MINES & MINDS LEVERAGING NATURAL WEALTH TO INVEST IN PEOPLE AND INSTITUTIONS MONGOLIA COUNTRY ECONOMIC MEMORANDUM SEPTEMBER 2020 1 2 COUNTRY ECONOMIC MEMORANDUM 2020 MINES & MINDS LEVERAGING NATURAL WEALTH TO INVEST IN PEOPLE AND INSTITUTIONS MONGOLIA COUNTRY ECONOMIC MEMORANDUM SEPTEMBER 2020 i © 2020 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org This work is a product of the staff of the World Bank. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Nothing herein shall constitute or be considered to be a limitation upon or waiver of the privileges and immunities of The World Bank, all of which are specifically reserved. ii COUNTRY ECONOMIC MEMORANDUM 2020 TABLE OF CONTENTS ACKNOWLEDGMENTS vi ABBREVIATIONS vii I. OVERVIEW 1 I.1 Prosper now, stagnate later? 2 I.2 An organizing framework 9 I.3 Three pillars: stability, productivity, and diversity (of endowments) 10 II. SEEKING STABILITY 15 II.1 Volatility is the norm not the exception 16 II.2 Macroeconomic policies amplify rather than dampen volatility 19 II.3 Policy priorities - Escaping from the procyclicality trap 23 III. BOOSTING PRODUCTIVITY GROWTH 33 III.1 An environment marked by weak productivity growth and declining innovation 34 III.2 Constraints to productivity growth 40 III.3 Policy priorities - Addressing constraints to lift productivity growth 44 IV. EXPANDING ENDOWMENTS 47 IV.1 Mongolia over relies on mines and underutilizes its minds 48 IV.2 Explaining Mongolia’s limited progress in expanding its endowments 51 IV.3 Policy priorities - Escaping the natural capital overreliance trap 57 Annex 1. The conceptual framework 68 References 70 BOXES Box 2.1 Cost of macroeconomic volatility 16 Box 2.2 Peru’s fiscal rules - Lessons for Mongolia 24 Box 2.3 International practices suggest independence is a key condition 27 Box 2.4 Sovereign wealth funds as effective instruments 28 Box 2.5 Model simulation of partial saving rule of mining revenue 29 Box 2.6 Independence and governance of the central bank 32 Box 3.1 Factors leading to innovation in Mongolian firms 38 Box 3.2 Innovations of large firms 46 Box 4.1 Mongolia’s comparative advantage 50 Box 4.2 OECD and World Economic Forum directives to improve learning and competencies 59 Box 4.3 Gender Responsive Budgeting and female labor participation 60 Box 4.4 Mongolia can learn from the Malaysian experience of attracting talent 61 Box 4.5 Industrial policy - Pros and cons 64 Box 4.6 Meat exports offer significant potential 66 iii FIGURES Figure 1.1 Rising importance of extractives in Mongolia’s economy 4 Figure 1.2 Mongolia’s resource rents have increased in recent years and exceed its peers 4 Figure 1.3 The positive side of Mongolia’s mining-led development 4 Figure 1.4 Mongolia has underperformed all its peers in the use of human capital… 6 Figure 1.5 …and its institutional quality has deteriorated in recent decades 6 Figure 1.6 Out of every dollar of mineral output, Mongolia has consumed 99 cents and saved one cent 6 Figure 1.7 How mineral revenues were spent (% of GDP), 1998–2019 7 Figure 1.8 Gross contributions to the Stabilization Fund and Future Heritage Funds have significantly increased in recent years (% of GDP)… 8 Figure 1.9 …while at the same time government debt level has steadily declined 8 Figure 1.10 Coal consumption is expected to fall significantly in China and OECD countries 8 Figure 1.11 China’s clean energy transition will adversely affect Mongolia 8 Figure 1.12 The impact of COVID-19 is like past economic crises 9 Figure 1.13 The organizing framework for the report 10 Figure 1.14 Even among the commodity exporters, Mongolia’s macro variables exhibit one of the highest volatilities 11 Figure 1.15 Labor has flown to lower-productivity non-tradable services… 12 Figure 1.16 …reducing the contribution of structural transformation to productivity growth 12 Figure 2.1 Mongolia’s output growth is elevated relative to many peers… 17 Figure 2.2 …its consumption growth is even more volatile 17 Figure 2.3 Surprisingly, non-mining sectors are more volatile than the mining sector 17 Figure 2.4 Output volatility increased after major mining discovery 18 Figure 2.5 Consumption has also become increasingly volatile 18 Figure 2.6 Financial sector is strongly correlated with volatile growth during mining boom, 2004-19 19 Figure 2.7 Commodity prices are associated with bank profitability 19 Figure 2.8 External and policy shocks explain most output variance in Mongolia 19 Figure 2.9 Mongolia’s resource rents exceed peers (% of GDP) 20 Figure 2.10 Mongolia’s growth volatility is strongly associated with commodity prices volatility… 20 Figure 2.11 …Mongolia’s consumption growth is also positively linked with commodity price volatility 20 Figure 2.12 Evidence points to the procyclicality of macroeconomic policies 21 Figure 2.13 Policy amplifies volatility during booms and busts… 22 Figure 2.14 …Policy and external shocks are positively correlated during booms and busts 22 Figure 2.15 Total public debt 30 Figure 2.16 Assets in FSF 30 Figure 3.1 Mongolia’s GDP growth has relied on factor accumulation, not productivity… 35 Figure 3.2 ...while remaining below the global productivity frontier 35 Figure 3.3 Labor productivity has risen 35 Figure 3.4 Even in the mining sector, labor productivity is lower than in peer countries 35 Figure 3.5 Labor productivity in manufacturing remains low 35 Figure 3.6 Labor productivity in services is also low 35 iv COUNTRY ECONOMIC MEMORANDUM 2020 Figure 3.7 Capital is concentrated in the mining sector 36 Figure 3.8 FDI is also concentrated in the mining sector 36 Figure 3.9 Labor has moved to lower-productivity non-tradable services… 37 Figure 3.10 …reducing the contribution of structural transformation to productivity growth 37 Figure 3.11 Mongolian firms innovate less today than 10 years ago… 38 Figure 3.12 …and are not as creative as they used to be 38 Figure 3.13 Firms have become more inward looking… 38 Figure 3.14 …with limited technology diffusion 38 Figure 3.15 R&D expenditures as a percentage of GDP 40 Figure 3.16 Real exchange rate appreciates during boom periods 40 Figure 3.17 Rapid wage growth… 41 Figure 3.18 …has exceeded productivity growth and eroded competitiveness 41 Figure 3.19 Mongolia has one of the largest public sectors 41 Figure 3.20 While Mongolia has made progress in improving aspects of its business climate… 42 Figure 3.21 …the regulatory burden on firms remains high 42 Figure 3.22 Competition framework is weak… 43 Figure 3.23 …and there are high levels of ownership concentration in key sectors 43 Figure 3.24 Firms face financing constraints 43 Figure 4.1 General government capital stock per worker deteriorated… 48 Figure 4.2 …while private capital stock per worker improved 48 Figure 4.3 Mongolia has underperformed all its peers in the use of human capital… 49 Figure 4.4 …and its social capital endowment has deteriorated 49 Figure 4.5 Asset diversification can facilitate product diversification 50 Figure 4.6 Mongolia lags its peers in asset and product diversity 50 Figure 4.7 Natural resources in Mongolia are depleting faster than in other countries 52 Figure 4.8 China’s clean energy transition will adversely affect Mongolia 52 Figure 4.9 Unlike Kazakhstan, Mongolia exhibited a limited return to education – high tertiary education and high youth employment 53 Figure 4.10 Mongolia’s youth tend to choose fields where employability is lower 53 Figure 4.11 The perceptions of capacity to attract and retain talent, 2019 53 Figure 4.12 Gross outflows of Mongolians into OECD countries 53 Figure 4.13 Migrant Mongolians are mostly highly educated 54 Figure 4.14 Mongolia’s female labor force participation is among the lowest in the EAP and other peers... 54 Figure 4.15 …it has consistently declined since 2012 54 Figure 4.16 Government capital stock has been plagued by inefficiency 55 Figure 4.17 Poor government spending efficiency is linked to weak control of corruption 55 Figure 4.18 Poor corruption control is associated with higher mineral rents 56 Figure 4.19 Weak rule of law is associated with higher mineral rents 56 Figure 4.20 Mongolia’s strong position among its peers as the sole unfettered democracy 57 TABLES Table 1.1 Mines and Minds: Policy Recommendations 14 Table 3.1 Marginal effects of logit regression – Random effects model 39 v ACKNOWLEDGMENTS The Country Economic Memorandum, Mines and Minds, was prepared by a team led by Jean-Pascal Nganou (Senior Economist) and included Sebastian Eckardt (Lead Economist), Luan Zhao (Senior Economist), Davaadalai Batsuuri (Economist), Undral Batmunkh (Research Analyst), and Katia D’Hulster (Lead Financial Sector Specialist). Substantial contributions were received from James Cust (Economist), Jigjidmaa Dugeree (Senior Private Sector Specialist), Badamchimeg Dondog (Public Sector Specialist), Fang Guo (Economist), and Bradley Robert Larson (Research Analyst). Deepak Mishra (Practice Manager) drafted parts of the report and provided overall guidance. The team is also thankful to Vinod Ahuja (Head of Office, FAO) for his helpful comments on the meat and cashmere value chains, and to Bernard Aritua (Sr. Infrastructure Specialist), Calvin Djiofack (Senior Economist), lavena Georgieva (Consultant), Ganbaatar Jambal (Consultant), Peter Johansen (Senior Energy Specialist), Deborah Mikesell (Senior Education Specialist) and Ikuko Uochi (Economist), and for their inputs. The team is also grateful to Glenn-Marie Lange (Senior Environment Specialist) for providing the Changing of Wealth of Nations (CWON) database to the team. The team would like to thank Aaditya Mattoo (Chief Economist), Irina Astrakhan (Practice Manager), Alma Kanani (Practice Manager), Rinku Murgai (Practice Manager), Ulle Lohmus (Senior Financial Sector Specialist), Carolina Vaira (Senior Governance Specialist), Bryan Christopher Land (Lead Mining Specialist), and Thorvaldur Gylfason (Professor, Iceland) for their helpful comments and suggestions including participating in several brainstorming sessions. The