerie manufacturing in the year 2009.
Hirdarmani Group (SL) investment in state of the art garment engineering technology.
Additionally, firms should also attempt to stream line their value chain by enhancing value adding activities such as improved quality levels, lead times etc. and also by focusing on removing and reducing non value adding activities such as raw material wastage, idle labour and machine hours, rejects and reworks etc.
The implementation of basic 5 S principals, Continuous improvement techniques (KAIZEN), standardization and total quality management principals would directly enable firms to benefit from increase yield, productivity and a lean cost structures which would directly facilitate improved margins.
The 2nd option mentioned above would be more encouraging to the SME segment because unlike the earlier option the financial resource requirement is far more less and it is also more convenient for SME owners to implement and monitor.
Furthermore, firms should invest on employees by providing them with adequate training and development in order to enhance their skills and learning rather than considering lay-offs. This would enhance employees performance and motivation levels and would also enable firms to develop a strategic asset which would deliver long term sustainable margin improvements.
Changes in Marketing Professional’s role
“Sri Lanka is at the point of a great resurgence and the UK acknowledges that there is great potential in the region as well. This means that marketers have stronger challenges here than elsewhere in the world. In order to capitalize on the opportunities that are emerging from other countries in the region, marketers in SL have to develop themselves” Mrs. Janet Ford. Head – British High Commission Trade and Investment.
Marketing at its basic level is essential to driving revenue, pushing the bottom line and satisfying customer needs and as marketing professionals in the apparel segment, it is important for us to move out from our comfort zones and engage in this new paradigm of business which is constantly facing change.
In order to ensure this transformation, the real essence of marketing should be practiced at its highest level in line with organizational objectives and customer needs thus requiring marketers to be more proactive in the industry.
Hence, marketers should take the initiative and develop a difference by promoting their corporate identities within the segments they operate in (especially in the export market) because this would enable firms to develop equity in their organizations and would also help increase their bargaining power.
Marketers should also persuade and negotiate specific deals which incorporate new ventures, partnerships that would enable the firms in the industry to sustain and mutually benefit themselves in the long term (Ex: MAS Intimates partnering with NIKE, Victoria’s Secret, Speedo and GAP). Strong communication and negotiation skill would be vital for a marketer when convincing partners with a business case and negotiating deals.
Additionally, marketers should also take the initiative and act in the capacity of a change agent by introducing new trends, technological advancements and improved production techniques into the business in order to develop a competitive advantage to successfully maneuver this function, a marketer would require strong leadership and change management skills in order to convince and incorporate these innovations.
Furthermore in terms of skills, a marketer also needs to possess sound finance, commercial and technical knowledge to enable him/her to develop a better judgment in decision making and also to justify his/ her case when interacting with customer, cross functional teams and various other stakeholder queries.
It is also important that a marketing professional in the SME sector ensure that they change their organizational scope from a traditional sales/product oriented organization into a marketing oriented organization which would ensure the development of a separate marketing function that will enable the organization to actively participate in promoting their products and identities.
Therefore, these behavioral changes and improvements in skills would enable marketers in this field to broaden their thinking and enable them to face and adapt to any environmental challenges successfully.
The Way Forward
It must be noted that trade concessions in nature are more focused upon the short term development of the industry. Firms cannot depend on them forever and they need to strategically utilize them to build up resources while they are available to develop and establish themselves in the market.
Therefore, instead of depending on trade concessions such as GSP to battle out competition the industry needs to focus on continuous improvements in terms of production, quality, technology etc. to outrun other players compelling the marketers in the industry to take the lead role in actively participating and introducing new trends, technology and developing partnerships with leading brands in order to ensure the sustainability of the industry.
Word Count: 2200 Words Appendix
1. Countries covered under the GSP Scheme Armenia
Costa Rica
El – Salvador
Sri Lanka
The above countries are covered for a period of three years (2009 -2011).
Presently Sri Lanka and El – Salvador have been temporarily withdrawn from the GSP beneficiary list due on going investigations pertaining to human rights violations.
