A final challenge of this exercise was its _timing_ . Looking for constraints in an environment of very rapid growth is challenging given the rapid changes and the likelihood that few constraints are actually binding (except if one believe the country could have been growing at 15 percent per annum). Added to that is the major shock introduced by the global economic crisis, which in many ways reshuffle the constraints. In both cases, nevertheless, the outcome seems to suggest that it was useful to take stock of constraints since some constraints were emerging despite rapid growth and since the exercise identified the vulnerabilities that the crisis made apparent.

37. To sum up:

- The financial sector was until mid 2008 unlikely to constrain growth immediately at an aggregate level;

- However, even then, it was constraining some types of investments that are important in some growth strategies; and

- It will become a constraint if domestic savings are not better mobilized in the medium term.

# **Costs of Factors**

38. **A recent appreciation of the Cambodian riel in real terms has increased all dollarbased costs of factors** . Based on a simple analysis<sup>13</sup> (comparing the level of prices to the level of development, Figure 11), Cambodia did not seem to present any major overvaluation.<sup>14</sup> If anything, there was in 2005 a small undervaluation, a feature which has been shown to be important for growth (Rodrik, 2008). Since then, good macroeconomic management and the appreciation of many currencies against the US dollar had led to a relative depreciation up until mid-2007. However, the sharp appreciation of the riel in real terms since then (driven by strong inflows of capital in 2007-08, on top of a steady stream of external assistance, together with a major terms-of-trade shock) has changed this. This appreciation, if sustained, is poised to become a major binding constraint on growth (and diversification as this is going to defeat Cambodia’s comparative advantage).

<!-- Start of picture text --> Figure 11: Some undervaluation in 2005 is likely to have morphed into overvaluation in 2008<br>a/ Undervaluation in 2005 b/ Trend in real effective exchange rate against main<br>120 competitors in garment sector (increase =<br>appreciation; base 100 = 2000)<br>100<br>115 0.3<br>80 110 0.25<br>105 0.2<br>60 100 0.15<br>95 0.1<br>40 90 0.05<br>85 0<br>20 Cambodia 80 -0.05<br>0 75 -0.1<br>- 5,000 10,000 15,000 20,000 25,000 30,000<br>GDP per capita (2005 PPP$)<br>Differential annual growth (*) Cambodia Average<br>Price (100 = US)<br>1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009<br><!-- End of picture text --> 13 See also IMF (2008).

14 Cambodia is largely a dollarized economy (see Im, Dabadie, and Sokha, 2007). The local currency – Cambodian Riels (CR) – in circulation represents only about 6 percent of GDP and is mainly used in the interior of the country and for small transactions. Over 90 percent of deposits (and loans) are denominated in dollars. The main exception is the public sector: riels must be used to pay taxes and other public sector bills and the public sector pays in riels. The dollar is also used as a store of value throughout the country. This feature implies that the fluctuations of the real exchange rate measured in riels have a diffused impact on the economy.

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