Chapter 2

Literature Review

The purpose of this chapter is to review theories and apply theories to

Cambodia’s determinant factors of FDI. This chapter is divided into 3 sections:

Section 1 : The theories and the determinants of foreign direct investment (FDI) activities.

Section 2 : Empirical evident on the determinant of foreign direct investment.

Section 3 : Overviews economic and foreign direct investment in Cambodia

a. The theories and the determinants of Foreign Direct Investment

activities

The theory of the determinants of MNE activity explains both the location of

value adding activities, and the ownership and organization of these activities. The

first is the theory of international resource allocation based upon the spatial

distribution of factor endowments and capabilities. This theory chiefly addresses itself

to the location of production. The second is the theory of economic organization,

which is essentially concern with the ownership of that production and the ways in

which the transactions relating to it (including those which may impinge on it

location) are managed and organized (Dunning 1993: p. 66).

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1. The Product Cycle Model

The earlier influential approach in explaining FDI was that of Vernon’s

product cycle hypothesis (1966). The product cycle hypothesis states that based on the

comparative advantage arising from the pattern of factor endowments; initially

a product was invented in the home country with comparative advantage in

technology and innovatory capabilities, and produced for the home market in the

home country near to both its innovatory activities and markets. At a latter stage of

the product cycle, because of a favorable combination of innovation and production

advantages offered by the home country, the product was exported to other countries

most similar to the home country in demand patterns and supply capabilities.

Gradually, as the product becomes standardized or mature and labor becomes a more

important ingredient of production costs, the attractions of sitting value-adding

activities in a foreign, rather than in a domestic, location increase. Eventually, if

conditions in the host country are right, the subsidiary could replace exports from the

parent company or even export back to the home country.

2. The Internalization Theory

In the mid 1970s some economists, for example Buckley and Casson

(1976), Lundgren (1977), and Swedenborg (1979), proposed the application of

internalization theory to explain why the cross-border transaction of intermediate

products are organized by hierarchies rather than determined by market forces. The

basis hypothesis of the internationalization theory is that multinational hierarchies

value-added activities across national boundaries to that of the market, and that firms

are likely to engage in FDI when ever they perceive that the net benefits of their joint

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ownership of domestic and foreign activities, and the transactions arising from them,

are likely to exceed those offered by external trading relationship. Internalization of

theory give a particular distribution of factor endowments, MNE activity will be

positively related to the costs of organizing cross-border markets in intermediate

products.

Internationalization theory is mainly concerned with identifying the

situations in which the markets for intermediate products are likely to be internalized,

and hence those in which firms own and control value-adding activities outside their

natural boundaries. Buckley and Casson’s (1976) assertion that MNEs are typically

both vertically and horizontally integrated led them to a model centered on the

relationship between knowledge, market imperfections and the internalization of

markets for intermediate goods. This comprehensive treatment of vertical and

horizontal FDI is possible in so much as “the vertically integrated firm internalizes a

market for an intermediate product, just as the horizontal MNE internalizes markets

for proprietary assets” (Caves, 1996: p.13).

Buckley, (1991) suggested that, it is better described as a paradigm than a

theory, in as much as the kinds of market failure that determine one form for foreign

added value activity may be quite different from that of another.

As Buckley and Casson observed, for multinational enterprises to serve

foreign markets through direct investment rather than alternative modes of doing

business, like exporting or licensing, there must exists some internalization

advantages for the firm to do so.

The internalization approach incorporates the idea of market imperfections

identified by Hymer and extends it to provide an explanation for the existence of

15

multinational firms across national boundaries. In general, it argues that, faced with

imperfections in the markets for intangible assets and imperfect information, firms

tend to internalize operations to minimize costs of transactions and increase

productive efficiency. While this approach emphasizes the importance of transaction

costs resulting from market imperfections, both Buckley (1987) and Casson (1987)

have acknowledged the need to integrate location-specific variables with

internalization variables to explain the MNE activities.

Buckley and Casson (1976: pp.37-38) specified five types of market

imperfections that call for internalization:

When the co-ordination of resources over a long period is needed;

When the efficient exploitation of market power requires

discriminatory pricing;

When bilateral monopoly produces unstable bargaining situations;

When the buyer cannot price correctly the (usually intangible)

goods on sale, or when public goods are involved;

When government interventions in international markets create

incentives for transfer pricing.

3. The Eclectic Paradigm

One organizing framework was proposed by Dunning (1980, 1981a, 1981b,

1993), who synthesized the main elements of various explanations of FDI, and

suggested that three conditions all need to be present for a firm to have a strong

motive to undertake direct investment. This has become known as the “OLI”

16

framework: ownership advantages, location advantages, and internalization

advantages.

a) Ownership specific advantage:

It is to what extent a company is able to, and interested in, engaging in

foreign direct investments in dependent mainly on the possession or the ability to

acquire ownership of specific advantages, patents, management knowledge, capital,

brand name and manpower allows the company to go abroad.

A firm’s ownership advantage could be a product or a production

process to which other firms do not have access, such as a patent or blueprint. It could

also be some specific intangible assets or capabilities such as technology and

information, managerial, marketing and entrepreneurial skills, organizational systems

and access to intermediate or final goods markets (Dunning 1993). Whatever its form,

the ownership advantage confers some valuable market power or cost advantage on

the firm sufficient to outweigh the disadvantages of doing business abroad. Although

ownership advantages are firm specific, they are closely related to the technological

and innovative capabilities and the economic development levels of source countries.

b) Location advantages:

It involves a number of factors that favor a location in comparison to an

alternative location to the extent that a company, which is to engage in a FDI, chose

the particular location a head of the competing location (Ekstrom, 1998). The factors

deciding the location of the foreign direct investment involve labor costs, marketing

factors, trade barrier and government policy (Hood & Young, 1982).

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It is included not only resource endowments, but also economic and

social factors, such as market size and structure, prospects for market growth and the

degree of development, the cultural, legal, political and institutional environment, and

government legislation and policies (Dunning, 1991 a) .

Labor costs are affected by imperfection in the international market for

labor. Since regulations for immigration exist worldwide, the mobility of labor is

reduced and differences in wage costs arise. This create different production cluster

area around the world, each specialized in different wage level. An example of this is

the low wage area in Southeast Asia producing toys and clothing, and on the other

hand Western Europe with it high tech production and high wage levels.

Marketing factors also affect the alternative location of FDI. Market

size, market growth, stage of development and the presence of local competition will

affect the decision of where to locate a FDI. In some market domestic brands are

preferred, and a presence in a specific market is needed for success. The location of a

FDI in that specific market is therefore essential to be able to label products “made

locally” (Daniels & Radebaugh, 2001).

The existence of trade barriers is a factor that influences the choice of

location for FDI. Trade barriers encourage companies to make FDI in markets that

would be too expensive to export to, due to tariffs and quotas (Hood et all., 1982).

Apart from labor costs, marketing factors and trade barriers, government

policy also affects the decision of where to locate FDI. Companies evaluate the

investment climate in the home country; meaning the political, social and economic

environment. This climate affects the perceived risk of locating operations in the

specific location.

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The reason why the location advantage is of such importance is the

relationship between the expected profitability of exporting versus the expected

profitability of locating operation a broad. The location advantages can then either

favor the decision to stay in the home country, or to locate operations abroad

examples of reasons for internalizing operations to specific location are; market size

and growth, source of supply, transportation costs, trade barriers and physical

distances (Ekstrom, 1998).

c) Internalization:

The multinational enterprise must have an internalization advantage. If a

company has a proprietary product or production process and if it is advantageous to

produce the product abroad rather than export it, it is still not obvious that the

company should set up a foreign subsidiary. One of other alternatives is to license a

foreign firm to produce the product or use the production process. However, because

of market failures in the transaction of such intangible assets, the product or process is

exploited internally within the firm rather than at arm’s length through markets. This

is referred to as an internalization advantage.