2. Vulnerable Nations In order to be classified as a vulnerable nation the following criteria needs to be satisfied.
Any country should not be classified as a “high-income or developed nation” and where its 5 largest section of its GSP covered imports are more than 75% of its total GSP covered imports, and
Where its GSP covered imports are less than 1% of the total GSP covered imports.
Ratification and effective implementation of
16 core human and labor rights and 11 environment and good governance conventions.
(Ex: International covenant on Civil and political rights, forced compulsory labor convention, Kyoto Protocol, Mexico Conventions against corruption etc.)
Sri Lankan situation based on this classification
3. Export structure breakdown 4. GSP preferential imports composition – 2007 Note: It is clear that over €13Bn (22%) of apparel imports to the EU in the 2007 is done under the GSP preference Scheme.
5. Average Prices of garment imports to the EU Note: Even before the withdrawal of the GSP Preference scheme the SL export price per Kg of apparel was the highest at €15.91 amidst other competitors.
6. Industry analysis The attractiveness of apparel industry can be analyzed as follows using the 5 forces frame work which was developed by Michael Porter in the year 1979.
Barriers to entry – Low At present there is no significant barrier to entry. Any investor willing to enter the market could do so. The Export zones and the industrial zones which are established around the county can be considered as added incentives for new entries into the market.
Competition – High Competition levels can be evaluated in two aspects.
Local – competition within the industry is at a higher level as there are vast number of players (1850 garments) involved in this industry to cater towards the export market.
International – Competition levels on a global scale is also at a higher level and is mainly dominated by low cost manufacturing nations such as China, Bangladesh, India, Vietnam etc.
Bargaining power of customers – High Customers do have the privilege of demanding a better bargain out a deal due to the vast availability of many other suppliers in the market.
Ex- If a SL manufacturer proposes for a price increase the customer could easily refuse it and place the order with another supplier (locally or internationally).
Bargaining Power of suppliers – Medium Most of the input within the industry is imported and in most occasions it is only the labor component which is sourced from the local market.
7. EU Apparel Market share Analysis Sri Lanka at present holds around 1.6% of the EU market which is clearly dominated by the Chinese and Bangladeshis who holds cumulative share of 62%.

The Dollarization of World Trade and Its Impact on Cambodian Economy

Introduction IRP is an essential part of IS 305 Global Governance course. With its aim to address each student’s understanding a particular issue of global governance in relevant to Cambodian current affair and its important place in the course’s assessment, I have paid tremendous amount of time working on each MC as well as the final MC.
Among all the topics suggested, I have chosen the 6th topic:”The Dollarization of World Trade and Its Impact on Cambodian Economy” This particular topic is related to economic as a course theme of global governance. Apparently, economic is an interesting and vital theme which is getting more and more recognition in global governance. Global governance is a complex interplay among many themes whose one of which is economic.
On top of this, I have chosen the above topic as my IRP topic for two main reasons. First of all, this topic is personally appealing to me. I have seen other neighboring country with stronger economy using their national currency so widely. In contrast, in Cambodia US currency is more preferably accepted throughout the whole country. This is actually only a short part of the story since dollarization started to spread worldwide after WWII ended. I want to find out more about the causes and effects of this phenomenon on the small economy of Cambodia. I am also keen to find out about the struggle of local government and other IGOs to govern the very impact of dollarization. Last but not least, this topic allows me to demonstrate the intersection of global governance with the US as one of the most powerful players in international arena as well as the role of IGOs, pattern of trade globalization and global governance, and indeed the response of Cambodian government on regulating the impact of dollarization on Cambodian economy.
I have divided my IRP into five main parts in which each aims to address different aspect of “dollarization phenomenon”.
Part I: Causes and Growth of Dollarization of World Trade International recognition of a foreign currency in world trade is not a brand new phenomenon. During the eighteenth and nineteenth centuries, the pound of Great Britain reigned as the first reserve currency in the world,but in the twentieth century, the U.S. dollar laid claim to this title. It has since been the dominant reserve currency since the end of World War II.