team appreciates the constructive comments received from peer reviewers Birgit Hansl (Country Manager), Gan-Ochir Doojav (Chief Economist, BoM), Rick Van der Ploeg (Professor, Oxford), and Rabah Arezki (Chief Economist). Inputs and background papers were received from Pierre-Richard Agénor (Professor, Manchester), Dominique van der Mensbrugghe (Director, GTAP Purdue), Supriyo De (Senior Economist), Baris Alpaslan (Associate Professor, Ankara), Hong Song Chang (Professor, KDI), Kenneth Amaeshi (Professor, Edinburgh), Hugo Alexander Rojas Romagosa (ETC), Hasan Dudu (Economist), Boldbaatar Dagva (Senior economist, BoM), Davaajargal Luvsannyam (Division Head, BoM), Li Yusha (Consultant), and Altan-Ulzii Chuluun (Consultant). The report was prepared under the overall direction of Martin Raiser (Country Director), Hassan Zaman (Regional Director), and Andrei Mikhnev (Country Manager). The team is grateful to Indra Baatarkhuu (External Affairs Officer) for her advice on the dissemination of the report, and to Diane Stamm (Consultant) for editing the report. Angar Enkhtur (Program Assistant) provided outstanding operational support. vi COUNTRY ECONOMIC MEMORANDUM 2020 MONGOLIA - GOVERNMENT FISCAL YEAR January 1 - December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of September 6, 2020) Currency Unit = Tugrug (MNT) US$1.00 = MNT 2,853.40 ABBREVIATIONS BoM Bank of Mongolia CGE Computable General Equilibrium DGE Dynamic General Equilibrium EITI Extractive Industries Transparency Initiative EIU Economist Intelligence Unit FDI Foreign Direct Investment FHF Future Heritage Fund FSC Fiscal Stability Council FSF Fiscal Stabilization Fund FX Foreign exchange GDP Gross Domestic Product GNI Gross National Income GRB Gender Responsive Budgeting ILO International Labour Organization IMF International Monetary Fund IT Information Technology MLSP Ministry of Labor and Social Protection MoES Ministry of Education and Science MoF Ministry of Finance MoFA Ministry of Foreign Affairs MoMHI Ministry of Mining and Heavy Industry MTFF Medium-Term Fiscal Framework NDA National Development Agency NFPS Nonfinancial Public Sector NSO National Statistics Office OECD Organization for Economic Cooperation and Development vii PPF Production Possibility Frontier PPP Purchasing Power Parity R&D Research and Development RP-T Residence Pass-Talent SIRM Systemic Investor Response Mechanism SME Small and Medium Enterprises SOE State-Owned Enterprises STEM Science, Technology, Engineering, and Math SWFs Sovereign Wealth Funds TalentCorp Corporation Malaysia Berhad TFP Total Factor Productivity WDI World Development Indicators WEF World Economic Forum WGI Worldwide Governance Indicators viii COUNTRY ECONOMIC MEMORANDUM 2020 I. OVERVIEW OVERVIEW 1 I. OVERVIEW Mines represent Mongolia’s present, while minds - broadly defined to include people and institutions - are its future. Current policies are excessively focused on preserving the mining-driven prosperity at the risk of future stagnation. Such complacency is ill-timed when climate change concerns and the COVID-19 shock require an acceleration of structural transformation. Mongolia faces deep-rooted, interrelated challenges: macroeconomic policy mistakes have amplified external shocks, an oligopolistic ownership structure and limited competition have led firms to become more inward-looking and less inclined to innovate, and gross underutilization of human capital - evident by an unprecedented exodus of young and educated workers to foreign countries - has eroded the foundation of a diversified economy. Breaking this gridlock calls for a shift in approach that weighs the well-being of future generations as much as the welfare of the current one - the Golden Rule that Phelps (1961) has long advocated. Specifically, macroeconomic policies should aim to smooth consumption over the business cycle and mitigate the corrosive impacts of the resource curse (World Bank 2014). Second, microeconomic reforms should focus on enhancing competition, securing investor rights, and lowering the barriers to entry. Third, the country needs to diversify its endowments, and especially better utilize its skilled and female workers. Finally, there is an urgent need to reduce political interference, increase transparency, and improve regulatory quality throughout the economy. I.1 Prosper now, stagnate later? Unintentionally, Mongolia’s current prosperity is being built at the expense of its future stagnation. This is evident in the fact that the country has become increasingly reliant on mining-led growth, while at the same time, saving a measly one cent out of each dollar of its mineral output. It is seen in the dramatic rise in the country’s indebtedness and steadily falling saving rate, signaling a premium put on the present times. It is apparent in the rise of an oligopolistic ownership structure in key industries that is chipping away the country’s long-term competitiveness. It is visible in the growing exodus of skilled human capital and the falling female labor force participation rate, diminishing the prospects of diversified development. It is observed in the gradual weakening of the country’s institutions, where autonomy, transparency, and accountability are being sacrificed at the altar of preserving the status quo. There is a great temptation to focus on the near term, given the significant and immediate benefits of mining-led growth. It is commendable that since the advent of large-scale mining in 2004, Mongolia’s economy has grown at an average rate of 7.2 percent per year, making it one of the fastest-growing economies in the world. Growth has translated to sustained poverty reduction without a significant increase in income inequality. Quality of life has improved, with Mongolia compared favorably with its peers in terms of the stock of human and physical capital. All these factors have been made possible by significant mineral revenues and a high level of external borrowing, providing the means to support a generous (but inefficient) social assistance system and a large public investment program. 2 COUNTRY ECONOMIC MEMORANDUM 2020 In the shadow of success have grown many of Mongolia’s enduring challenges, further exacerbated by climate change and the COVID-19 pandemic. Mongolia’s rapid growth has been obscured by its extreme macroeconomic volatility and frequent boom and bust cycles. Growth has almost entirely come through capital accumulation and the intensive use of natural capital rather than through sustained productivity growth. Elimination of extreme poverty owes more to the generous social transfer system than to the creation of abundant well-paying jobs. Instead of using mineral wealth to gradually reduce its dependence on the sector, Mongolia has increasingly become more addicted to it. Such complacency is ill-timed as demand for key minerals is likely to tumble due to climate change concerns, a shift of investors’ preference toward sustainability, China’s ambitious goal to reduce coal consumption, and persistence of the COVID-19 shock. Without a fundamental shift in approach that puts minds on an equal footing with mines, Mongolia risks resembling a resource curse economy in a few years. Mongolia must get more out of mining, as well as livestock, cashmere, and tourism. But to build the foundation of a diversified, high-income economy, it needs to do more. First, it should implement countercyclical fiscal and monetary policies - supported through transparent fiscal rules, an independent fiscal council, a market-driven exchange rate, and a well-functioning stabilization fund to smooth consumption over the business cycle rather than maximize current consumption. Second, the investment climate needs to be radically improved to enhance competition, secure investor rights, and create a more level playing field that enables productive firms to invest and grow. Third, the country needs to move away from the mindset of diversifying products to expanding endowments, especially better utilization of its young and educated, especially female, labor force. And finally, there is an urgent need to implement fundamental governance reforms to reduce political interference, increase transparency, and improve regulatory quality throughout the economy. Fortunately, there are many encouraging signs of improved macroeconomic management in recent years, providing the newly elected government an opportunity to further strengthen its reform credentials. There appears to be an unprecedented shift in the fiscal management of the country since 2017. For example, the fiscal balance has been in surplus in two of the last three years, the public debt- to-GDP ratio has declined for three consecutive years, and more than 2.5 percent of GDP have been annually transferred to the Stabilization and Future Heritage Funds for the last three years - remarkable achievements given Mongolia’s checkered history of macroeconomic management. Interestingly, these impressive fiscal outcomes were achieved not by introducing new reforms but by effectively implementing the existing ones. They demonstrate that with the right political will and leadership, similar improvements are possible in other areas including monetary and exchange rate policy, the financial sector, the business environment, and the labor market. But rather than relying on reforms through an individual leader, which are susceptible to reversal when the leader leaves office, the new administration has an opportunity to institutionalize these reforms and avoid policy regression in the future. OVERVIEW 3 I.1.1   Mining has served Mongolia well, in the near-term… Mining has always been an important part of Mongolia’s economy, and this I.1.1  Mining    has served Mongolia well, in the near‐term…  dependence has intensified in recent decades. Following the discovery of major new   mineral resources (coal I.1.1  Mining  hasdeposits  served Mongolia and gold-copper  well, in the near ore) ‐term… in  the early 2000s, the economic Mining   significance has   always   been   an   important   part   of   Mongolia’s   economy,   and  this  dependence  has    of the mining sector has increased, surpassing that of the traditional livestock intensified sector. 