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1. I submit for your approval the following report and recommendation on (i) a proposed loan, and (ii) a proposed grant, both to the Kingdom of Cambodia for subprogram 2 of the

Promoting Economic Diversification Program (PED-SP2); and (iii) a proposed grant for capacity development for the Competition, Regulatory Efficiency, and Small and Medium-Sized

Enterprise Technology (CREST) Project. The design and monitoring framework is in Appendix1.

2. PED-SP2 will support the government's key reform priorities aimed at diversifying the sources of economic growth, supported by increased contribution of the private sector. The

reform priorities include efforts to enhance governance in the business climate by promoting competition policy and regulatory efficiency. PED-SP2 also aims to increase private sector

competitiveness through innovation and enhanced trade facilitation measures. The Development Policy Letter is in Appendix 3 and the Policy Matrix is in Appendix 4.

3. Reforms to the business climate implemented under the National Strategic Development Plan 2006 2010 (NSDP) and sector strategies have helped Cambodia move up 15 places in the World Bank Group's Doing Business global rankings since 2006.1 Despite this progress, much needs to be done to attract investment and generate better jobs for a rapidly expanding labor force. As Cambodia's economy advances, new policy and structural challenges for the private sector need to be addressed. These include emerging competition policy issues in key sectors, the high business compliance costs of regulations (estimated at 3%-5% of gross domestic product), low levels of innovative activity in the private sector, and the relatively high cost in trade facilitation. Food safety is poor in Cambodia and this is a barrier to private sector growth and international trade in processed food products, which has huge growth potential. It is also a major risk to the human population and lowers productivity. With over 60,000 enterprises engaged in the food sector, reforming sanitary and phytosanitary standards (SPS) management systems is a critical part of the government's economic diversification strategy.

4. The PED cluster approved by the Board of Directors of the Asian Development Bank (ADB) in December 2008 comprises three subprograms from 2008 to 2012. 3 Under subprogram 1 (PED-SP1), financed by ADB ($19 million) in 2008, the government implemented a series of investment and trade facilitation measures that laid the foundations for a more competitive and diversified economy in the longer term. It also included the first SPS capacity development project (SPS-1 project) financed by ADB ($2 million). The current phase, PEDSP2, builds on progress made under PED-SP1 for investment climate, trade policy, and trade facilitation. It also responds to new policy challenges arising from the impact of the global financial crisis such as the need for competition policy, regulatory efficiency, and innovation to promote private sector competitiveness. These reforms are designed to promote economic diversification by (i) enhancing competition in domestic markets and lower cost regulation, (ii) strengthening investor confidence in the regulatory environment and promoting marketbased innovation, and (iii) strengthening trade facilitation measures along the entire supply chain. ADB technical assistance has been targeted to support the government accomplish the policy triggers under PED-SP2.4 The final phase, PED-SP3, is expected to be completed at the end of 2012. PED-SP3 includes 10 policy triggers building on progress made under PED-SP2.

5. PED-SP2 has several features that draw on best international practice for a comprehensive trade and investment program. These include (i) supply-side incentives through

improving trade policy and taxation related to international norms, (ii) capacity development assistance to address constraints of SPS service providers to small and medium-sized

enterprises (SMEs), (iii) addressing SMEs' demand-side issues through a pilot SPS technology matching grants component, (iv) addressing issues of sustainability of reforms by establishing a permanent government body to oversee regulatory reforms, and (v) assisting Cambodia's global and regional integration efforts via support for Cambodia's World Trade Organization's trade policy review (TPR) and its participation in the Association of Southeast Asian Nations (ASEAN) regional trade agreements and ASEAN commitments to develop competition policy and law.