Definition of Dollarization To fully understand the impact of dollarization on Cambodian economy, the initial step is to define what dollarization is. Most simply put, Dollarization means adopting the US dollar as the currency of choice in a foreign country [1] . However, dollarization’s definition does not end here. Dollarization is a generic term that can fall into three categories:
Official Dollarization: The dollar is the only legal tender. In other words, there is no other local currency. Examples are that in Panama, El Salvador and Ecuador. For example, since independence in 1903, Panama has only used the U.S. dollar.
Semi-Dollarization: A country will use both its own currency and the U.S. dollar interchangeably as legal tender. Lebanon and Cambodia are good examples of this.
Unofficial Dollarization: For many countries in the developing world, the dollar will be widely used and accepted in private transactions, but it is not classified as legal tender by the country’s government. [2]
Official dollarization occurs mostly in small or developing countries. Countries that normally adopt such a radical change in monetary policy are often encountering instable economies, high levels of inflation and a very low competitive currency. Under official dollarization the local currency is completely replaced by the dollar, with the possible exception of coinage. That means domestic banks only accept dollar checking accounts and issue dollar loans. Federal Reserve notes are legal tender and the only form of paper money recognized by the government.
In the case of Semi-dollarization, as in Latin America and in the former Soviet Union, where the purchasing power of the local currency has been volatile and people put more confidence on foreign currency, people often hold dollars as a store of value. In those cases the domestic currency is commonly used in small transactions, but the dollar is preferred in large transactions and in savings.
It should be noticed that although many people associate dollarization with the U.S. dollar, the association is not exclusive. Dollarization may increasingly refer to conversion to other currencies such as the Euro. Besides, South African rand, Russian ruble, New Zealand dollar and Australian dollar are also accepted outside their countries, although in a localized nature. For example, the Russian ruble is accepted in a number of the countries from the old Soviet Union. Thus dollarization may not solely refer to US Dollar. Despite this, in this MC as well as IRP, I will exclusively talk about US Dollar to link it with the reality of
dollarization in Cambodia. Dollarization, in this sense, is different from monetary union because the US continues to set monetary policy in its own interest alone, whereas the European Central Bank is required to take all Eurozone countries’ interests into account.
Origin of Dollarization in World Trade The origin of dollarization rooted back to the Bretton Woods Agreement. In the aftermath of World War II, US dollar was the only major currency in which international exchange could freely take place thanks to its relatively stable value while all other European’s big economies were shattered due to the war. The dollar’s role was formalized under the 1944 Bretton Woods monetary agreement, an international agreement to govern monetary policy among nations. Other nations set official exchange rates against the dollar, while the US agreed to exchange dollars for gold at a fixed price on demand by central banks. It was a chance to create a stabilizing international currency and ensure monetary stability once and for all. The Bretton Woods Agreement also had the purpose of rebuilding after World War II through a series of currency stabilization programs and infrastructure loans to war-ravaged nations. By 1946, the system was in full operation through the newly established International Bank for Reconstruction and Development (IBRD, the World Bank) and the International Monetary Fund (IMF).
It is also important to note that the United States owned 80 percent of the world’s gold reserves at the time. So the United States had every motive to agree to the use of the gold standard to organize world currencies and to create and encourage free trade.
This system functioned well for a brief period. However by about 1958 the initial worldwide dollar shortage had turned into an overabundance. As only gold and the U.S. asset were considered seriously as reserves, when gold production was lagging, dollar reserves had to expand to make up the difference in lagging gold availability, causing a growing U.S. current account deficit. The Bretton Woods agreement collapsed in 1973.
As it is seen, the actual outcome of the Bretton Woods Agreement was to replace the gold standard with the dollar standard, and this is the origin of dollarization in the world.
Growth of Dollarization Following the origin of dollarization, it is important to take a closer look at how dollar grew and the reasons behind it.
After World War II ended, the US ran large current account surpluses as the war did not fight on its land. As the biggest economies in the world, the US also aimed to have the strongest ideological power, democracy. During Cold War period, in order to deter communism in Western Europe, the US initiated the plan famously known as the Marshall Plan. Through this, American financial aid is offered for a program of European economic recovery. During its three years of existence, 1947-1951, the US spent almost $12,500,000,000. The result of this was a buildup of dollar assets by foreign firms and central banks.