4. Factors influencing choice of location

In an attempt to explain the underlying factors that are influencing the

choice of host market, Gilomre, O’s Donnell, Carson and Cummins (2003) presented

ten factors. These factors are explained below.

a) Knowledge and experience of foreign market:

The more information and experience a company has about a certain

location, the more likely it is that this company invests there. Increased knowledge

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about a foreign country reduces both the costs and uncertainty of operating in that

foreign market place (Gilmore et al 2003).

b) Size and growth of the foreign market:

Factors like proximity and access to a free trade area, the size of the

foreign market and its growth potential are regarded as key factors according to

Gilmore et al. (2003). Regarding the free trade area one should keep in mind that the

size and growth of that particular free trade area may be more important that the size

and growth of the particular country in which the company is about to invest.

c) Government emphasis on FDI and financial incentives:

If the government of the host country actively works to attract FDI, then

that country will be more attractive compared to a system with government bodies forcing

the foreign investors to undertake lengthy, bureaucratic processes before the investments

are approved. Examples of incentives are; generous tax incentives, worker-training

support packages, good transport facilities and well developed telecommunications.

However, Gilmore et al. (2003) argue that, based on earlier research studies, financial

incentives have relatively little impact on the choice of location.

d) Economic policy:

Inflation, tax rates and the tax structure of the host country are examples

of economical policy factors and these examples are also key investment

considerations. Several studies have shown that the rate of corporate taxation has a

negative effect on investment decisions, meaning that the higher corporate taxes the

fever investments are conducted.

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e) Cultural closeness:

The cost for entering a market, which is similar in culture to the home

market, is smaller compared to entering a market with few cultural similarities.

However, there is a disagreement among researchers about the extent to which

companies prefer to invest in markets exhibiting near and similar cultures.

Nevertheless, most companies tend to successively enter markets at an increasingly

cultural distance from the home country.

f) Cost of transport, material and labor:

Transport and raw materials are key cost factors that companies take

into consideration when conducting an FDI. However, the cost of labor has been more

extensively explored in the FDI literature and the research has produced mixed

feelings. Dunning (1980), for example, has conducted research showing that higher

wages reflect a more productive workforce and associated with increased foreign

investments. At the same time, other researchers have come to the conclusion

showing the reverse effect, meaning that high salaries have a negative impact on the

flow of FDI (Gilmore et al., 2003).

g) Availability of resources:

Companies conducting FDI are influenced by the availability of

resources, in particular labor and raw materials. Population density and

unemployment rates are two examples of labor related factors, while the standard and

amount of local suppliers are raw material related factors, while the standard and

amount of local suppliers are raw material related factors. However, the importance of

availability of raw materials has recently showed to have less impact since raw

materials are already often sourced on a global basis. Concerning the human resources

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the single most important factor is to what the education of the workforce are

comparable to the needs of the specific company.

h) Technology:

Access to technology is considered to be one of the most important

factors concerning investment location, and especially the ownership level of the

investing company in today’s globalize markets. It is important to note that high

levels of research and development expenditures are not necessarily connected to a

high level of technological advancement.

i) Political stability:

A great concern for companies conducting FDI is that host government

will “change the rules of the game” within the industry where the company is active.

Therefore, a climate with political stability is very attractive for companies active on

the global market.

5. OLI versus internalization

The generalized predictions of the “OLI” framework are straightforward. At

any given moment of time, the more a country’s enterprises, relative to those of others

possess ownership advantages, the greater the incentive they have to internalize rather

than externalize their use, the more they find it in their interest to exploit them from a

foreign location, then the more they are likely to engage in foreign production. The

framework also can be expressed in a dynamic form. Changes in the outward or

inward direct investment position of a particular country can be explained in terms of

changes in the ownership advantages of it enterprises relative to those of other

nations, changes in its location advantages relative to those of other countries, and

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changes in the extent to which firms perceive that these assets are best organized

internally rather than by the market (Dunning, 1993).

Dunning (1993a: p.85) argues that “the eclectic paradigm is less an

alternative theory of international production than one which pinpoints the essential

and common characteristics of each of the mainstream explanations”. That is the

reason why he renamed it ‘paradigm’ instead of the original ‘theory’. However, the

claim that the eclectic paradigm has uniquely the global explanation of international

production is not universally accepted. Rugman (1980), in particular, claims that

internalization is in itself a general theory of foreign direct investment. He extensively

analyzed previous contributions to the theory of FDI to demonstrate that

internalization is the key element in all existing explanations. Buckley (1983a) saw it as

the consequence of applying static concepts to a dynamic issue - the growth of the firm.

Dunning’s distinction between asset and transaction ownership advantages may be

seen as a concession to this criticism (Corley, 1992: p.11). But Casson (1987)

admitted that the empirical work recognizes the importance of ownership advantages.

Ownership advantages may be dynamic and volatile, but they are the factors

that, by being internalized, allow firms to cross borders and become MNEs. Dunning

(1991) accepts that the internalization theory has the leading explanation of why a

firm should choose to engage in foreign investment. But he dismisses its capacity to

explain the level, structure and location of all international production. Dunning sees

the internalization theory not as an alternative but as a very important contribution to

his approach. One, he admits, that considerably influenced the evolution of his view

of foreign direct investment (1991: pp.122-123). Since the very beginning, and

despite the many subsequent developments, the internalization approach is a theory of

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the firm that chose to cross national borders - a theory of the MNE. By contrast, the

eclectic paradigm is a theory of FDI. It wraps the theory of the firm with the

macroeconomic and socio-political environment in which the decisions are made:

“The main difference between the determinants of intra-national and international

production lies in the unique economic, political and cultural characteristics of

separate sovereign states” (Dunning, 1993a: p.86).

6. Motives for foreign production

The motives for firms to engage in foreign production can be classified in

four groups: natural resources seeking, market seeking, efficiency seeking and

strategic asset seeking.

Natural resources seeking FDI is justified by the fact that these resources,

e.g. minerals, raw materials and agricultural products - tend to be location specific.

The need to guarantee a cheap and safe supply of natural resources justified much of

the FDI flows in the 1800s and early 1900s, largely from the most industrialized

nations (i.e. Europe, USA and Japan) to the less developed areas of the globe

(Dunning, 1993a: pp.110,124).

Market seeking corresponds to FDI that aims at supplying the local market

or markets in adjacent territories. It may represent a deeper involvement of the firm,

following the success of exports, or the expansion of the firm to a wholly new market.

Transportation costs and government regulations are the main reasons behind market

seeking FDI. However, Dunning (1993a: pp.58-59) suggested that strategic reasons

may also be associated with this type of FDI. Some examples are to follow the firm’s

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clients in their foreign expansion, the need to adapt products to local conditions and

tastes, or the reduction of transaction costs.

Efficiency seeking FDI has three main forms:

First, and probably the most frequent type, firms often seek to increase their

cost efficiency by transferring production, totally or in part, to low labor costs

locations. This is especially likely to happen in industries where unskilled or semi-

skilled labor represents an important part of the production costs.

The second type of efficiency seeking FDI corresponds to investment

aimed at rationalizing the operations of existing MNEs. The target may be the

exploitation of comparative advantages in adjacent territories (e.g. following a process

of economic integration, such as the creation of the single European market, in 1992),

or to exploit economies of scale and scope across borders. However, prior market

seeking FDI or costs reducing FDI is a pre-condition for this variation of efficiency

seeking foreign investment.

Finally, strategic asset seeking FDI is probably the fastest growing of the

four motives for overseas investment (Dunning, 1994).

In contrast to the other motives for FDI, strategic assets seeking investment

does not imply the exploitation of an existing ownership advantage of the firm.