1   in  recent Today, Mining  has mining   decades.   always accounts   Following   been  an  important for nearly   the   discovery   partone-quarter   of  major   of  Mongolia’s  of   new   and GDP, economy, mineral up from   this   resources one-tenth   dependence    has (coal in   deposits 2000.  and Foreign  gold intensified ‐copper direct  ore) investment   in  recent in the early    decades. (FDI)  2000s,   Following inflows   the the    discovery economic are mainly  significance   of   major   new  concentrated  of  the mining mineral in the   resources  sector mining  has   (coal     increased, sector,  surpassing deposits whose share and  that gold has  of ‐  the  traditional copper gone ore)up  the early  infrom  livestock 44  2000s, percent sector. of  Today, 1  the economic  mining total significance FDI  accounts in 2000  of theto for nearly  73  mining  sector  has percent one ‐  in quarter   of   GDP, 2019. Mineral exports represent around 90 percent of total exports and 26 percent of  increased,   up     from surpassing   one   ‐ thattenth  of  the  in     2000. traditional   Foreign  livestock   direct  sector.   investment  Today,  mining   (FDI)     inflows accounts  for    are nearly   mainly  one ‐ 1 concentrated fiscal revenuequarter   of  mining GDP,   the  in(figures up 1.1   from and  one  sector,  whose 1.2). ‐tenth 2  share  in  2000. has   Foreign gone up   direct  from   investment  44 percent  of  total   (FDI) inflows  FDI  in  2000   are mainly      to 73 percentconcentrated  in 2019. Mineral  in the  mining exports  sector,  represent whose  share has  around  90 gone  up from  percent  of  total 44 percent  exports  of total  and   FDI 26  in  2000 to percent      of 73  percent   in  2019.   Mineral  exports  represent  around  90  percent  of   total  exports  and  26   percent  of   revenue (figures 1.1 and 1.2).    fiscal 1.1 Figure 2 Figure 1.2 fiscal revenue (figures 1.1 and 1.2).    2 Rising Figureimportance  1.1 Rising  of in of extractives  importance Mongolia’s extractives  in  Mongolia’s Figure resource    1.2  Mongolia’s rents have resource increased  rents  have  in economy Figure Figure 1.1 Rising importance of extractives in  recent 1.2 Mongolia’s years and exceed  resource  rents have  its peers  economy  economy  Mongolia’sMongolia’s increased  in recent increased  years  in recent  and  years  exceed  and exceed  its  peers  its peers    89% 89% 50 % of  GDP 50 % of GDP Growingimportance Growing mining ofmining importance of 2000 2000 73% 73% since 2004 since 2004 40 40 Mongolia 2019 2019 Mongolia Structural peers Structural peers 44% 30 42% 30 Aspirational peers 42% 44% Aspirational peers 24% 26% 20 24% 26% 20 11% 5% 10 11% 5% 10 Mineral Mineral Mineral FDI in mineral 0 sector/GDP exports/Total revenue/Total sector/Total FDI 1990 1994 1992 1996 1994 1998 1996 2000 1998 2000 2002 2004 2006 2008 2008 2010 2010 2012 2012 2014 2014 2016 2018 Mineral Mineral Mineral rxports FDI in mineral revenue 0 sector/GDP exports/Total revenue/Total sector/Total FDI     1990 1992 2002 2004 2006 2016 2018 Sources:  NSO; MoF; BoM; rxports  World Bank staff estimates  revenue Sources: WDI; World Bank staff estimates  Sources: NSO; MoF; BoM; World Bank staff estimates   Sources: WDI; World Bank staff estimates   Sources: NSO; MoF; BoM; World Bank staff estimates  Sources: WDI; World Bank staff estimates  Mining  wealth  has  been  associated  with  rapid   growth,  low  poverty  headcount,  and  a  moderate  level  of  inequality.  Since  the  commencement  of  large‐scale  mining  in  2004,  Mongolia’s  economy  Mining  wealth   has  been   associated   with  rapid   growth,   low   poverty   headcount,   and   a  moderate   Mining wealth has  grown has   atbeen   an  averageassociated   rate  of  7.2 with rapid   percent   per growth,year,  making low povertyit  one  of  the headcount,   fastest‐growing and   level  of  inequality. economies   Since     in inequality.the   commencement the  world.  Extreme   poverty   of   large ‐ scale   has  been  eliminated   mining     andin   2004,   Mongolia’s   inequality  has   economy   not  increased     a moderate level of Since the commencement of large-scale mining in 2004, has  grown   at  an  average dramatically,   although   rate  28    of   7.2   percent percent    according per  year,   making   it   one   of  line the   fastest ‐growing     at anare   poor   to   the percent official poverty   (figure   1.3).   The 3 Mongolia’s economy has grown average rate of 7.2 per year, making it one economies   in  the country   world.  enjoys   Extreme  relatively  strong  poverty  human   has   been   eliminated  the quality  of and   inequality   has  not   increased  given    of the fastest-growing economies in the  world. capital,  and Extreme poverty infrastructure, has been though  scarce eliminated and dramatically, the has not inequality middle   although size   of   the   increased28     percent country   and   are   low dramatically,   poor population  according   although density,   to     isthe 28     official nevertheless percent   poverty   comparable are poor   line   (figure with according     other1.3).  to The lower 3   the     country  enjoys relatively‐income   countries.  strong  human  Many   of   these  capital,   gains  andenjoys   can  the quality  be   traced   to   generous  of infrastructure,   social   assistance  thoughcapital,    scarce givenand   a     official poverty line (figure 1.3). 3 The country relatively strong human and the   size  oflarge thequality  of the    public country infrastructure,   investment   and  low   program, though   population   financed  density,   by  mineral  the   revenues    is  nevertheless and  external  borrowings of the comparable   with  other   (World   lower     Bank  2018a). Yet, as the  analysisscarce  in this report given  shows, size  such  spending country  has oftenand  beenlow  poorly population  targeted  middle‐income density, isand   countries.  Many nevertheless comparable   of  thesewith   gains   can  be other   traced lower   to  generous  social middle-income   assistance  and  a   inefficient, failing  to lay the foundations  for more  diversified  growth.   countries. Many of large   public these gains   investment   program,   financed   can be traced to generous social assistance and a large public investment   by   mineral   revenues   and   external   borrowings   (World  Bank 2018a). program,  Yet, as the financed by  analysis mineral  this report and  inrevenues shows,  such spending external borrowings has often  been poorly Bank  targeted (World 2018a).  and as Yet, inefficient, the  failing to analysis in  lay this  the  foundations report shows,  for  more such  diversified spending  growth. has often   been poorly targeted                                                                and inefficient, 1 Erdenet failing  copper was to lay in  opened  1974foundations the for  and for quite some time more  was diversified  one of the growth.  largest copper mines  in the world. 2 Mongolia’s mining sector concentrates on a few products and export destinations. In fact, coal, copper, and gold made up an average  of 70 percent of total exports over the past five years; and exports to China alone reached over 90 percent of total exports.    While  inequality  indexes  in  Mongolia  have  remained  stable  over  time,  in  recent  years  they  have  increased  in  urban  areas  and  3    each other’s impact (World Bank, 2018a).                                                             decreased in rural areas, offsetting 1 Erdenet copper was opened in 1974 and for quite some time was one of the largest copper mines in the world. 3  2  Mongolia’s mining sector concentrates on a few products and export destinations. In fact, coal, copper, and gold made up an average    of 70 percent of total exports over the past five years; and exports to China alone reached over 90 percent of total exports.  3   While  inequality  indexes  in  Mongolia  have  remained  stable  over  time,  in  recent  years  they  have  increased  in  urban  areas  and  decreased in rural areas, offsetting each other’s impact (World Bank, 2018a). 1 Erdenet copper was opened in 1974 and for quite some time was one of the largest copper mines in the world. 3  2   Mongolia’s mining sector concentrates on a few products and export destinations. In fact, coal, copper, and gold made up an average of 70 percent of total exports over the past five years; and exports to China alone reached over 90 percent of total exports. 3 While inequality indexes in Mongolia have remained stable over time, in recent years they have increased in urban areas and decreased in rural areas, offsetting each other’s impact (World Bank, 2018a). 4 COUNTRY ECONOMIC MEMORANDUM 2020 Figure 1.3   The positive side of Mongolia’s mining-led development Figure 1.3 The positive side of Mongolia’s mining‐led development  Rapid growth  Relatively low poverty headcount  Moderate inequality  12 60 160 $3.20 a day (2011 PPP)  50 Economic growth (y/y): 2004‐19 140 Poverty headcount ratio (% of  10 120 Gini index: 2018 40 8 100 population) Mongolia 30 6 80 20 60 Mongolia 4 40 10 2 20 0 Malaysia Armenia Mongolia Kazakhstan Peru Chile UAE Australia Canada Colombia Russia Ecuador 0 0 0 10,000 20,000 0 10,000 20,000 ‐2 GDP per capita: 2018 GDP per capita: 2018 Sources: NSO; WDI; World Bank staff estimates  Sources: NSO; WDI; World Bank staff estimates I.1.2  …but has weakened the prospect of a diversified economy    I.1.2 The focus…but  on has weakened preserving  miningthe ‐drivenprospect prosperity of hasa diversified  come at theeconomy  expense of underutilization of  other  factors   of production.  