Another reason behind the growth of dollarization is that the rapid growth of the industrialized economies after World War II created a growing demand for dollar balances around the world. The more of its own currency a central bank issued, the more dollars it wanted as underpinning for its currency. [3]
Besides these former reasons, US dollar possesses some outstanding characteristics that made it the currency of choice. Stability is one of the major factors that explains why a number of countries have adopted the U.S. dollar as official currency. With American both economic and military might, the U.S. dollar has never been devalued nor invalidated. This characteristic of dollar makes countries with uncertain financial circumstance all familiar with bank failures, devaluation and inflation, has a peace in mind by adopting and enjoying the benefits of the stability of the U.S. dollar.
As it is noted, similar to official dollarization, unofficial dollarization is also very hard to reverse once it is in place. As unofficial dollarization also takes root in countries with unstable and weak economy, only certain policies and remarkable national economic growth will reverse the trend, and this does not happen very often.
Dollarization Today As of nowadays, dollarization is clearly seen. As of the start of 2000, 28 countries and territories have officially dollarized, and countries with unofficial dollarization are numerous. Over half of all dollar notes in circulation are held outside the borders of the US. About half of US Treasury securities are owned by foreigners, mainly held as reserves by foreign central banks. The dollar is the main currency in international capital flows, as well as the currency of invoice for commodities and for many manufactured goods and services. All countries that trade directly with the US invoice both imports and exports in US dollars.
Part II: History of Dollarization in Cambodia This part is going to discuss the main reasons why Cambodian economy is dollarized by providing evidences as well as my own analysis. It will also about the present situation of semi-dollarization in Cambodia. This part crucially contributes to the Individual Reflection Paper since an understanding of the causes as well as the situation of Cambodian dollarized economy is essential to analyzing the responses to this phenomenon.
How Dollarization Took Root in Cambodia Dollarization in Cambodia occurs primarily to several main reasons. I arrange each cause according to their formality.
Firstly, Cambodian people have lost a big trust on local currency, Riel, after it was completely abolished during the Pol Pot regime. Cambodian people have bitterly seen all the savings they had in Riel become just scraps of paper in one day. Virtually, Cambodia is the only country in the world ever to have abolished money. This radical experiment, which left Cambodia being without a currency from 1975 to 1980, has left its mark on Cambodian people perception today. In March1980 Riel was once again introduced as the national currency in Cambodia. However, massive central bank financing of recurrent budget deficits during 1988-1991 led to high inflation in the range of 90%-177% a year. [4] This further eroded public confidence in the national currency. As a result, although the reissued Cambodian riel has been in circulation for three decades, Cambodians remain distrustful of it and regularly convert their riel into gold, jewelry, or U.S. dollars instead.
The second reason links to the peacekeeping operation performed by the United Nations from 1991-1993. During this period, millions of Dollar were poured into Cambodia each year. With tremendous amount of Dollar in circulation and a big number of Cambodians started using Dollar, Cambodia’s economy became effectively dollarized. Simultaneously, since most public still tried to protect their own assets, they sold their riel-denominated assets in exchange for gold in the first phase and for the dollar in the second phase. They got stuck with dollars afterward. [5]
Thirdly, the reason may lie on the nature of Riel itself. Riel, compared to dollar, is less convenient to use for large transactions. Ten US dollar bill already equal in at least four ten-thousand Riel bills. The government gradually has introduced larger denominations, but these bills have not come into common usage. On top of that, since the introduction of Riel in 1980, Riel has seen continuous depreciation which subsides Cambodian citizens’ willingness to store it as an asset. From the first time Riel was reintroduced in 1980 until now, value of Riel has gone down for 1000%. [6]
Last but not least, dollarization in Cambodian may link to Cambodian people perception. Majority of Cambodian views Dollar as the demonstration of wealth and sophistication which leads to certainly high Dollar usage in urban area. A simple example can be seen. High class restaurants and boutiques in Phnom Penh all have their price labeled in dollar whereas smaller shops still have some tendency to use Riel. As much, in sophisticated workplace, Dollar is used instead of Riel, and as people becomes richer, they will automatically convert the use of Riel to that of Dollar, thus continuing the Dollarization trend.