Instead, FDI may be a vehicle for the firm to build the ownership advantages that will

support its long-term expansion at home and abroad, as argued, for example, in the

network literature. Alternatively, strategic asset seeking investment may not involve

strengthening the firm’s position, but rather to weaken the competitive position of its

competitors (Dunning, 1993a: p.60).

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7. Czinkota and Rokainen’s major determinants of Foreign

Direct Investment.

According to Czinkota and Ronkainen (2001) there are a variety of reasons

for companies to expand internationally. In the table below, we have listed the reasons

of companies conducting FDI according to these authors.

a) Marketing factors:

• Size of market

• Market growth

• Desire to maintain share of market

• Desire to advance exports of parent company

• Need to maintain close customer contact

• Dissatisfaction with existing market arrangements

• Export base

Marketing objectives, the shareholders pressure for increased profits,

and corporate desire for increased growth are major reasons for companies conducting

FDI. In today’s competitive global environment companies are forced to seek wider

market access in order to maintain and increase their sales. The quickest way to

extend the company’s activities internationally is to acquire a foreign firm.

Conducting a FDI as a way of entering a new market provides the company with

better intelligence about the political climate and easier access to opinion makers, as

well as other decision makers.

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b) Trade restriction

• Barriers to trade

• Preference of local customers for local products

Another group of incentives for conducting FDI is to avoid current

barriers to trade like duties, tariffs, import quotas, preferences of local customers for

local products and other trade restrictions. In addition to these trade restrictions and

cultural barriers, companies sometimes are forced to establish a plant or facility in a

foreign country due to the country-of-origin-effect. The country-of-origin-effect

means that a country has a built-in positive stereotype for production location and

product quality.

c) Cost factors

• Desire to be near source of supply

• Availability of labor

• Availability of raw materials

• Availability of capital/technology

• Lower labor costs

• Lower production costs other than labor

• Lower transport costs

• Financial (and other) inducements by government

• More favorable cost levels

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For a firm to stay competitive is has to aware of the cost structure. It is

difficult for a company to compete on market if its costs are substantially higher than

those of the competitors. Therefore, many companies conduct FDI to increase the

availability of labor, raw materials or capital and technology. Another way of cutting

costs is to enter a foreign market that presents the company to lower labor, transport,

and other production cost. Except from these factors, companies also conduct FDIs

due to more favorable cost levels in as specific country, or because a certain

government in a country can offer them financial or other inducements.

d) Investment climate

• General attitude toward foreign investment

• Political stability

• Limitation on ownership

• Currency exchange regulations

• Stability of foreign exchange

• Tax structure

• Familiarity with country

Once a company has made the decision to expand internationally, the

investment climate plays a major role. A company will be reluctant to invest in a

country with low economic growth, political instability and major limitations in

ownership. On the other hand, a company will be positive towards investing in a

country with a positive general attitude toward foreign investments, a stable exchange

rate and where the culture is similar with the culture in the home country.

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8. Rugman and Hodgett’s reasons for foreign direct investment.

Czinkota and Ronkainen (2001) argue that there are five major areas of

reasons for conducting FDI. However, Rugman and Hodgetts (2003) believe that

there are seven major reasons, namely; increase sales and profits, enter rapidly

growing markets, reduce costs, gain a foothold in economic blocs, protect domestic

markets, protect foreign markets and acquire technological and managerial-know-

how. These reasons will now be discussed more thoroughly.

a) Increase sale and profits

When looking at the large and best known MNCs, one can see that they

earn extremely large amounts of money through overseas sales. At the same time,

smaller companies being active in smaller economies need to look outside their home

boarders. Sometimes large MNCs write contracts with local companies and if these

small companies are performing what they are expected too, and then the MNC might

want to extend the contract and allow the small local firm to supply other worldwide

locations. In addition, the global markets often are considered to be much more

lucrative than the domestic market.

b) Enter rapidly growing markets

When new market is emerging they present great opportunities for many

companies. In order to utilize on these benefits the companies have to enter the new

market as quick as possible. One way of increasing the speed of entry is to conduct a

FDI. China, which has been considered as a closed market throughout the history, has

during the past two decades started to move towards a more market-driven economy

and is therefore experiencing and annual growth rate of seven to eight percent. This

29

has also lead to more and more MNCs trying to enter the Chinese market and it is

today one of the worlds most attractive markets to enter.

c) Reduce costs

High labor expense or high transportation cost together with a shortage

of supply of materials is two reasons for companies choosing to conduct FDI. A third

reason is the cost of energy. In energy, intensive industries companies might be forced

to move their operations overseas in order to cut costs. A fourth cost is high

transportation costs. If the production facility is located to far away from the suppliers

or the customers, then the transportation costs will disable the company from being

competitive. An example of reducing costs due to production location is the US

companies that have set up operations closely connected, but on each side of the US-

Mexican border, for the purpose of shipping goods between the two countries. US

components are shipped into Mexico duty free, allowing the company to benefit from

the low wages in the country, and after being assembled by Mexican workers the

products are re-export to the US.

d) Gain a foothold in economic blocs

For quite sometime, the EU and NAFTTA (North America Free Trade

Area) have been the two dominant economic blocs. For many international companies

it is crucial to access these blocs from inside, since once a company has established

itself within a free trade area it can export goods to other member nations without

having to pay for customs and taxes. However, a third strong economic bloc is

developing which is called the ASEAN bloc. A common believe is that these

economic blocs will grow stronger over time and finally it will be a must for MNCs to

be presented in all three blocs to stay competitive on the international market.

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e) Protect domestic markets

There are numerous examples of when MNCs have entered a new

market only with the aim to defend their home market. If, for example, a Danish

company enters Sweden, then Swedish companies might react to this by establishing

themselves on the Danish market. This is done to bring pressure on the Danish

company that entered the Swedish market. Furthermore, some companies go

international because their customers on the home market are demanding it, resulting

in a situation where the company either can not meet customer demand or has to

follow their customers out on the international marketplace.

f) Protect foreign market

As well as companies have to defend their home market; they have to

defend all those foreign markets they have invested in. One example of this is to extend

the product line by acquiring a company on a foreign market and merge it with another

company on the same market. However, in to days globalize marketplace it is

sometimes hard to tell the difference between home market and host market for MNCs.

g) Acquire technological and managerial-know-how

A final major group of reasons behind why companies conduct FDI is to

acquire technological and managerial expertise. One way of doing this is to establish

themselves close to leading competitors, or close to universities and other research

centers.

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9. Performance of Foreign Direct Investment

a) Financial capital factor

When business firms invest in foreign countries, capital financing

activities affect their entering mode, and further more, their investment performance.

There is a strong relationship between size of parent companies, dept ratio, size of

investment, parent company’s product growth rate, profit making capability and

capital obtaining capability, source of capital, and capital application. These related

factors can be summed up as the financial capital factor.

Company size is to be measured relative to the capital obtaining

capability. For long-term capital, subsidiary firms largely depend on the parent

company. For many other purposes they may consider the local bank. At any time,

size reflects the business firm’s competitive capability in both output market and in

terms of obtaining finance.

Clearly, bit business firms have better capital obtaining capability, and

more opportunities to enlarge their competitive capability, and capture a bigger

market share; they can better channel their resources than those of small business

firms. So, the performance of big business firms may be better than that of small

business firms. Gomes-Cassers, (1990) Cavusgil & Nevin (1981) measure the parent

company size as the employee number. Their research result verifies that the business

firm size is the predictable index for profitability.

As mentioned before, another factor, investment size, also affects

business firm’s performance. When investing in the foreign countries, business firms

can be assumed to hold the optimistic attitude and a direct result may be, other things

being equal, a high investment size that may lead to a better profit performance.