Mongolia The focus on preserving mining-driven prosperity has come  ranked  51st  globally  in  the  Human  Capitalat  Index, the expense  higher than of  its income level ranking underutilization of other  (92nd),  largely of factors due  to its high educational production. Mongolia  attainment ranked  (World 51st globally  Bank, 2018b). in the   This implies Human Capital  Mongolia’s  thatIndex, higher  peoplethan  have its  theincome health,  skills, level  knowledge, ranking  and resilience (92nd), largely due  – theirto  its human high   capital  –  to  become educational attainment   more   productive, (World Bank   flexible, 2018b).   innovative.   andThis implies   Alas,   Mongolia that Mongolia’s   does  not   make people   full  have use   of   this  capital,  as  evidenced  by  the  country’s the skills, health, knowledge, and resilience - their human capital - to become more  status   as  an  outlier  among  its  peers   when  it  comes   to  utilization productive,   of  human flexible, and  capital   wealth Alas, innovative. in  its  Mongolia production does process not   (figure make full     1.4). 4 At  the use of  this same   time,  capital, asMongolia’s evidenced   performance by the country’s status  as   on  institutional (for  example, capital an  outlier among   corruption its peers   control when  and   rule  ofto it comes   law)the  has   deteriorated   in   recent   decades.   It   has   substantially utilization of human capital wealth in its production process (figure 1.4). At the same   underperformed   vis ‐ à ‐ vis   all4  its   aspirational   time, peers, Mongolia’s   as  its  growth performance   process  remains on   widelyinstitutional   dominated capital (for example,   by  exploitation   of  natural corruption   capital  control (figure  and rule of law) has deteriorated in recent decades. It has substantially underperformed 1.5). 5,6   vis-à-vis   all its aspirational peers, as its growth process remains widely dominated by the exploitation of natural capital (figure 1.5).5,6                                                                          4 Human capital wealth is defined as the present value of future earnings for the labor force in The Changing Wealth of Nations (World  Bank, 2018c).  5 Strikingly, Mongolia’s natural capital accounted for 63 percent of its total wealth in 2014, the highest among its resource‐dependent  peers. However, a significant portion consists of non‐renewable natural capital, as Mongolia focused mostly on non‐renewables in the  past  two  decades.  This  dramatic  expansion  of  non‐renewable  natural  capital  has  led  to  an  increase  of  the  natural  capital  rents  that  account for about 30 percent of GDP in recent years, up from 7 percent of GDP in 1990.  4 Human 6  capital of The buildup  socialis wealth defined  capital as  is an the present  important value  driver of  of  future earnings economic  growth, for just the labor  as is the force in The Changing accumulation  capital,of  of humanWealth Nations  physical (World  capital,  Bank, and 2018c).   natural  capital.  While   the   buildup   and  use  of   physical   capital  boosts   growth   directly,  human   capital,   social  capital,   and  natural   5 Strikingly, Mongolia’s natural capital accounted for 63 percent of its total wealth in 2014, the highest among its resource-dependent capital, if judiciously managed, encourage growth indirectly by underpinning efficiency and technology.  peers. However, a significant portion consists of non-renewable natural capital, as Mongolia focused mostly on non-renewables in the past two decades. This dramatic expansion of non-renewable natural capital has led to an increase of the natural capital rents that 4    account for about 30 percent of GDP in recent years, up from 7 percent of GDP in 1990. 6 The buildup of social capital is an important driver of economic growth, just as is the accumulation of human capital, physical capital, and natural capital. While the buildup and use of physical capital boosts growth directly, human capital, social capital, and natural capital, if judiciously managed, encourage growth indirectly by underpinning efficiency and technology. OVERVIEW 5 Figure 1.4 Figure 1.5     Mongolia has underperformed all its peers in the use …and its institutional quality has deteriorated of human capital… Figure 1.4  Mongolia has Figure 1.4  underperformed  Mongolia  all its   has underperformedFigure in  all its recent  1.5  …and  decades its institutional Figure  quality  1.5 …and its  has   quality has   institutional peers peers in the use  in the use  of human  of human  capital…    capital…  deteriorated deteriorated in  in recent  recent decades    decades    70% 70% 70% 70% 2014 2014 2000 2010 2014 2000 2010 2014 2010 2000 2010 2000 60% 60% 60% 60% 1995 1995 Figure 1.4 Mongolia has underperformed all its   …andMONGOLIA Figure 1.52005  its institutional  quality has  1995 MONGOLIA 1995 MONGOLIA 2005 2005 MONGOLIA 2005 Natural capital (Mines)a Natural capital (Mines)a Natural capital (Mines)a Natural capital (Mines)a 50% 50% 50% 50% peers in the use of human capital…  deteriorated in recent decades  40% 40% KazakshtanKazakshtan 40% 40% Kazakshtan Kazakshtan Qatar Qatar 70% Peru Peru 70% 2014 30% 2000 201030% UAE UAE 30% Peru 30% Armenia Peru2000 UAE UAE Qatar2014 Ecuador Ecuador 2010 Armenia Qatar 60% Chile1995 Chile MONGOLIA Chile Chile 60% Russia 20% 1995 Russia 20% Armenia Russia Armenia 20% Ecuador 20% Ecuador Russia Australia Australia 2005 Malaysia Malaysia MONGOLIA 2005 Natural capital (Mines)a Natural capital (Mines)a 50% Colombia Malaysia Colombia Malaysia 10% 10% Australia Colombia Australia Colombia 10% 50% 10% Canada Canada Canada Canada 40% 0% 0% Kazakshtan 0% Kazakshtan 0% 40% Qatar 0% 20%60% Peru 40%80% 20% 60% 0% 100% 40% 80% ‐0.5 ‐1.5 0.5 ‐0.5 1.5 0.5 2.5 1.5100% ‐1.5 2.5 Peru UAE 30% UAE  (Minds) Human capital Ecuador Human a  capital (Minds)a 30% Quality of InstitutionsQuality Armenia  of  (Minds)b  Institutions (Minds)b Qatar Chile     Chile     20% Russia Armenia Ecuador Russia Sources: Sources:  WorldBank World  Bank  (2018c); Sources:  WDI;  World (2018c);  World  WDI; Bank  Bank  (2018c); World   staff  WDI; Bank World    staff Malaysia  Bank staff Sources:    World Sources:20% Sources:  Bank  (2018c); World  World  WDI; Bank  Bank World  (2018c); (2018c);  BankWDI;  WDI;  staff World Bank    World  staff Australia Bank   staff calculations  calculations calculations  Australia calculations   calculations calculations  Colombia Malaysia 10% Colombia 10% Note: Note:  Note: a. Measured a. Measured Note: as a  as a  Note: share  share  a.  of total  Measured of total  as  wealth wealth a share    of Canada total wealth Note: b.  Quality Note: Note:  of b. of  institutions  b. Quality  institutions Quality of institutions is  the  average  score  is the is the  of  average Rule of   score average Canada score of of Rule Rule of  0% Law and of Law  Corruption Law and  and  Control  in the WGI  Corruption Corruption    Control Control  in in the the  WGI WGI  0% 0% 20% 40% 60% 80% 100% ‐1.5 ‐0.5 0.5 1.5 2.5 Mongolia  has   not  only Mongolia   consumed   has Human   not capital   only   consumed   almost  (Minds) a   all  its   almost   mineral   all   its  mineral   outputs,   but   outputs,   has   also Quality   of but   borrowed   has  also  Institutions   heavily  (Minds)   borrowed b     heavily       against them,  bequeathing against  negative wealth  them, bequeathing  negative  to the  wealth  next generation.  to the next Out  of every  Out generation. dollar  of of every mineral  dollar    of mineral Mongolia Sources: World wealth  that  hashas  Bank not wealth (2018c);   been   that only  WDI; World   generated   has  been consumed  Bank staff    during   generated   the  past almost   during the  past   20  years, all Sources:   Mongolia its  World   20  years, mineral  Bank (2018c);   has   Mongolia   consumed outputs,  WDI; World Bank   has   99  consumed   cents  and but  staff   99 has       cents  and  also calculations  calculations  borrowed saved   one heavily   cent saved   (figure   one against     Note: Note: a. Measured as a share of total wealth  1.6) cent    them, (through (figure   1.6)   bequeathing its  (through   Stabilization   its     and Stabilization negative   Future    wealth Heritage and   Future Note: b. Quality of institutions is the average score     to Funds). Heritage the   Since  next   the Funds). generation.      Since of Rule    the of    of every Outrealization dollar  sustained mineral  ofrealization of mineral of sustained  revenues wealth  mineral  in 2004, that  revenues has  Mongolia  in 2004, been Law  has  Mongolia  and generated  successfully  Corruption  has    successfully  produced Control during  in the  produced  nearly  WGI the    US$28 past  nearly   20 years,  US$28  Mongolia billion  worthhas consumed   of billion   worth   mineral    of 99 outputs. mineral cents   These and   proceeds   outputs. saved   These   have one   proceeds   generallycent   have   (figure been  generally   split 1.6)   been   across (through   three split  across  broadits  Stabilization  three  broad  Mongolia and categories: Future   has   not  Heritage salary, categories:   only  profits,    consumed  salary, Funds). and taxes  profits,  and Since   almost and  the  royalty taxes   all  and   its  realization payments.   mineral  royalty  Taxes  payments. of   outputs,  and  royalties sustained  Taxes   but  and has  mineral  amounted   also  royalties    revenues borrowed  to amounted  nearly   to   heavily  nearly in 2004,   against Mongolia  them, US$9 billion has  in   bequeathing US$9 the   billion last 15 successfully  in  the  years.  negative  Inproduced  last   addition 15 years.  wealth to In  the  to  addition nearly  the  royalties,  next  to  the  US$28 the   royalties, generation.  government billion   Out  the government has worth  of every  borrowed of has  mineral dollar  US$8.7  borrowed    of mineral  US$8.7 outputs.    