Current Situation of Dollarization in Cambodian Economy Although Cambodia is still a country with semi-Dollarization, Dollar is widely used throughout whole Cambodia, and the percentage of Dollar usage is incredibly high in urban area.
In 1998, the National Bank of Cambodia, or Central Bank, conceded that it was unable to account for the volume of foreign currency in circulation. Bank officials believed that it exceeded their official ¬gures, and they estimated that the U.S. dollar was probably three to four times more liquid than the riel. [7] 8
The subsequent years have seen the growth in banking sector in Cambodia, and the habit banking deposit and lending has substantially increased. In 2005, bank deposits grew by about 16% with the upward trend continuing into 2006, reflecting improved confidence in the banking system. Despite this positive sign, the share of the riel in these areas has been as low as 4% and 6% respectively [9] , indicating the highly dollarized nature of Cambodia’s economy. In other words, the percentage of Riel deposits has grown by merely 2% from 1990 until 2004. [10]
Although Cambodian authorities want to encourage greater use of the national currency, they have emphasized that they have no intention of imposing restrictions on the use of foreign currency. They on the other hand believe the use of the riel will develop as an outcome of economic development. Nowadays, the exchange rate system consisted of two rates: the official rate and the parallel market rate.
Part 3: Costs and Benefits of Dollarization in Cambodia The high degree of dollarization in Cambodia has played a major role in shaping Cambodian’s economy. It brings about many advantages to the small Cambodian economy which just started from the zero-point thirty years ago and whose aim is to be integrated in to regional or even global economy. However, along with benefits, high dollarization also poses a challenge to Cambodian economy. This paper will briefly present these whole issues.
Costs of Dollarization to Cambodian Economy There are certain costs caused by high dollarization in Cambodia. First and most apparently, high dollarization makes it hard for government to conduct fully effective monetary policies. With any policies government makes, high degree of dollar holding in Cambodia will hinder the policies to be fully implemented and thus undermine its effectiveness. These policies include the management of money supply, interest rates, and to some extent the exchange rates. Due to high dollar deposit in banks, the role of National Bank of Cambodia (NBC) as lender of last resort for banks facing liquidity problems is also greatly constrained. The high degree of dollarization limits the flexibility of exchange rate policy to deal with external shocks. For instance, the increase in world oil prices in 2005 was followed by inflation in Cambodia. The inflation rate rose between 9% and 10% in just a few months.
Secondly, government’s income from seigniorage is reduced. Seigniorage, simply put, is the difference between the value of money and the cost to produce it – in other words, the economic cost of producing a currency within a given economy or country. [11] The amount of loss is quite significant as the net annual income forgone is estimated to be in the range of $20 million to $90 million. [12]
Another cost is that dollarization may lead to currency mismatches. This happens to firms or business whose income is in Riel. As a high amount of deposit in Cambodia is in dollar, these firms and businesses may have to take on dollar-denominated debt because that is the only way to receive longer-term loan. In this sense, in the event of a large devaluation of Riel, such firms and businesses may find themselves at great lost and are unable to service their debt. Although this problem occurs only to small number of firms, this is also a challenge of dollarization.
The last disadvantage of high dollarization deals with the real role of Riel. Under such circumstance, Riel may only stand as a symbol of sovereignty and national identity and does not play a full role in the economy. This is not a good idea since the symbol of national identity is not sufficient for a national currency.
Benefits of Dollarization to Cambodian Economy Despite above costs, dollarization also brings about remarkable advantages to Cambodian economy. First of all, the introduction of dollar during UNTAC operation in 1990s has helped Cambodian people to convert their assets from gold to dollar and consequently made money deposit in banks easier and as incentive to place savings abroad was eliminated, this encouraged domestic financial intermediation to flourish which resulted in the growth of the financial system.
Secondly, dollarization lowers the risk of Riel devaluation. Because of high degree of dollar circulated in Cambodian economy, the demand for Riel remained low. With this low demand, the NBC will not unnecessarily print more amount of Riel. Very high dollarization in Cambodia is therefore resulted in low inflation and economic stability.