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Danials (1970), Vernon (1983), and Shama (2000) verify that business firm’s perform

well when parent companies provide abundant capital for investment. Growth rate and

profit capability of parent companies reflect the conditions in the product market as

well as business competition. Business firm which make a profit can supply at least

part of the capital themselves and also can get help to obtain capital from outside in

order to replace the out-of-date plants and facilities and absorb the market risk when

pursuing a rapid growth strategy.

b) Business performance

The measurement of the effectiveness of global operation can be

determined in terms of various aspects with multiple criteria. Chen (2001)

summarized all kinds of criteria in two main categories: objective criteria and

subjective criteria. The objective criteria are based on financial indicators such as

profitability, return on investment, and return on assets. Kan (1997,1998) emphasizes

the relation between location, infrastructure, domestic resource exploitation and

profitability of FDI. Some non financial indicators such as the level of business

survival (Killing, 1983), duration of survival (Harrigan, 1988), and stability of

shareholding (Gomes-Casseres,1987) are also used in the literature Khan and Aghro

(1992) found exchange rates to be a major determinant of FDI in South Africa. The

objective criteria have been used widely in measuring the effectiveness of foreign

direct investment in a firm. But they also have practical constraints. Anderson (1997)

pointed out that the objective indicators, of effectiveness could be only used as part of

measurement dimensions. A firm needs to make use of some relevant qualitative

dimensions to measure its overseas market because it usually takes several years to

show positive financial performance.

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b. Empirical Evident on the Determinant of Foreign Direct

Investment.

1. Domestic market

Empirical evidence of the relevance of the host country’s market as a

determinant of FDI was recurrently found in survey studies and in the investigation of

US FDI in the EEC. Naturally, all the subsequent econometric tests of the location

determinants of FDI included the domestic market as an independent variable. Most

found it to be significant.

The market size hypothesis also derives from neoclassical theory. It was

introduced in the studies of the determinants of FDI as a location variable associated with

economies of scale (Scaperlanda and Mauer, 1969: p.560) and, thus, market

imperfections. It assumes two levels: the absolute size of the market, and its growth rate.

Despite the strong theoretical sense of the claim, the empirical support is

apparently inconclusive. Studies that used data prior to the first enlargement of the

EEC, when new investment was dominant, found market size significant, but not

market growth (Bandera and White, 1968; Scaperlanda and Mauer, 1969). The

opposite was found by Culem (1988) with more recent data. Nevertheless, the results

of Schmitz and Bieri (1972), Lunn (1980) support both hypotheses.

Clegg (1998) tested both variables with data for a 40 years period (1951-

1990). The aggregate data produced very poor results. However, after dividing the

period of analysis there was strong support for the market size hypothesis in the

period 1951-72, and for the market growth hypothesis in the period 1973-90. In other

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words, new investment seems to be associated with market size, while expansionary

investment is responsive to market growth.

2. Export market ]

There is abundant empirical support for the claim that export orientation

attracts FDI (Riedel, 1975; Kravis and Lipsey, 1982; Hein, 1992; Dollar 1992; Lucas,

1993; Jun and Singh, 1996) cited by Dunning (1993).

Most of the empirical evidence of the attractiveness of export markets to

FDI is indirect. The importance of export markets is implicit in the observation that

FDI grew steadily in Europe after the announcement of the creation of the EEC, in the

1950s, and that of the 1992 internal market. The same can be concluded from the

findings of Root and Ahmed (1978) that economic integration is a significant variable

among developing countries.

More direct approaches were used by O’Sullivan (1993). O’Sullivan (1993:

p.141) based his model on the fact that in the period studied (1960-80) foreign

investors in Ireland exported over 80 percent of their non-food output. Since the

United Kingdom was the destiny of a big percentage of these exports, export markets

were proxy by the UK’s real GDP. It was found strongly significant. Lucas (1993)

used an index of foreign GDP to assess the importance of export markets in attracting

FDI to the export oriented countries in East and Southeast Asia. He concluded that

FDI was more responsive to foreign markets than to the home market despite being

both significant.

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3. Government policies and protectionism

There is, however, a clear contradiction between these results and the tariff

discrimination hypothesis discussed above for the studies of US investment in the

EEC. The suggestion was that FDI can be encouraged by barriers to trade

(Schmitz and Bieri, 1972; Lunn, 1980; Scaperlanda and Balough, 1983.

A number of factors help to explain the contradicting results associated with

protectionism. Market imperfections and ‘relative discrimination’ (Clegg, 1996)

between foreign and domestic firms vary widely across industries and countries,

making the results particularly sensitive to sample and methodology. Furthermore,

protectionism often coexists with export orientation. Protected economies can attract

export-oriented FDI by opening selected industries to FDI or by creating export

processing zones.

In any case, barriers to trade tend to be significant only when market

seeking is the main motivation of FDI. When that is not the case, protectionism

becomes less important. Moore (1993) did not find evidence that German FDI was

induced by tariffs in the host countries. Similarly, Kumar (1990) concluded that

protection was not a determinant of investment in India. Dunning (1993a: p.165)

mentions that Agodo (1978) obtained the same result for US investment in Africa.

4. Government incentive

The incentives are a determinant of FDI frequently cited in surveys

(Robinson, 1961; Forsyth, 1972; Andrews, 1971; all cited in Dunning, 1993a).

However, it was the opinion of UNCTAD (1998: p.104) that incentives are not a

relevant determinant of inward FDI. They are much more likely to influence the

36

precise choice of location within a country or region once the investment decision has

actually been made.

Government incentives are difficult to quantify. Kumar (1994) found

incentives less successful than export processing zones. Lim (1983) and Wheeler and

Mody (1992) concluded that they were no substitute for good infrastructure, natural

resources, or an expanding domestic market. Tsai (1991) and O’Sullivan (1993)

claimed that government support was not a significant determinant of FDI in Taiwan

and Ireland, respectively, inspire of massive programs to attract FDI.

5. Natural resource

Owen (1982) found a dummy variable representing natural resources

intensity a significant determinant of FDI in Canada. This is consistent with the

results of Buckley and Dunning (1976), who found a similar variable not significant

for the UK. Taveira (1984) studied the determinants of US investment in two sets of

developed and developing countries and found the percentage of primary commodity

exports in total incentives less successful than export processing zones. Lim (1983)

and Wheeler and Mody (1992) concluded that they were no substitute for good

infrastructure, natural resources, or an expanding domestic market. Tsai (1991) and

O’Sullivan (1993) claimed that government support was not a significant determinant

of FDI in Taiwan and Ireland, respectively, in spite of massive programs to attract FDI.

6. Labor cost

In the case of investment among developed countries labor costs were

normally found to be irrelevant. Some examples are Buckley and Dunning (1976),

Owen (1982), Gupta (1983), Dunning (1980), Taveira (1984), or Culem (1988).

A different conclusion was, nevertheless, reached by Caves et al (1980) and by

37

Saunders (1982). Both studies found wages a significant determinant of US

investment in Canada.

When developing countries were included in the sample, the relevance of

labor costs tended to increase. This was the case with Schneider and Frey (1985),

despite wages being less important than the level of development or the balance of

payments, Lucas (1993), and Kumar (1994). Jeon (1992) found that increasing

domestic wages at home were associated with Korean FDI in developing countries.

Riedel (1975) and O’Sullivan (1993) suggested that relative wages were among the

most important determinants of FDI in Taiwan and Ireland, respectively. Finally,

Flamm (1984) concluded that offshore investments were sensitive to labor costs,

despite a moderate response to wage changes.

Two exceptions to this were Kravis and Lipsey (1982) and Wheeler and

Mody (1992). Neither of the studies found labor costs to have a significant impact on

the location of US subsidiaries in samples that included both developed and

developing countries. Kravis and Lipsey (1982) suggested that labor skills, which

were not accounted for in the model, could be the reason for the unexpected result.

Wheeler and Mody (1992) provided a different interpretation. Their results suggested

that, as the national income increases, market size offsets the importance of labor

costs as a location factor - the loss of one location advantage is compensated by

improvements in the other, which invalidates the regression analysis.