billion, wealth   mostly   that  has  been billion,   by     mostly leveraging     generated by  its  leveraging   mineral     during   revenue. its   mineral   the   From   past    2011, revenue.   20  years,   the   From   government 2011,     Mongolia   the   started government   has   to   save     consumed salary,   started some     to   99  centssave   some   and    These proceeds have generally been split across three broad categories: profits, of the saved     revenue one   of the cent  revenue in  stabilization (figure     in stabilization 1.6) and   heritage (through  and   funds. its  In the  heritage   Stabilization  last nine  funds.  In     the and years,     last  nearly Future nine   years,  US$1.4 Heritage  billion  nearly    US$1.4  were  billion Funds). Since  were   the    and taxes deposited and and royalty  US$1.2 billion deposited  and US$1.2payments.  were  withdrawnbillion were Taxes  withdrawn  from and  these two royalties  from  these  funds, amounted  leaving  two funds,  a net  leaving to  saving of nearly a net US$0.2 saving US$9    of US$0.2  billion inrealization the last billion. of sustained  15  In short, years.  Mongolia billion.  In short,  mineral In  has addition  Mongolia  revenues  spent almost to spent  has  the  in 2004, all its   royalties, almost mineral  Mongolia  all revenues. the has  its mineral  successfully has  government  revenues.  produced borrowed  nearly US$28 US$8.7   billion mostly billion, worth  of   mineral by   outputs. leveraging   These its mineral   proceedsrevenue.   have  generally From 2011,   been the split  across  three  broad government   started Figure 1.6  Out categories: salary,  of every Figure   profits,  1.6  dollar Out of to save some of the revenue in stabilization   and    mineral  of  every taxes  dollar   and  output,   royalty  Mongolia  of mineral  payments.  output, has  Mongolia    consumed Taxes  has   and cents  99  consumed   royalties and 99 cents   saved and heritage funds. In the last nine years,   amounted  one  cent  saved  and     one  to nearly  cent     (2004–19; billion  US$)   billion US$)  (2004–19; US$9   billion   in   the   last   15  years. nearly US$1.4 billion were deposited and US$1.2 billion   In   addition   to   the   royalties,  the government were withdrawn  has borrowed from these  US$8.7   two billion, funds,  mostly by leaving a  leveraging net saving  itsof mineral US$0.2  revenue. billion.  From In  2011, short,  the  government Mongolia has started spent  to  save some almost all  its of   the   revenue mineral revenues.   in   stabilization   and   heritage   funds.   In   the   last   nine   years,   nearly   US$1.4   billion   were   deposited and US$1.2 billion were withdrawn from these two funds, leaving a net saving of US$0.2  billion. Figure 1.6 In short,  Mongolia New  has  borrowings  spent New  borrowings  almost all its mineral revenues.  27.8 27.8 8.7 8.7 Out of every dollar of mineral output, Mongolia has consumed 99 cents and saved one cent Figure 1.6 (2004-19; of every dollar of mineral output, Mongolia has consumed 99 cents and saved one cent    Out US$) billion 9.0 9.0 Revenue  billion1.4 Revenue  (2004–19;  US$)  1.4 0.2 0.2 Mineral outputs Mineral revenue Mineral outputs  plus   revenue plus Mineral   savings  Gross savings Gross   savings Net Net savings mineral enabled mineral enabled (stabilization fund+    (stabilization (stabilization  fund+   (stabilization  fund+     fund+   borrowings borrowings heritage fund) heritage fund) heritage fund) heritage fund)     Source: World Bank Source:  staff   World estimates   staff estimates   Bank 5  5     27.8 New borrowings 8.7 9.0 1.4 Revenue  0.2 Mineral outputs Mineral revenue plus  Gross savings  Net savings mineral enabled (stabilization fund+   (stabilization fund+   borrowings heritage fund) heritage fund)   Source: World Bank staff estimates  Source: World Bank staff estimates 5    6 COUNTRY ECONOMIC MEMORANDUM 2020 Much of the mineral revenue has been spent on programs that are politically popular. With such a measly amount of mineral revenue saved, it raises the question of how the money was spent. Since mineral revenues are part of the consolidated budget, and money is fungible, it is not possible to track how every tugrug was spent. But a comparison of the spending pattern before (1998–2003) and after the advent of mineral wealth (2004–19) is revealing (figure 1.7). It shows that the public spending pattern did not change in the first few years of realization of mineral revenue, which also overlaps with the period of a declining ratio of public sector debt to GDP. But coinciding with the 2008 general elections and continuing through the next two general elections in 2012 and 2016, there were significant spikes in spending on social transfers (3.1 percent of GDP), public investment (6.3 percent of GDP), and wages and pensions of civil servants (1.8 percent of GDP). Since mineral revenues account for 6.7 percent of GDP during this period, some of the additional spending was financed through new borrowings. Political convenience and not economic merit appear to determine how mineral revenue has been utilized. Based on our analysis, and under the assumption that mineral revenues were largely spent on the above three items, one can conclude that nearly 56 percent of mineral revenues were spent on public investment, 28 percent on social transfers, and 16 percent on wages and pensions. It is later shown that Mongolia’s public investment program is inefficient by global standards, and the generous social transfers have been cited as a possible cause for anemic productivity growth. Figure 1.7 How mineral revenues were spent (% of GDP), 1998–2019 Figure 1.1 How mineral revenues were spent (% of GDP), 1998–2019 33% Pre-mineral Post-mineral 33% Wages and pension 28% General elections 28% Presidential election 23% 23% Actual 18% 18% Government investment Period average 13% 13% 8% 8% Social assistance 3% 3% Stabilization and Hertiage Funds -2% -2% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: World Bank staff estimates Source: World Bank staff estimates There are encouraging signs of mineral revenues being invested more prudently in recent years, giving the newly elected government an opportunity to build on its own reforms. Mineral revenues averaged 7.2 percent of GDP during 2017–19, one of the highest levels in the last decade. But instead of using it to further top-off social transfers and public investment programs – as has been done in the past – the government has allocated a large part of it to the two funds and to retire the high-cost debts (figures 1.8 and 1.9). In fact, 2017–19 marked a decisive shift in the fiscal management of the country, with the fiscal balance in surplus in two of the three years, three consecutive years of decline in the public debt-to-GDP ratio, and more than 2.5 percent of GDP transferred to OVERVIEW 7 the Stabilization and Future Heritage Funds. While significant, these improvements are     susceptible to reversal should the political architects of these reforms leave the office. The new consecutiveadministration consecutive   years  of  years   of  should   decline decline inbuild   the in  the   public on public    debt ‐to its debt ‐GDP recent ratio, ‐ to ‐GDP  track   andratio,   more record   and   than   more  to   2.5than introduce   percent   of  GDP   2.5  percent institutional   of  GDP  changes that transferred transferred   to ensure  to  the that the  Stabilization mineral   and  Future   Stabilization revenues   and Future  Heritage   Heritage are prudently   Funds.   While Funds.   While used   significant, irrespective   these   significant,   improvements of which   these  improvements   party   and people are in   to  reversal are  susceptible are  susceptible power.   should  the   to  reversal should  political   the  political   architects   of  these   architects   of   these  reforms   reforms   leave  office.   leave office.   The   The   new     new    administration administration should  should  build  on  build  on its  its recent  track  recent  record  track  record  to  to introduce  introduce  institutional  institutional  changes  that ensure  changes  that  ensure  Figure 1.8 Figure 1.9 that mineral that mineral revenues  revenues  are prudently  are prudently  used irrespective  used irrespective  of which  of  party  which  party  and  people  and are people  in power.     are in power.   Gross contributions consecutive   years to  the Stabilization of  decline   in  theFund   public  debt‐to ‐GDP at …while the  same ratio, time  government and  more debt   of  GDP  than  2.5  percent and Figure  1.8 Future  Gross Figure  1.8 Heritage  contributions  Gross Funds  contributions  to the have  to the Stabilization  Stabilization significantly     level  1.9 Figure   Figure …while has 1.9  at …while  steadily  the declined same  time  at the  government  same  time government     transferred Fund increased and  Future Fund  and in recent   to   the  Future  Heritage years   Stabilization Funds  (%  Heritage of  GDP) have     Funds and significantly …   Future  have     Heritage  significantly debt Funds.  debt    level  has  level  While  steadily   significant,  has  steadily declined  declined     these     improvements  are  susceptible increasedincreased  in recent  in   to recent  years  reversal  (% years should   (%  of GDP)  of   the …  GDP)  …   political  architects  of  these  reforms  leave  office.  The  new  consecutive  years  of  decline  in  the  public  debt‐to‐GDP  ratio,  and  more  than  2.5  percent  of  GDP  administration 3.5% transferred 3.5%   to  the   should  build  and Stabilization on its  recent   Future  track100%   Heritage  record   to   Funds.100% While      introduce External   significant, debt    External  institutional  to GDP  debt to   these GDP  changes that   improvements    ensure  that 3.0% are  mineral  revenues 3.0%   susceptible to  reversal  are  prudently   should  used irrespective   the  political   architects   of  of       which these Domestic  party     reforms  debt Domestic  to   leave  GDP  debtand  to GDP   office.   