Foreign investor activity in the Kingdom of Cambodia is on the rise. Last year, the country notched up $2.32bn in new FDI inflow pledges; up substantially from $684m in 2005 and less than $150m in 2004.

This is a promising development for a country in which a third of the 15 million population live in poverty, and the rise in FDI reflects some tangible progress made in the field of regulatory reform. As David King, executive director at DFDL Mekong, notes: “Cambodia has one of the most liberal investment laws in the region, which allows foreign investment, without restriction or limitation, in most sectors of the economy.”

As always, the challenge will be in sustaining those FDI inflows and seeking to ensure they help to catalyse the wider economy. Efforts in this regard will not be helped by the relatively weak institutional base, substantial levels of corruption, and a regulatory environment that is very much a work in progress. However, according to Mr King: “The legal and regulatory infrastructure is improving all the time, which may be one reason why more serious foreign investors are eyeing, and investing in, Cambodia.”

Narrow economic base

To date, FDI activity in Cambodia has tended to reflect the narrow economic base of the country. A large proportion of foreign investment has been focused on either garment manufacture or tourism. With no domestic textile industry to support it, virtually all of the inputs needed for garment production have to be imported. Nonetheless, the industry – which is dominated by foreign firms – accounts for about 80% of the country’s total exports, generating about $2.5bn in foreign exchange earnings in 2006.

Numerous foreign garment manufacturers established operations in Cambodia in the latter half of the 1990s, largely to benefit from the relatively generous quotas allocated to the country under the Multi-Fibre Agreement (MFA) in 1996. But with the introduction of the Agreement on Textiles & Clothing (ATC) in January 2005, and the end of quotas, there was considerable and widespread concern that Cambodia’s garment sector might rapidly evaporate, despite the country having joined the World Trade Organization (WTO) in 2004.

The argument was thus: foreign garment manufacturers would no longer need to base their production in Cambodia to enjoy the generous quotas awarded to Cambodia, and therefore would relocate their operations to countries where the costs of production were less, such as China or Vietnam. Although average salaries may be higher in such countries, higher productivity levels of workers and the better physical infrastructure are just two factors that can make them more competitive than Cambodia in terms of the overall costs of operation.

So far that scenario has not played out: garment exports increased by more than 15% in 2006 alone. But Vietnam’s entry into the WTO in January this year, thereby allowing Cambodia’s larger neighbour – and direct competitor in garment production for export – to also benefit from the lifting of quotas under the ATC, has revived concerns about the fate of the industry and the 300,000 or so Cambodians it employs.

Should Cambodia’s garment industry survive Vietnam’s WTO accession, some observers still caution against placing too much emphasis on its long-term economic potential. “One has to be slightly sceptical about the real value add of the garment sector to Cambodia,” warns one observer. “As most inputs and machinery are imported, and all profits are either made offshore or repatriated offshore, it is only the labour of the Cambodian workforce that provides any benefit to the economy.”

Resource activity

For the country’s economic planners at least, any future downturn in the garment industry could be more than mitigated by a marked increase in resource-related FDI activity. Onshore, BHP Billiton and Mitsubishi Corporation recently commenced exploration for bauxite in the north-east of the country. And Australia’s Oxiana has embarked on an exploration programme in Cambodia.

But it is offshore where the most intense interest is currently focused. This follows Chevron’s 2005 find of a commercially viable oil reserve in one of five blocks awarded to foreign energy companies. Production is expected to commence in 2009. The aggregate size of Cambodia’s oil reserves remains unknown, but the World Bank has made a tentative estimate of two billion barrels. The Chevron find alone is put at about 500 million barrels, and the expectation is that more oil will be found in other blocks.

The windfall revenues generated from this quantity of oil would be substantial (as much as $4.5bn per year), and could radically improve the country’s financial and fiscal base. However, there is already some concern being expressed – notably from the large resident donor community, which provides about $600m in aid each year, equivalent to 60% of the government budget – that this could prove to be a poisoned chalice if Cambodia does not prepare wisely for such a large and rapid injection of money into the state’s coffers, and into the economy as a whole.

Oil revenues

Legitimate fears that Cambodia could suffer a serious case of ‘Dutch disease’ (the deindustrialisation of a nation’s economy that can occur when the discovery of a natural resource raises the value of the currency) are being mooted. Government officials have talked of establishing a fund into which oil revenues will be poured, which will then be used to finance projects that benefit the whole populace.

Even so, sceptics speculate about how much money might be siphoned off by corrupt officials or allocated to ‘pork barrel’ projects (government spending that is intended to benefit constituents of a politician in return for their political support). Tellingly perhaps, the Sultan of Brunei recently visited Cambodia and may have proffered guidance to policy-makers on the challenges posed in harnessing substantial oil-derived revenues.

The tourism sector has been attracting substantial FDI inflows, much of it revolving around the Angkor Wat heritage site, near the town of Siem Reap. Cambodia received 1.7 million foreign visitors in 2006, injecting about $1.5bn into the local economy and helping the country to exceed the $1bn mark in foreign currency reserves for the first time. If the political situation remains stable (national elections are to be held in 2008), visitor inflow numbers should continue to rise by as much as 20% a year, creating demand for more hotels and tourism-related projects.

There has been a steep rise in land prices in the past few years in Phnom Penh and Siem Reap in particular. And a similar scenario may play out in the port city of Sihanoukville if it develops into the main hub for energy firms drilling offshore. Local construction companies and banks alike have benefited from this property trend but could come unstuck if land prices correct sharply. Rising land prices have exacerbated the problem of land-grabbing by officials, which premier Hun Sen has conceded poses a serious threat to socio-economic stability.

Beyond the main towns, FDI activity is thin on the ground in most of the rural provinces. Few foreign investors have ventured into agro-related production and processing, even though agricultural activity is the principal source of income for the majority of Cambodians, and accounts for roughly a third of national gross domestic product (GDP). Yet a lack of investment means that agricultural produce accounts for less than 5% of total export value. A number of Vietnamese rubber companies have plans to develop plantations in Cambodia, having run out of available land at home, but such projects tend to be the exceptions that prove the rule.

SEZ plans

The government has ambitious plans for a number of special economic zones (SEZs), which are intended to act as lynch-pins that will attract FDI beyond the principal cities. Most of the SEZs are to be located close to the borders with Vietnam and Thailand, partly to allow them to plug into more reliable electricity supplied by Cambodia’s neighbours. Investors that locate in the SEZs should be able to avail themselves of speedier administrative procedures in conducting business, and face less red tape than most firms, whether local or foreign. If they are successful, they should illustrate to provincial and national officials the economic benefits to be derived from administrative reform.

Most proposed SEZs have yet to be developed but policy-makers hope that they will provide a platform for Cambodia to attract the kind of low-end manufacturing and assembly activity that will allow it to integrate better into regional production networks and value chains. The hope is that backward linkages can be established between foreign firms located in these SEZs and local small enterprises. In so doing, the SEZs should help Cambodia to diversify away from the garment sector. And there is some room for guarded optimism in this regard. “Cambodia has a very trainable workforce, particularly at the light industry and manual trades level. However, the challenge is to develop Cambodian managers and entrepreneurs,” suggests Mr King.

Cambodia’s economic growth trajectory is impressive. For the last dozen years, the economy has grown by an average of more than 8% a year, and the IMF anticipates GDP will rise by a further 9% in 2007. Should Cambodia’s macroeconomic backdrop remain broadly benign, as seems likely, FDI inflows are likely to remain robust.