7. Labor skill

Taveira (1984) and Schneider and Frey (1985) used the percentage of

population in secondary education, but found no evidence of its significance. This

38

variable is, however, too aggregated and is probably no more than an indicator of the

level of development.

In fact, school attendance is unlikely to be the relevant element. March

(1988) extracted a sample of 200 British men from the General Household Survey of

which 41 per cent had no qualifications and a further 10 per cent had only an

apprenticeship. However, only 3.5 per cent were classified as unskilled manual

workers. This suggests that even in the presence of low levels of formal education, the

existence of an industrial tradition, for example, may lead to reasonable productivity

levels with low training costs.

Most support for the relevance of labor skills is, in fact, indirect.

Swedenborg (1979) was surprised by a positive relationship between the wages of

foreign Swedish subsidiaries and FDI. Her suggestion was that high wages simply

reflected the skills of foreign workers (Dunning, 1993a: p.164). Lall (1980) and

Kravis and Lipsey (1982) made a very similar interpretation of their results regarding

labor costs, while Lansbury et al (1996) concluded that MNEs were attracted to

Central and Eastern Europe by labor skills as much as by labor costs.

At the firm or industry level, the investigation of the role of labor skills is

much simpler. Lall and Siddarthan (1982) tested both total remuneration and the

proportion of non-production workers in the labor force as determinants of inward

FDI in the US. Neither was significant, which is consistent with the fact that foreign

investment in the US is likely to be predominantly market or strategic asset seeking.

8. Physical and cultural proximity

The development of the internationalization theory (Johanson and

Wiedersheim-Paul, 1975; Johanson and Vahlne, 1977; Johanson and Mattsson, 1988;

39

Vahlne and Nordstrom, 1988) was essentially inductive. Its development was based

on evidence from small samples of Scandinavian firms. But the same conclusions

were reached by Davidson (1980), for example, with a much wider sample. Moreover,

Taveira (1984) found US investment in both developed and developing countries to

be negatively affected by physical distance. Grosse and Trevino (1996) identified an

association between physical and cultural distance and investment in the US.

Veugelers (1991) concluded that a shared language and neighborhood increase FDI.

The latter was equally supported by Moore (1993). Papanastassiou and Pearce (1990)

found dummy variables for EC and Commonwealth countries positively related to UK

investment but a negative association with physical distance. Previous levels of bilateral

trade were identified by Lansbury et al (1996) to be a determinant of FDI in the US.

9. Political risk

Some econometric studies frequently fail to establish a relationship between

political risk and FDI flows (e.g. Chase et al, 1988; Flamm, 1984). Tu and Schive

(1995) combined survey analysis with econometric testing to conclude that political

stability and social order are, in general, preconditions for FDI, but have little

influence on the amounts invested.

This is consistent with Lucas’ (1993) suggestion that events which generate

political instability (e.g. Marcos’ martial law in the Philippines, Park’s assassination

in South Korea) do reduce FDI, but have a short run impact.

Schneider and Frey (1985) found political aid received from Western

countries and the World Bank to have a strong positive effect on FDI in developing

countries, while aid received form the Communist block had a negative impact.

Political instability had, nevertheless, a significant negative impact.

40

c. Overviews Economic and Foreign Direct Investment of Cambodia

1. Current situation of foreign direct investment in Cambodia

Since Cambodia began implementing its new investment law in September

1994 up to the end of 2003, the Council for the Development of Cambodia (CDC) has

approved 957 projects, worth a total of more USD 6,469,622,017 which employed

Cambodian’s labor more than 508, 801 people (See table 2.1).

Table 2.1: Investment project data

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Total

Number of project 26 124 186 205 144 91 61 39 34 47 957 Capital Investment USD

505,698,494

2,242,890,373

763,062,160

744,551,560

853,924,698

447,921,269

218,037,881

204,683,613

237,659,232

251,233,736

6,469,623,016

Labor (person) 13261 36392 70265 128,457 116,235 77,171 33,112 16,408 17,500 N/A 508801

Source: Cambodia Investment Board

All of 957 projects which had been approved, only 477 projects had been

operated (1994 to 2002) with the worth of capital investment in the amount of 2,386.3

million USD (See table 2.2).

Table 2.2 : Investment projects in operation Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total

Number of project 10 51 70 84 89 59 46 39 29 477 Capital

Investment($) 219.1 546.1 257 168.7 387.9 307.0 154.1 197.7 148.4 2,386.3Source: Hing Thoraxy, 2003

41

The flow of capitalization from ASEAN countries between first of January,

1995 to the end of 2003 were 2,320,883,663 USD, constituted by the capital investment

from Thailand 199,937,098 USD ranking number 2 among ASEAN countries (see table

2.3). Malaysia is an investment leader in Cambodia because of the huge amount of

capitalization investment in 1995, which the amount of capital up to 1,411,121,067

USD in many projects. But actually, most of projects has not implemented until now.

Table 2.3: ASEAN’s capital investment in Cambodia (USD) Country 1995 1996 1997 1998 1999 2000 2001 2002 2003 Total

Malaysia 1,411, 121,067

193,612,422

65,778,925

124,611,979

13,866,720

2,223,800

50,600,141

1,006,660

5,132,485

1,867,974,198

Thailand 18,554,817

52,366, 919

27,297,898

33,412,267

20,684,928

26,042,055

14,709,701 0 6,868,

512 199,937

,098 Singapore 104,465

,381 32,805,

146 15,120,

278 20,901,

340 1,021,185

8,058,816 1,000,

000 3,705,050

187,077,196

Indonesia 656,000 13,496,318

1,264,583.8

7,935, 637

783, 894

15,137,000 39,273,

432 Vietnam 173,

499.2 431, 030

512, 540

315, 000 24,165

,095 25,597,165

Philippines 1,024,575 1,024,

575

Total 1,534,970,764

292,280,804

109,461,684

187,292,253

36,869,267

51,776,671

66,334,417

26,171,755

15,706,047

2,320,883,663

Source: Cambodia Investment Board

More than 50 % of the FDI in the last few years had flown from ASEAN

countries, followed by those of the Asian-Pacific region, America and Europe. Before

1996, more FDI went to the tourism and hotel sector, particularly in 1995. However,

the textile, garment and agro-industrial sectors have attracted considerable investment

over the last few years.

According to the official figures supplied by the CDC, Malaysia was the largest

investment in Cambodia during 1995–2003, which accounted for 31.32% of total

investments and 70% of investment from ASEAN countries. Malaysia was the first

country to sign a bilateral visa exemption agreement with Cambodia in 1992 and

42

Malaysian investors were the first to come, and thus received a great many investment

concessions, including concessions in mining and forestry. Other important sources of

FDI were Taiwan (8.41%), China (5.36%), Korea (4.86%), the United States (4.12%),

Hong Kong (4.01%), Thailand (3.35%) accounted for 8.6% of ASEAN investment,

Singapore (3.14%), France (3.31%) and UK (1.53%) (See Appendix E).

Foreign investment in Cambodia grew in 1998, but has been constantly

declining in the last 3 years. In 1998, the Council for the Development of Cambodia

approved 144 projects with the capitalization in fixed assets worth of $ 853,924,698

and with the potential to provide 59,279 jobs. CDC also approved 91 projects worth

of $ 447,921,269 in 1999. The amount of investment capital was decreased 47.5% in

1999 comparing to 1998. It was also decreased about 51.3% in 2000 comparing to

1990 and 6.1% decrease in 2001 comparing to 2000. Comparing 2002 with 2001, the

capital investment has been increased 16% and also further increase 6% in 2003

comparing to 2002 (See Appendix E).