people  are The  in  power. new      2.5% 2.5% 80% 80% administration should build on its recent track record to introduce institutional changes that ensure   1.8 Gross contributions to the Stabilization Figure2.0% 2.0%   60% Figure 60%  1.9 …while at the same time government  that  mineral Fund  and   revenues  are prudently Future Heritage  used  Funds have  irrespective  significantly debt  party   of which level  has and   people   steadily are  in power. declined      1.5% 1.5% 40% 40% increased Figure 1.0%  1.8  in recent  Gross 1.0%  years (%  contributions  to  of  GDP) the  …   Stabilization   Figure 1.9 …while at the same time government  Fund  and   0.5% 3.5% 0.5% Future   Heritage   Funds  have  significantly   20%  level debt 20% has steadily declined  100%    External debt to GDP increased 0.0% 3.0% 0.0%  in recent  years  (%   of  GDP)  …   0% 0%    Domestic debt to GDP 2011 2012 2011 2013 2012 2014 2013 2015 2014 2016 2015 2017 2016 2018 2017 2019 2018 2019 2010 2011 2012 2010 2013 2011 2014 2012 2015 2013 2016 2014 2017 2015 2018 2016 2019 2017 2018 2019 3.5% 80% 2.5% 100% 3.0%        External debt to GDP     Sources: 2.0% MoF; World Sources:  Bank  MoF;  staff  World    estimates  staff estimates  Bank Sources: Sources: MoF;  MoF; World  Bank     Domestic 60%  World  debt  staff  to Bank     GDP  staff estimates  estimates Sources: 2.5% MoF; World Bank staff estimates 80%Sources: MoF; World Bank staff estimates 1.5% I.1.3   Climate 2.0% I.1.3  Climate and COVID  change  change  and‐ 19 pandemic COVID ‐19 pandemic  will put will 60% put pressure  40%  pressure  on accelerating  on accelerating  the transition  the transition     1.0% I.1.3 1.5% With Climate  0.5% global With   coal change global  coal  consumption consumption and  expected COVID-19   expected pandemic   to   to  decline 40%   decline 20% will put pressure on accelerating due  to  due climate   to    change  change climate   concerns, concerns,   Mongolia’s   Mongolia’s     1.0% the transition coal  could 0.5% 0.0%   could  become coal   become   a  stranded   a  stranded asset.  China’s   asset.   China’s   coal coal  share 20%   in   0%electricity   in  electricity   share   generation   generation   is  targeted   to    is  targeted  to  2011 2012 2013 2014 2016 2015 2017 2016 2018 2017 2018 2019 2010 2011 2014 2012 2015 2013 2016 2014 2017 2015 2016 2017 2018 2019 decline With global 0.0%  decline from coal 64   to  consumption   from   64 30   percent   and  non   to  30  percent and ‐electricity  expected   generating   non‐electricity to0%decline   generating  coaldue   consumption   coal to   consumption climate   to  decline by  19   to  decline change     by  19  concerns,     2011 2012 2013 2014 2015 2019 percent   from percent  2018  from  to    2018 2050    to  2050 (figure  1.10).   (figure  A 1.10).   simulation  A     using simulation  a   using computable  a    general computable    general equilibrium    (CGE) equilibrium    (CGE)  2010 2011 2012 2013 2018 2019 Mongolia’s Sources: MoF; coal  World could Bank staff estimatesbecome   a stranded   asset. Sources:  MoF; China’s  World Bankcoal share  staff estimates   in electricity   model model   suggests Sources: generation   that suggests is  targeted  MoF; World  Bank  a   steady   that  staff   a  decline  estimates to steady decline   in  China’s   decline from   in  China’s 64 coal Sources: to 30   coal demand   demand  MoF; percent   would  World  reduce and  would Bank  staff Mongolia’s   reduce  estimates non-electricity   exports   Mongolia’s      by  exports generating   by  coal 1.1I.1.3   percent   1.1  Climate   and  economic percent  change   and  economic  and   growth  COVID   growth by  0.7 ‐19  pandemic by   0.7  percentage   percentage  will   points  put  on   pressure points average  on accelerating   on  average   each   year   each   if  the year the   if   the   country  transition     country    consumption I.1.3  continued continued Climate  to rely to decline  change  significantly  to rely  and by COVID  significantly 19 ‐  on mines percent 19 on  pandemic (figure from  mines  1.11).  will (figure 2018     put 1.11). pressure   to 2050 (figure 1.10).  on accelerating A simulation  the transition   using a computable general equilibrium (CGE) With  global  coal  consumption  expected  to  decline  due  to  climate  change  concerns,  Mongolia’s  model suggests that a steady decline in China’s coalWith Figure demand coal   global  1.10Figure   could   coal  Coal  consumption   1.10 would become   consumption  Coal reduce  is expected consumption   a  stranded   expected  is expected Mongolia’s  fall   asset.   to     decline  fall   China’s   due  Figure exports coal   to Figure  1.11  by    climate share China’s 1.1 change   in   clean China’s  1.11percent  energy electricity   concerns,  clean and   transition  energy generation   Mongolia’s  will   will  transition economic     growth   is  targeted by   to   significantly coal   could   significantly  become in China   and in   a China  OECD   stranded  and  OECD  countries   asset.  countries    China’s     coaladversely   share   adversely  in affect    Mongolia electricity affect   Mongolia  generation       is  targeted  to  decline  from  points 0.7 percentage 64  to  30 on average   percent   and  each non‐electricityyear if  the generating country   coal continued   consumption to  Exports rely to  declinesignificantly   by  19  decline  from  64  to  30  percent  and  non‐electricity  generating   coal GDP   consumption GDP   to   decline Exports   by  19  on mines percent (figure  from 2018 1.11).  to 2050 (figure 1.10). A simulation 0.6 using a computable general equilibrium (CGE)   0.6 percent from 2018 to 2050 (figure 1.10). A simulation  using a 0.4  computable general equilibrium (CGE)  0.4 model  suggests  that  a  steady  decline  in  China’s model  suggests  that  a  steady  decline  in  China’s  coal0.2   coal  demand   demand 0.2  would  reduce would   Mongolia’s reduce  Mongolia’s   exports  by    exports  by  1.1 Figure 1.1   percent  1.10 percent   and   and   economic   economic   growth   growth   by   by  0.7   0.7  percentage   percentage 0.0   Figure points   points 0.0 1.11   on  average on  average   each   each  year   year   if  the   if  the   country     country  ‐0.2 ‐0.2 Coal continued continued consumption  to  rely  to relyis  significantly  significantly expected  to   onfall  mines on  mines  (figure  (figure 1.11). significantly  1.11).   China’s ‐0.4   ‐0.4 clean energy transition will adversely ‐0.6 ‐0.6 in China and OECD countries affect Mongolia Figure Figure  1.10  1.10  Coal  Coal  consumption  consumption  is expected  fall   fall  Figure  is expected ‐0.8  Figure 1.11 ‐0.8  China’s  1.11  China’s  clean clean energy  energy transition  transition will   will  significantly significantly  in China  in China  and   and  OECD OECD  countries  countries     adversely ‐1.0 adversely  affect ‐1.0  affect  Mongolia 2020  Mongolia 2020 2040   2040   ‐1.2 ‐1.2 GDP GDP Exports   Exports   0.6     0.6 Source: Source: Energy  Energy Information  Information  Administration  Administration  (2019)   (2019)  Source: 0.4  World 0.4 Bank Source:  staff  World Bank    estimates staff estimates  0.2  Initial Note:  rise Initial Note: 0.2 in demand  rise in  demand  for  coking  for coal  coking  in 2020  coal  in  by  2020  35    by 35  0.0  followed percent, percent, 0.0     byfollowed   demand   by    demand changes   that   changes   are   2.5   that     are  2.5  percentage ‐0.2 percentage  points lower  than  points  lower  than  the year  the year  before    before  ‐0.2 ‐0.4 ‐0.4 ‐0.6 7  7  ‐0.6     ‐0.8 ‐1.0 ‐0.8 2020 2040 ‐1.2 ‐1.0 2020 2040 ‐1.2       Source: Energy Information Administration (2019)  Source:  World Bank staff estimates    Source: Source: Energy Information Administration (2019) World Bank staff estimates Source: Energy Information Administration (2019)  Note: Initial rise  in Source:  demand World  for  coking  coal in 2020  by 35  Note: percent, Note: Initial followed rise  in  by demand Bank  staff demand  estimates for  changes  for coking that   coal  are 2.5 in 2020 by    in 2020 by 35  35 percent,  Initial   rise followed   in   demand by demand   coking   changes coalthat are 2.5 percentage  points percent,  lower than  followed  by  the  year before  demand  changes   that are  2.5  percentage points lower than the year before percentage points lower than the year before  7    7    8 COUNTRY ECONOMIC MEMORANDUM 2020 The COVID-19 pandemic has added a new type of external shock, with an economic impact similar to that of global commodity price shocks. Being a commodity exporter,   Mongolia has been prone to frequent commodity price swings that are detrimental to sustained growth. The impact of COVID-19, without its health dimension, is like that of a The COVID‐19 pandemic has added a new type of external shock, with an economic impact similar  commodity price shock. An event study analysis shows the behavior of macroeconomic to that of global commodity price shocks. Being a commodity exporter, Mongolia has been prone  variables such as mineral output, exports, FDI, and fiscal balance to the COVID-19 shock to  frequent  commodity  price  swings  that  are  determinantal  to  sustained  growth.  The  impact  of  is fairly similar to what happened during the 2009 global financial crisis and the 2016 COVID‐19,  without  its  health  dimension,  is  like  that  of  a  commodity  price  shock.  An  event  study  slowdown in China (figure 1.12). If anything, the COVID-19 pandemic reinforces the analysis shows the behavior of macroeconomic variables such as mineral output, exports, FDI, and  point that Mongolia needs to steadily diversify its economy away from minerals to avoid fiscal  balance  to  the  COVID‐19  shock  is  fairly  similar  to  what  happened  during  the  2009  global  excessive instability in its macroeconomic environment. financial  crisis  and  the  2016  slowdown  in  China  (figure  1.12).  