Thirdly, dollarization makes Cambodian economy more stabilized. The diminished risk encourages both local and foreign investors to invest money into Cambodia. Currency stability promotes macroeconomic stability and a predictable business environment. Evidently, high degree of dollarization protected Cambodia against contagion in the face of the Asian financial crisis of 1997-1998.
Last but not least, the use of the dollar facilitated the integration process of Cambodia’s trade in the international economy. It reduced the transaction costs by omitting currency conversions cost. Besides, it also enabled the boom in the garment industry in Cambodia. [13]
Part 4: Role of Cambodian Government and International Actors on Reducing the Impact of Dollarization Having been exposed to the costs and benefits of high dollarization, it is essential to take a further step to find out what the stance of Cambodian government is and what it has done so far to make the best out of this situation. Accompanied this, the role of other international actors regarding dollarization’s impact issue will also be discussed and presented.
Cambodian Government’s Policies To begin, it is important to understand that in Cambodia, the decision maker regarding monetary policy is the National Bank of Cambodia (NBC). NBC is autonomous from the government and government cannot interfere with NBC’s monetary policy decision. However, to make it simplified, I will merely use the word “Cambodian government” along with “NBC” in terms of monetary policy’s decision maker.
So far, NBC has taken advantage of dollarization in Cambodian economy to stabilize inflation rate and obtain a favorable exchange rate. As government-backed securities such as treasury bills and government bonds do not exist in Cambodia, dollar serves as an alternative for the Open-Money Operation (OMO), one of the conducts of monetary policy to control money supply and thus inflation rate. To illustrate, OMOs are defined by National Bank of Cambodia (NBC) as operations to purchase or sell dollars against the riel with the objective to stabilize the fluctuation of the exchange rate between the two currencies. [14] With dollar, NBC can manipulate the inflation rate to a desirable level and thus achieve price stability. History has shown that dollar auction has been an effective tool to adjust the exchange rate. [15]
Although dollar plays an important role in OMO in Cambodia, the ultimate goal of Cambodian government is still to increase the role of riel in economy and make it more than a mere sign of sovereignty. Various steps have been taken by the NBC regarding de-dollarization measure. [16] Most importantly, for macroeconomic policies, NBC aims on maintaining the stability of exchange rate and low inflation rate, while concerning legal reforms, NBC has set a fixed amount of riel as reserve requirement ratio for banks. However, these steps have been insignificant and so have been the result. This is probably because of
the current situation of Cambodian economy, whereas we will discuss this issue more deeply in the next part.
Role of Other International Actors In currency affairs, the need for more cooperation is urgently pronounced since apparently harsh decision of one state’s monetary policy can draw varieties of external effects that go beyond the host state’s territory, and for which a unilateral response is not desirable. Contrastingly, even with call on more cooperation in international monetary policy among great powers, monetary policy still rests primarily on individual state to decide.
On the national level, regarding dollarization issue, it is apparent the US Federal Reserve has not taken into account those countries that are officially dollarized, not to mention unofficially dollarized countries like Cambodia. The Fed has stated that it would never act as a lender of last resort to foreign banks, nor would its monetary policy be contrary to the best interests of the US. Thus, dollarized countries have to bear their own cost and find appropriate policies to deal with it. So far, US Fed has taken a neutral position, neither encouraging nor discouraging dollarization.
On the international level, there has been more sign of interest for cooperation. However, even with more cooperation, it still stresses only on major currency such as dollar, euro and yuen, whereas economy for small states like Cambodia is ignored. Thus, main decision still rest with Cambodian government on how to steer for a blessing environment for its currency. Despite this fact, we should all be aware that, desirable or not, any decision made by the US Fed to appreciate or depreciate its currency will make the effect be felt in Cambodia who is highly dollarized.
Part 5: Future Response of Cambodian Government: Dollarize or De-Dollarize High dollarization in Cambodia has blessed the economy with stability and growth. However, even with increased economic and political stability, dollarization has been persistent which is not a good sign for a healthy economy with its national currency. The National Bank of Cambodia has taken measures to eventually de-dollarize and improve its power over monetary policy, but the realization of this goal is still a long way to go.