According to data from investment project monitoring, most of the present

investment activities try to take advantage of the special trade rights under the Most

Favored Nation (MFN) and General System of Preferences (GSP) that the United States,

European Community and other developed countries have awarded to Cambodia. All of

957 project, which had been approved from 1994 to 2003, the investment in industry

fields are accounted for 37% with 704 projects, the investment in tourism fields are

accounted for 35% with 76 projects, the investment in service fields are accounted for

22% with 89 projects, and the investment in the agriculture fields are accounted for 6%

with 88 project (See table 2.4, figure 2.1).

43

Table 2.4: Analysis of capital and project by sector Approved from 1994-2003

Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Agriculture

N/P 2 6 26 24 4 12 5 1 6 2 I/C 559,815 6,041,768 118,495,570 65,577,452 51,609,320 63,884,623 9,758,836 400,000 40,345,020 3,711,375 L/C 100% 61.83% 46.81% 23.42% 24% 63.50% 63% 34.17% 50% F/S 38.17% 53.19% 22.42% 76% 36.50% 37% 65.83% 50%

IndustryN/P 20 82 127 168 125 66 40 28 19 29 I/C 84,475,679 299,484,392 413,007,633 512,464,298 647,582,145 161,474,723 59,402,781 85,926,761 52,049,332 86,628,379 L/C 32.25% 24.72% 28,85% 16.61% 22.36% 21.33% 16.95% 26.39% 23.05% 21.31% F/S 67.75% 75.28% 71.15% 83.39% 77.64% 78.67% 83.05% 73.61% 76.95% 78.69%

ServiceN/P 3 22 17 6 7 10 8 4 6 6 I/C 396,973,000 424,754,912 112,491,804 124,939,800 42,782,350 50,763,791 69,059,034 44,601,030 98,164,880 46,429,828 L/C 17% 23.39% 30.71% 38.50% 38.14% 45.20% 53.13% 77.50% 61% 66.67% F/S 83% 76.61% 69.29% 61.50% 61.86% 54.80% 46.88% 22.50% 39% 33.33%

TourismN/P 1 14 16 7 8 3 8 6 3 10 I/C 23,690,000 1,512,609,301 119,067,153 41,529,010 111,950,883 171,798,132 79,817,230 73,755,822 47,100,000 114,464,155

L/C 27.75% 24.19% 29.29% 58.88% 75% 28.25% 57.50% 66.67% 66% F/S 100% 72.25% 75.81% 70.71% 41.13% 25% 71.75% 42.50% 33.33% 34% Total 505,698,494 2,242,890,373 763,062,160 744,510,560 853,924,698 447,921,269 218,037,881 204,683,613 237,659,232 251,233,737 Total 26 124 186 205 144 91 61 39 34 47 Total I/C 6469622017 Total N/P 957 Source: Cambodian Investment Board Note: N/P= Number of Projects; I/C= Investment Capital; L/C= Local Share; F/S=Foreign Share

2.3.2. Overview of potential factors and the government policy

Figure 2.1: Percentage of capital by sector

6%

37%35%

Agriculture

22%

Industry

Service

Tourism

44

2. Overview of potential factors and the government policy toward

FDI in Cambodia.

Based on the theories above, the potential factors and government policy

toward FDI in Cambodia has been grouped to market factor, cost factor and

investment climate of Cambodia which will be more explained in the following

paragraph.

a) Market factors

1) Market size and growth

Cambodia has population of 13 million with GDP per capita is $ 297

in 2000 and purchasing power was about five times as great ($1,446) (See appendix C).

The real GDP grew well in 1995 (7.6%) and 1996 (7%) but declined sharply in 1997

(1%) and 1998 (2%). It has pick up again to grow strongly. GDP increased by 5 % in

1999 and 2000 and 5.5% in 2002 and 6% in 2003. The average annual GDP is 4.6%.

Cambodia’s upper and middle class, with a purchasing power

sufficient to buy sophisticated consumer goods, is to be found mainly in Phnom Penh

and other urban areas. However, the market of most interest to potential investors is

less the domestic than the regional one.

Indeed Cambodia are accessed by the investors as platforms from

which to enter the larger of ASEAN+4 market and gain benefit from Generalize

System of Preferences (GSP) and Most Favored Nation (MFN) and membership of

WTO. As a member of ASEAN+4, Cambodia has joined a market of more than 2

billion people from ASEAN 10 plus China, Korea, Japan and India. Within the

framework of the Common Effective Preferential Tariff (CEPT) of the ASEAN Free

Trade Area (AFTA), tariffs on most Cambodian exports to ASEAN will be reduced to

45

0–5% for most products by year 2010 and abolished entirely by year 2018.

(The CEPT scheme works on the principle of reciprocity and Cambodia has until year

2010 to reduce most tariffs on its imports to 0–5 %.)

As for international market access, Cambodia, a least developed

country (LDC), offers the prospective investor preferential access to the European

Union, Canada and the United States for a number of products, including garments.

2) Export oriented market

Through the Most Favored Nation (MFN) and the General System of

Preferences (GSP) status which were obtained in 1996 and 1997, Cambodia has

preferential access to such international markets as those of the United State,

European Community, with exemption tax and recently Cambodia obtained more

MFN and GSP from Canada, Japan, and China.

Cambodia was admitted to ASEAN in 1999. One of the advantages to

begin a member of ASEAN is that the investors in Cambodia can access to the

markets of ASEAN countries in the framework of AFTA. With Cambodia acceded to

the WTO in 2004, the forthcoming end of the Multifibre Arrangement (MFA) at the

end of 2004 will not necessarily hurt the industry, as its long experience and low

wages can keep it competitive.

According to the report from the Ministry of Commerce

(see Appendix D1-D7), the total amount of exports from Cambodia to foreign market

from January-October 2001 is USD 965,495,840.61, in year 2000 is

USD 1,025,382,809.94, in year 1999 is USD 673,214,770.92, in year 1998 is

USD 673,214,770.92, in year 1997 is USD 281,375,975, in year 1996 is

USD 101,756,627 and year 1995 is USD 27,407,723.

46

The single most important exporting industry has been ready-made

garments. Cambodian textile products have been exported to 27 countries, including

Japan, the United States and the countries of the European Union. In 1997, the

industry earned $ 222,324,545 in exports and has been increase dramatically to

USD 938,627,460.21 in October 2001.

b) Cost factors

1) Work force and labor cost

Cambodia has a population of 13 million people, of whom 51% are in

the “working age” group and over 60% of the workers are women. Cambodia’s low

labor costs are very attractive to investors. Labor costs are low compared with those

in other Asian countries with the average out to only US$ 75 per month. The

minimum wage in the garment industry is only $45 per month. Foreign companies are

currently paying approximately US$100 to US$150 per month for non qualified

workers with minimal English skills; US$200 to US$350 per month for workers with

good English language skills and perhaps a higher education, and up to US$700 per

month for bilingual and well educated employees.

Although Cambodians have low levels of education, the labor force is

traditionally a hardworking and strongly motivated one. (The Angkor complex in

Siem Reap offers historical evidence of the skills and patience of the Khmer people).

Investors generally found the Cambodian workforces trainable and

motivated. Shortage of skilled employees was seen as a problem, although some

investors acknowledged a modest positive trend in skill levels.

Expatriates are allowed to work in Cambodia provided that they

obtain a work permit. Such permits are usually granted to employees of foreign

47

enterprises authorized to operate in Cambodia so long as the applicants are key

personnel. Expatriates may be recruited for non-key positions when Cambodian labor

is not available.

2) Natural resource

Cambodia can build on its comparative advantage by developing

natural-resource-based industries of many kinds, including those based on non-

metallic mineral resources.

Oil and gas exploration recommenced in Cambodia in 1991,

following earlier efforts of the late 1960s and early 1970s, and has already produced

promising results. Altogether, 16,000 line kilometers of high-quality seismic data

have been obtained, indicating a potential for substantial oil and gas generation.