If  anything,  the  COVID‐19  pandemic  1.12   the  point  that  Mongolia  needs  to  steadily  diversify  its  economy  away  from  minerals  to  reinforces Figure avoid excessive instability in its macroeconomic environment.  The impact of COVID-19 is like the past economic crises Figure 1.12 The impact of COVID‐19 is like the past economic crises  Mineral sector output (index)a  Exports (index)a  Primary balance as % of GDP  350 2009 2016 2020 500 2009 2016 2020 2% 2009 2016 2020 450 300 1% 400 250 0% 350 300 ‐1% 200 250 ‐2% 150 200 ‐3% 100 150 ‐4% 100 50 ‐5% months 50 months quarters 0 0 ‐6% T‐9 T‐6 T‐3 T T‐12 T+3 T+6 T+9 T+12 T‐9 T‐6 T‐3 T T‐12 T+3 T+6 T+9 T+12 T‐4 T‐3 T‐2 T‐1 T T+1 T+2 T+3 T+4 Source: NSO; BoM; World Bank staff estimation  Source: Note: a.NSO; BoM;  Values World Bank  are indexed staff T  at period estimation  = 100  Note: a. Values are indexed at period T = 100 I.2  An organizing framework   I.2 An organizing Mongolia’s framework   economy  suffers   from  three  interrelated  challenges:  (i)  excessive  macroeconomic  volatility,  (ii)  negative Mongolia’s economy   productivity suffers from   and   growth, three excessive  reliance   (iii)  interrelated   on  natural  and challenges: (i)  produced excessive   capital  and  not  enough macroeconomic volatility, (ii) negative productivity growth, and (iii) excessive reliance  on  on  human  and  institutional  capital.  Each  of  these  challenges  implies   a  certain welfareand natural and,  hence, capital   loss  produced scope  for   improvement. and not enough   Reducing on human   volatility and   would   lower  uncertainty institutional capital.   and Each   thereby   encourage  firms  and  households  to  invest of these challenges implies a certain welfare loss and, hence, scope for improvement.  more,  make  long ‐term  plans,  and  enter  into  long ‐ term  contracts, Reducing volatility   which   would would   be  positive lower uncertainty   for  investment, and thereby   productivity, encourage   andfirms  growth. and   The   welfare  households tolosses invest  from more,  greater make   volatility long-term   are  particularly plans, and   highenter  in  Mongolia into long-term   as  mostcontracts,   householdswhich   and  firms would   are be credit   constrained   and   the   government,   having   positive for investment, productivity, and growth. The welfare losses from greater volatilityspent   most   of   its   mineral   revenues,   is   not   in  a  are particularly position  to compensate high in  for Mongolia  the lost consumptionas most  households or investment.and firms   Boosting are credit  productivity constrained  would  imply  and from  inside  to  having the   government, moving the  edge spent   of  the most   production of its   mineral possibilityrevenues,   frontier  (PPF), is not   andin a position   hence   would  to compensate translate  to  higher for the lost  of   levels consumption   income  in  the or investment.   future. Boosting   And  expanding   and productivity   making  better would   use imply of  moving from   human underutilized inside  and to the edge of   institutional the production   capital   in  the  production possibility  process frontier   would  mean (PPF), and     pushing hence the  would translate PPF  outward. to higher   These   three levels parallel of income in   transitions   –  the future. through And expanding   stabilization,   higher and making  and productivity, better   use of underutilized expansion   or  diversification human   ofand institutional   endowments   –  formcapital in the   the  three production   pillars   aroundprocess   which  this would   report mean   is  pushing organized. the ThisPPF outward.  is illustrated  in These  figure 1.13 three  and parallel  expanded transitions  further in Annex – through  1.  stabilization, higher productivity, and expansion or diversification of endowments – form the three pillars around which this report is organized. This is illustrated in figure 1.13 and expanded further in Annex 1. 8    OVERVIEW 9   Figure 1.13 The organizing framework for the report Figure 1.13 The organizing framework for the report    Source: World Bank staff  Note: World Source: PIM = public investment management  Bank  staff Note: PIM = public investment management I.3  Three Pillars: Stability, Productivity, and Diversity (of endowments)    I.3 Three pillars: stability, productivity, and diversity (of endowments) The  Report  is  organized  around  the  three  pillars.  Pillar  1  explores  the  nature  of  macroeconomic  The Report is organized around the three pillars. Pillar 1 explores the nature of volatility,  its  underlying  causes,  and  how  to  tame  the  tide  of  volatility  through  fiscal,  monetary,  macroeconomic volatility, its underlying causes, and how to tame the tide of volatility exchange rate, and financial sector policies. Pillar 2 examines the productivity problem at both the  through fiscal, monetary, exchange rate, and financial sector policies. Pillar 2 examines macro  and  firm  level,  identifies  the  factors  behind  low  productivity,  and  discusses  policy  the productivity problem at both the macro and firm level, identifies the factors behind recommendations. Pillar 3 studies the extent of undiversified growth in Mongolia, what explains it,  low productivity, and discusses policy recommendations. Pillar 3 studies the extent of and what are its potential remedies.   undiversified growth in Mongolia, what explains it, and what are its potential remedies. I.3.1  Seeking stability  I.3.1 Seeking stability Mongolia’s macroeconomic environment is characterized by high levels of volatility. This is evident  Mongolia’s macroeconomic environment is characterized by high levels of in most of its macro indicators, especially consumption, both at the aggregate and household levels  volatility. This is evident in most of its macro indicators, especially consumption, both at (figure  1.14).  Sharp  variation  in  consumption  over  time,  coinciding  with  the  swings  in  global  the aggregate and household levels (figure 1.14). Sharp variation in consumption over commodity prices, is known to lower welfare relative to a smooth consumption function.  This also  time, coinciding with the swings in global commodity prices, is known to lower welfare explains why the poverty headcount ratio sharply increases during recession and falls during boom  relative to a smooth consumption function. This also explains why the poverty headcount periods.  Such  swings  can  be  extremely  costly  for  the  economy,  especially  for  the  stability  of  the  ratio sharply increases during recession and falls during boom periods. Such swings can befinancial  sector. Volatility is also likely to affect investment decisions as changes in macroeconomic  extremely costly for the economy, especially for the stability of the financial sector. variables  (exchange  rate,  interest  rate,  inflation,  real  wages)  affect  the  expected  return  on  Volatility is also likely to affect investment decisions as changes in macroeconomic investment variables  and, hence, (exchange  affect rate,  the level interest  of labor rate,  productivity real in inflation,  the economy. wages)    the expected return affect on investment and, hence, affect the level of labor productivity in the economy. 9    10 COUNTRY ECONOMIC MEMORANDUM 2020 Figure 1.14   Even among the commodity exporters, Mongolia’s macro variables exhibit one of the highest volatilities Figure 1.14 Even among the commodity exporters, Mongolia’s macro variables exhibit one of the  highest volatilities  10 UAE Qatar Real consumption growth (std dev, %) 9 8 Guyana Mongolia 7 6 Kazakhstan 5 Armenia 4 Russia Chile 3 Peru Colombia Ecuador 2 Australia Malaysia 1 Canada 0 0 1 2 3 4 5 6 7 8 Real GDP growth (std dev, %)   Source: World Bank staff  Source: World Bank staff Domestic  policies  have  amplified  rather  than  dampened  volatility.  Part  of  Mongolia’s  macro  instability is Domestic  due to the policies  economy’s have amplified  increased rather reliance than on  the mineral dampened  sector, which volatility.  makes Part  Mongolia  of Mongolia’s   to  frequent proneinstability macro is  commodity due to the   price But  worryingly,   swings.  increased economy’s   Mongolia’s reliance on the   macroeconomic mineral sector,   –  fiscal, which   makes Mongolia monetary, prone  to   and  exchange ratefrequent   –  policies commodity   are  found  toprice swings.   exacerbate   theBut worryingly,   external Mongolia’s   shocks  rather   than  macroeconomic mitigate them. For -  fiscal, example, monetary,  the exchange exchange and rate  has not rate policies been -allowed  to are found  to depreciate exacerbate during  periods  the external of low  commodity shocks  prices,  whichthan rather mitigate  them.  has encouraged greater For importsexample,  and higher the exchange  current  accountrate has  deficits,   not been allowed to depreciate during periods of low commodity prices, culminating  in  larger  required  adjustments  later  and  an  overshooting  exchange  rate.  The  fact  that  which has consumptiongreater encouraged  volatility imports exceeds output and higher  volatilitycurrent account  implies that deficits,  culminating  macroeconomic management has in  larger been  required adjustments a significant  contributor later and  to the an overshooting  country’s  instability.   exchange rate. The fact that consumption volatility   exceeds output volatility implies that macroeconomic management has been a significant To  maintain   stability,  to contributor the country’s macroeconomic instability.   