Why Cambodia Should Remain Dollarized and Why Cambodia Should De-Dollarize As expressed in the previous part, high dollarization has brought about significant advantages to Cambodian economy. Dollarization, for instance, helps maintain low inflation rate, and as a result also stable exchange rate. The Open-Money Operation (OMO), one of the conducts of monetary policy, strictly speaking, do not exist in Cambodia due to a lack of government-backed securities such as treasury bills and government bonds. However, OMOs are defined by National Bank of Cambodia (NBC) as operations to purchase or sell dollars against the riel with the objective to stabilize the fluctuation of the exchange rate between the two currencies. [17] With dollar, NBC can adjust the inflation rate to a desirable level and thus achieve price stability. Since 2005, only NBC has the legal rights to conduct the dollar auctions, and history has shown that dollar auction is really an effective tool to adjust the exchange rate. Besides, dollarization also assists the integration of small Cambodian economy with the rest of the world by reducing transaction costs for purchasing international currency.
Despite the above factors, it is still convincing for Cambodia to de-dollarize because of some reasons. Most apparently is that NBC cannot manipulate the flexibility of its monetary policy due to high level of dollar circulation in the economy. As illustrated in 2005, inflation rose between 9% to 10% in just a few months due to the rapid increase in the world oil price. Also, any slight change with US monetary policy can have effect on Cambodian economy as well. Besides, high dollarization also limits Cambodia’s effort to maintain a currency value favorable for export since dollarization hinders price-wage flexibility. Last and most importantly, de-dollarization is a sign of growing and healthy economy. For Cambodia to keep depending on foreign currency is not a favorable choice to make. Mainly, de-dollarization will bring about a meaningful national currency as well as a powerful and effective monetary policy tool to influence the national economy.
Possible Solutions Besides what Cambodian government has done so far, there are some recommended policies that could be done to strengthen the de-dollarization process. Firstly, the NBC will start refinancing banks with Riel only for operations conducted in Riel. This is a dramatic move. Secondly, NBC will have to make operations in Riel more attracting compared to dollar in the banking system. This include, for example, making the interest rate of Riel-denominated deposits much higher than that of the dollar. Another way is to develop a new financial instruments denominated in Riel such as treasury bills, and these bills have to offer higher yields for the compensation for exchange rate risks. Last but not least, there has also been encouragement for Cambodia to adopt a Currency Board Arrangement (CBA). Creating CBA means to peg the national currency to another currency. If so, NBC can only issue a certain amount of Riel that is fully backed by foreign assets at fixed exchange rate, which in the case of Cambodia would be naturally dollar. By adopting a fixed exchange rate, a successful CBA would allow Cambodia to de-dollarize as well as to maintain continued economic stability for economic growth. However, Cambodia would need substantial foreign reserves in order to sustain the amount of money in circulation.
Remaining Challenges Among all the envisaged solutions, there is still left with one remarkable challenge Cambodia must overcome to make the above policies effective. This challenge is that the NBC has to ensure exchange rate stability and macroeconomic stability so that private sectors will gain confidence that it will not be penalized for holding riel-denominated assets. Ensuring exchange rate stability and macroeconomic stability requires time, effective effort as well as continuing healthy economy, thus the success of de-dollarization is still in the far future to come for Cambodia. As shown nowadays, interest rate for Riel-denominated deposits is already higher than that of the Dollar, but public opinion still place their confidence in Dollar and the ratio of Dollar-denominated deposits is still higher than that of Riel. [18]
In conclusion, Cambodia should de-dollarize its economy, just like what a country with a healthy economy would do. However, given the unresolved challenges, the de-dollarization of Cambodian economy is still a long-term goal. These challenges may increase as Cambodia gets exposed to more capital flows from FDI in dollar which makes it even more difficult for the NBC to achieve its ultimate goal. On top of renewed investment, more tourism receipts, the launching of financial market and increased lending in dollar can all contribute to more dollar circulation.