For the purpose of exploration, both land and sea areas of the

Cambodian territory have been divided into blocks, 32 altogether, of which the

offshore blocks I to IV have so far been explored. Three major oil companies:

Enterprise Oil Exploration Ltd, Premier Oil Petroleum Cambodia Ltd. and Campex;

have engaged in drilling with 30-year contracts. Positive results from drilling in Block

III in late 1993 were followed by the most successful test so far, carried out in Blocks

I and II in the first part of 1994, which produced a maximum flow rate of 4.7 m cubic

feet of gas and 180 barrels of condensate per day. Another company testing in Block

IV in the same year produced a maximum flow rate of 1.3 m cubic feet of gas and

1,180 barrels of oil per day.

Although Cambodia has good mineral resources, events of the last

two decades have prevented the development of the mineral sector. Potential exists in

respect of gold, gemstones (ruby, sapphire and zircon), phosphates (for fertilizer),

48

limestone (for cement and building stone), bauxite, clay, sand/gravel and granite, with

the first two commercially the most promising. Copper and zinc also exist but require

more exploration.

3) Infrastructure; utilities and transportation cost

Progress in certain infrastructure services and utilities was widely

acknowledged, while in some areas the private sector saw little change over the past

five years. Telecommunications were seen to have advanced most in recent years.

Although network disruptions had not been eradicated, the majority of private-sector

participants did not feel that this area constituted a problem for their business activities.

The improvement of the road transport network in the major cities and business centers

was mentioned as another area of significant improvement. On the other hand, road

transport in rural areas was still hampered by poor maintenance and with the higher cost.

One area identified as a particular problem for the private sector was power supply. The

problems was mainly cost, which was significantly higher than in neighboring countries.

In fact, the costs were so high that even the rather expensive operation of individual

power generators was cheaper than relying on supply from public operators.

4) Availability of capital and technology transfer

One issue affecting the development of industrial land is the inability

to secure loan capital using real estate as collateral. Financial institutions are reluctant

to finance property development using real property as collateral because the legal

and institutional framework governing land registration and the enforcement of

collateral is not satisfactory. A mortgage law has not been put in place and neither has

a law on bankruptcy. The recovery of defaulted loans is the main issue for investors.

49

Cambodia is country with low technology in the processing

manufacturing by using labor intensive in some industries. Meanwhile, the Cambodia

has offered incentive to investors who provide training and development of human

resources and the transfer of technology and expertise to local staff. There is no other

provision related to technology transfer.

c) Investment climate

1) Government incentive and protectionism

The government of Cambodia has established the Council for the

Development of Cambodia (CDC) in 1994 which responsible for attracting foreign

investment and approving the application for investment incentive pursuant to the

investment law promulgated in August 5, 1994 (see Appendix F). The Cambodian

Investment Board (CIB) is a department of CDC. Together the CDC/CIB is the

government agency responsible for granting investment incentive and approving

investment projects.

(a) Investment guarantees

The Investment Law and Sub-Decree contain a number of

important guarantees for the investors, as follows:

• Equal treatment of all investors.

• No nationalization adversely affecting the property of

investors.

• No price controls on products or services produced by

licensed investors.

• Remittance of foreign currencies a broad.

50

(b) Investment incentive

The following incentives are available to investment projects in

Cambodia:

• Nine percent corporate profit tax

• Up to eight year exemption from corporate profit tax,

beginning from the year of first profit.

• Five year loss carry-forward.

• Exemption from import duties for the period of construction

of the project and first year of business operation.

• Tax free distribution of dividends and profits.

• Employment of foreign expatriates where no qualified

Cambodians are available.

(c) Import duty exemption

Exemption from payment of import duties is available for most

investment project for the construction period and the first year of operation.

Investment projects exporting at least 80% of their production or located in Special

Promotion Zone may receive duty exemption for a longer period of time.

(d) Tax incentives

The Law on investment provides the following tax incentives to

eligible investors:

• A corporate tax exemption of up to six years, depending on

the characteristics of the project and the priority of the

government, as mentioned in a Sub-Decree. Corporate tax

51

exemption takes effect from the year the project derives its

first profit or after three years of operation, whichever occurs

first; or a special depreciation equal to 40% of the capital cost

of new and/or used tangible property used in manufacturing

and processing by the qualified investment project (QIP) if the

QIP elects not to use the corporate tax exemption above.

• 100% import-duty exemption on construction materials,

production equipment, intermediate goods, raw materials

and spare parts.

• Export-oriented QIPs; and

• Supporting-industry QIPs; and 100% exemption of export

tax, if any.

2) Political climate

In the transitional period between the signing of the Paris Peace

Agreements in October, 1991 and free national elections conducted by UNTAC in May

1993, Cambodia was governed by a Supreme National Council (SNC), regrouping all four

major political parties. Administration of the country was temporarily entrusted to UNTAC,

which successfully organized the elections with a large population turnout. Following the

installation of interim Provisional Government, the elected Constituent on September 24,

1993 the nation’s constitution which proclaimed King Norodom Sihanouk as a head of state

and established the Royal Government of Cambodia (RGC) within the framework of

parliamentary democracy. This same date marked the official end of UNTAC’s mandate.

The general election of July 1998 and 2003 considered as free and

fair by all national and international observers led to the formation of a new

52

parliament headed by Samdech Chea Sim at the upper house (Senate) and Prince

Norodom Ranariddh at the lower house (National Assembly) and the Royal

Government with Samdech Hun Sen as the Prime Minister (See Appendix G1).

After the resignation of King Norodom Sihanouk, King Norodom

Sihamoni was elected as a king of Cambodia which was celebrated on 29 October 2004.

Many foreign firms noted that Cambodia offered a stable political

environment. Firms stressed in particular the pro-business attitude of the Government.

This was reflected mainly at senior levels of the administration; cooperation at lower

levels was sometimes wanting. Despite claims that the government sometimes lacked

political will and would not act decisively enough, there was a consensus that it was

committed to helping investors, domestic as well as foreign, make their businesses work.

Table 2.5: History of political, legal & economic system

Era Legal system Political system Political power Economic system Pre-1975

French based Civil Code and Judiciary

Constitutional Monarchy

Held by Prince Norodom Sihanouk as Prime Minister until 1970; Lon Nol from 1970 to 1975

European socialist, centrally planned industrial development

1975-1979

Legal system destroyed

Monarch abolished, extreme Maoist agro communism

Khmer Rouge Agrarian, centrally planned

1979-1989

Vietnamese communist model

Communist Party, Central Committee and local committees

CPP (Vietnamese backed)

Soviet style central planning

1989-1993

Greater economic right

Communist Party, Central Committee and local committees

CPP (Cambodian controlled)

Liberalized central planning

1993-present

French based Civil Code combined with common law in certain sectors

Constitutional Monarchy

Shared between FUNCINPEC and CPP

Transition market economic

Source: DFDL, 2002

53

3) Economic environment

Cambodia is one of the most open economies in the developing

world. The Economic Freedom Index of the Heritage Foundation in the United States

ranks it at the top of the LDCs it covers. The economy is dominated by agriculture,

with rice the main crop. Since the country re-established a constitutional monarchy in

1993, the economy has grown rapidly, except for a period between mid-1997 and late

1998, when it suffered from political instability and the spillover effects of the Asian

financial crisis. It began to rebound in late 1998, with the establishment of a coalition

government, but foreign investment in most sectors has lagged. Since early 1999, the

government has intensified its economic reform program, a process that donors and

international financial institutions participate in and monitor closely.

Development assistance to Cambodia from the donor community,

including multilateral and bilateral donors and international organizations, has

averaged about $500 million every year since 1993. At the Consultative Group

meeting of June 2002 in Phnom Penh, Cambodia secured $US 635 million and 2004

received more than $US 400 million from donors.

Real GDP grew well in 1995 and 1996 but declined in 1997 and

1998. It has picked up again to grow strongly (table 2.6). GDP increased by 6.3% in

2001 and 5.5% in 2002 and is expected to grow by 6% in 2003 (RGC, 2003).

54

Table 2.6: GDP growth rates Country GDP Growth Rate (Percentage) Average

Annual

1995 1996 1997 1998 1999 2000 1990-2000

Cambodia 7.6 7.0 1.0 1.8 5.0 5.0 4.6 Lao PDR 7.0 6.8 7.0 4.0 7.3 5.7 6.5 Myanmar 6.9 6.4 5.7 5.9 10.9 N/A N/A Thailand 9.3 5.9 -1.4 -10.4 4.2 4.3 4.2 Viet Nam 9.5 9.3 8.1 5.8 4.8 5.5 7.9 China 10.5 9.6 8.8 7.8 7.1 7.9 10.3 LDCs 6.1 5.2 4.9 4.5 4.7 4.8 N/A Source: UNTAD, based on the World Bank, World Development Indicators,2002, http://publications.worldbank.org/WDI/, and World Development Report 2002

(a) Tax rates

The rate of the VAT is 10% of the “taxable value” of the goods

or services. The taxable value is the sum of the sale price of the goods or services,

including any charges for transportation or additional service provided at the time of

the sale services. Imported goods are assessed at their customs value including

insurance, freight, customs duties and specific tax. Used goods are assessed a taxable

value of the difference between their selling price and their purchase price.

Table 2.7 : Summary of taxes relevant to business Tax Rate Profit tax 20 % (Unless investment incentive rate of 9% or 0%) Advance profit tax 1% of turnover Withholding tax 15% to 20% or salary, 20% of fringe benefits VAT 10% Import duty Varies Export duty Varies Specific tax on certain Merchandise and service

4.35%, 5%, 15%, 25%, 33.33%, 45%, 80% or 110% depending on the item

Source: DFDL, 2002

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(b) Tax structure

As elsewhere, taxes in Cambodia fall into two broad categories,

direct and indirect taxes.

(1) Direct taxes

Corporate profit tax

A profit tax is levied on all businesses and calculated on the

basis of either actual profit or estimated profit, depending on the tax regime applicable

to the taxpayer. Under the amended Laws on Investment and on Taxation, which were

adopted in March 2003, the tax on profits is 20% for all taxpayers, excluding certain

natural-resource-development projects, but including all qualified investment projects

(QIPs: those registered with the CDC). Only pre-existing QIPs that have already been

granted a 9% rate will be eligible for the reduced rate for a transitional period ending

in 2008. QIPs granted a profit tax exemption would receive a maximum tax holiday of

up to 6 years plus a trigger period, resulting in the possibility of an exemption from

profit tax for up to 9 years.

Taxpayers are required to make a prepayment of profit tax on

a monthly basis, equivalent to 1% of monthly turnover. However, QIPs registered

with the CDC are exempted during the profit tax exemption period. There is also a

minimum tax for real regime taxpayers, equivalent to 1% of annual turnover, but QIPs

registered with the CDC are exempted from it.

Additional tax on dividend distribution

A new tax that affects investment companies and QIPs was

introduced with the Law on Amendment to the Law on Taxation. Companies that

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enjoy a tax rate of either 0% or 9% are subject to an additional tax on profits that have

not been taxed at 20%, upon the distribution of dividends. The additional tax moves

the effective tax-on-profit rate up to 20%.

Salary tax

Salary payments to an employee in Cambodia give rise to the

salary tax. There is a distinction between residents and non-residents in relation to the

calculation of the salary tax. Residents are taxable on their worldwide salary income,

irrespective of where paid, whereas non-residents are subject to salary tax only on

Cambodian-source salaries.

Employers are required to pay a fringe benefits tax on

benefits provided to employees. The rate of the tax is 20% of the market value of the

benefit, inclusive of all taxes. (UNCTAD-ICC).

Withholding tax

A series of withholding taxes were introduced by the 1997

Law on Taxation. Withholding taxes are the responsibility of the payer and are

applicable to the following payments to residents of Cambodia:

• 15% on payments made to individuals for the provision

of services (this covers most services, including

commission, brokerage, transportation, repair,

construction, management, consultancy and professions);

• 15% on the payment of royalties for intangibles, interest

in minerals and interest (except interest paid to domestic

banks or savings institutions);

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• 10% on the rental of movable or immovable property;

• 6% on interest paid by a domestic bank or savings

institution to a resident taxpayer having a fixed-term

deposit account;

• 4% on the interest paid by a local bank to a resident

taxpayer with a non-fixed-term savings account.

No withholding tax is levied on payments of tax exempt

income, which may include payments to non-profit organizations approved by the

Ministry of Economy and Finance. There is also a withholding tax of 14% on the

following payments to non-residents:

• Interest;

• Royalties, rent and other income connected with the use

of property;

• Compensation for management or technical services; and

• Dividends.

Indirect tax

Import and excise duties and the value-added tax (VAT) are

the most important indirect taxes in Cambodia. Import duties come in four bands: 0%,

7%, 15% and 35%. Export duties are levied on only a limited number of items, such

as timber and certain animal products (including most seafood). Excise duty is called

“tax on specific goods and services”, and applies to a wide range of imported or

domestically produced goods and services, including petroleum products, tobacco

products, beer, soft drinks, vehicles and entertainment.

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Value-added tax

VAT was introduced on 1 January, 1999. It is chargeable on

a wide range of goods and services supplied in Cambodia and on the import of goods.

The basic principle of VAT is to tax each stage of production, allowing each supplier

credit for the tax paid, so that the ultimate impact is on the final consumer. Taxable

items attract VAT either at the standard rate of 10% or at the zero rates. Zero-rating

applies to the export of goods and services, and certain charges related to international

transport. On imports, VAT is payable at 10% of the value of the import, including

any customs duty, insurance and freight charges.

4) Currency and foreign exchange

Cambodia is primarily a cash based economy with checks and credit

cards only infrequently accepted commercially. The national currency of Cambodia is

the Cambodian Riel which has remained fairly stable since the 1998 at about 3,900

per U.S Dollar.

In spite of a 1992 Sub-Decree prohibiting transactions denominated

in foreign currencies, the U.S Dollar remains in common circulation and is freely

traded throughout the country.

There are currently no restrictions on the repatriation of profits or

capital derived from investments made in Cambodia or on most transfers of funds

abroad. The 1994 Investment Law guarantees that investors may freely remit foreign

currencies abroad for the purpose of:

• Payment for imports and repayment of principal and interest on

international loans;

• Payment of royalties and management fees;

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• Remittance of profits; and

• Repatriation of invested capital on dissolution of an investment

project.

Under the Foreign Exchange Law of 1997, foreign currencies may be

freely purchased through the banking system. The law specifically states that there

shall be no restrictions on foreign exchange operations, specifically including the

purchase and sale of foreign exchange, transfers and all types of international

settlements. However, the Law does require reporting to the National Bank of

Cambodia transactions is excess of US$ 10,000. There is no requirement that the

investor sending or receiving the funds make a report on the transaction. The burden

rests solely on the bank as the authorized intermediary.

It is important to note that while foreign exchange transfers are not

currently restricted; the law does allow National Bank to implement exchange

controls in a foreign exchange crisis.

5) Culture

Cambodia is a largely homogeneous nation with a Khmer majority of

about 90% and small ethnic minorities of Chinese, Cham and others. About 90% of

the population is Buddhism is recognized by the Constitution as the national religion.

Followers of other religions, mainly Islam and Christianity, are allowed to practice

their faiths without restriction.

Cambodia’s border is bordering to Thailand and Loa in the west and the north,

and Vietnam the east and south. Cambodia has culture closeness with Thailand.