policies   should  aim  to  smooth  consumption  over  the  Tobusiness maintain   cycle   rather  than stability,   maximize  current macroeconomic   consumption. policies should   This   calls aim   for to   countercyclical smooth consumption   policies  through over the  the   introduction business cycle transparent   of  rather than   fiscal maximize   rules,  a  credible current   and   autonomous  fiscal consumption. This   council, calls  for a  market‐driven  exchange countercyclical policies  rate through  and  wellthe‐functioning introduction   stabilization of transparent   and  heritage fiscal   funds. rules,   Specifically, a credible   policy  settings  should  allow  greater  exchange  rate and autonomous fiscal council, a market-driven exchange rate and well-functioning  flexibility  to  avoid  real  exchange  rate  appreciation   while  focusing stabilization   monetary and   policy heritage   on  anchoring funds.   inflation  and Specifically,   addressing policy settings   external should  imbalances. allow  greater During  boom periods exchange rate with  high commodity flexibility to avoid real  prices,  some foreign exchange rate exchange appreciation  (FX) inflows  should be  while focusing sterilized  monetary policy on anchoring inflation and addressing external imbalances. During boom by   accumulating   reserves   accompanied   by   commensurate   steps   to   mop   up   domestic   periods liquidity.   with high commodity Macroprudential prices,  measures  shouldsome foreign dollarization  discourage exchange  (FX) and FX inflows  indebtedness, should be sterilized  while  public debt by   management reserves accumulating should  focus accompanied   on  reducing by commensurate   the   FX  share  in  public steps to mop   debt, up domestic   including   deepening liquidity.   the  Macroprudential measures should discourage dollarization domestic  bond  market. Fiscal  policies  should  aim  to  support  stabilization  while  securing  long‐term and FX indebtedness, while public debt management sustainability  through the use should focus  of existing on reducing  stabilization the FX  and savings share  funds. in  public  This should be debt, including  underpinned   deepening the domestic by  institutional   reforms  to bond market.   strengthen   the Fiscal   independence policies  of should aim  council   the  fiscal to support   and  stabilization the  Bank  of  while securing Mongolia.  long-term sustainability through the use of existing stabilization and savings   funds. This should be underpinned by institutional reforms to strengthen the independence of the fiscal council and the Bank of Mongolia. 10    OVERVIEW 11 I.3.2     Boosting productivity growth Over the past decade, Mongolia has experienced anemic productivity growth. A   Boosting I.3.2I.3.2   Boosting resource-intensive growth growth  productivity  productivity  growth pattern   with  limited productivity gains is confirmed by a growth accounting exercise, suggesting that total factor productivity has contributed negatively to Over growthOver   the for   the past   decade,   past most of  decade, the   Mongolia   Mongolia recent   has decade. experienced    has experienced  Consequently,   anemic   anemic   productivity   productivity Mongolia’s   growth. total   growth. factor resource   A  resource   A  productivity ‐ ‐ intensive intensive     growthgrowth     pattern pattern  with     limited with   limited   productivity   productivity registered at only around 35 percent of the U.S. total factor productivity level in 2017,     gains gains   is   confirmed   is   confirmed   by    a by  growth   a     growth accounting   accounting     exercise, exercise, considerably  suggesting  suggesting lower  that than  total  that  total all  factor  productivity  factor structural  productivity contributed  has has and aspirational  contributed  negatively peers.  negatively The   to growth mining  to growth  for  most sector for  of   of   most remains the intensive the recent capital recent  decade.  decade.  and  Consequently, Consequently, thus exhibits  Mongolia’s  Mongolia’s  total the highest  total  productivity  factor  factor level of labor  productivity.  productivity  registered registered  at only at only  around  However,  around  35    35  even percent percent  of   in the mining sector, the level of labor productivity is lower than in structural peers. and  the  of   the U.S.    U.S. total    factor total     factorproductivity  productivity level     level in    in 2017,    2017, considerably  considerably  lower    lowerthan    all than     structural all     structuraland    aspirational aspirational  peers.  peers. The The mining  mining  sector  sector  remains  remains  capital  capital  intensive  and  and  intensive thus thus  exhibits  exhibits  the highest  level the highest  of   of   level labor Figurelabor  productivity. 1.15  However,  productivity.  even  However,  even the mining  in mining  in the  sector,  the sector,  Figure  level 1.16  of labor the level  of labor  productivity  is lower  productivity  than  is lower      than in   in   structural structural  peers.  peers.     Labor has flown to lower-productivity non- …reducing the contribution of structural tradable services… transformation to productivity growth Figure Figure  1.15 1.15  Labor  Labor has flown  has  flown  to lower  to lower ‐productivity ‐productivity   Figure   Figure  1.16 1.16  …reducing  …reducing the contribution  the  contribution of   of  tradable non‐non  services… ‐tradable    services…   structural structural  transformation  to productivity  transformation  growth  to productivity    growth   Industry Industry 8 8 60% 60% Agriculture Agriculture Within‐ Within sector‐sector Structural  change Structural  change 7 7 1991-2000 1991-2000 Share of people employed in the sector Share of people employed in the sector 2011-2017 2011-2017 Services Services 50% 50% 6 6 40% 40% 2001-2010 2001-2010 5 5 2001- 2001- 1991-2000 1991-2000 30% 2010 30% 2010 4 4 2011-2017 2011-2017 3 3 20% 20% 2011-2017 2 2011-2017 2 10% 10% 1991-2000 1991-2000 1 1 2001-2010 2001-2010 0% 0% 0 0 0 0 5000 5000 10000 10000 15000 15000 20000 20000‐1 ‐1 Value per Value added  worker added  per worker  (in constant  (in constant  2010 US$)  2010 US$) 2001‐05 2001‐05 2006‐10 2006‐10 2011‐17 2011‐17     Sources: Sources: World  NSO; NSO;  World  Bank Bank staff illustration   staff illustration   Sources: Sources: World  NSO; NSO;  Bank Bank  World staff calculations staff calculations     Sources: NSO; World Bank staff illustration Sources: NSO; World Bank staff calculations      Y – axis: Note:Note: axis: annual  Y –  annual  average  average  contributions  to growth  contributions  in labor  to growth Note: Y – axis: annual average contributions to growth in  in  labor  productivity, productivity,  percentage  percentage  points    points labor productivity, percentage points   Weak Weak   productivity   productivity   growth  growth   reflects   reflects   a  resource   a  resource   allocation   allocation   pattern   pattern   that   that   is  driven   is  driven by  commodity   by  commodity     cycles Weak cycles   and    and productivity   macroeconomic macroeconomic growth   mismanagement.   mismanagement. reflects a   resource While   While  capital   capital   has allocation gravitated   has   gravitated pattern   toward   toward that  the  is mining the   mining driven     sector, by sector,   labor commodity   labor  has    has moved cycles   moved   andtoward  toward   non macroeconomic  ‐non tradable‐tradable   services   services   away mismanagement.   away   from   from  tradable   While tradable   goods   goods capital   and  and    has manufacturing, manufacturing,   where     where the   the scope   scope  for   gravitated toward the mining sector, labor has moved toward non-tradable services awayproductivity   for   productivity   gains     gainstends     tends to   be  to     be higher     higher (figure     (figure 1.15).     1.15).As   a  As     a result,       result, structural from structural tradable   transformation   transformation goods and   –  resources   –  resources manufacturing,   moving   moving from  where   lower   from the   scope to  higher   lower   to  higher for   productivity   productivity productivity   activities   activities gains   tends –  has   –  has to   contributed contributed be higher  negatively (figure  negatively  to  to productivity 1.15). As  productivity a result,  growth  growth  in recent structural  in recent  years.  years. transformation  While  While labor  –labor  reallocation  reallocation resources  into    moving into higher ‐ ‐  higher from productivity productivity   sectors   sectors  generated   generated  about     about35 lower to higher productivity activities – has contributed negatively to productivity growth    35 percent  percent  of  the of   the labor     laborproductivity  productivity  growth  growth  between  between  2001  2001   and  andin   2010, recent   its 2010,    growth years. its  growth While   contribution   contribution labor reallocation   turned   turned   negative   negative during into  higher-productivity   during   2011–17   2011–17   (figure   1.16).   (figure sectors   1.16).   generated At   the At   the same   same  time, about   time,   35   ownership ownership percent of   has the become   has labor   become   more productivity  more  concentrated   concentrated growth   in   key   in  key between sectors   sectors 2001   and  and  and firms   firms   have 2010,   its   havebecome  growth become   more more   inward  contribution   inward     turned negative during 2011–17 (figure 1.16). At the same time, ownership has become looking looking  and  and   less   prone less   prone   to     innovate to  innovate  and    and adopt   adopt new     newtechnologies.  technologies.         concentrated in key sectors and firms have become more inward-looking and less more prone Mongolia Mongolia to innovate  needs  needs  to create  and to create adopt  annew  an environment  environment technologies.  where  where  more  more  productive productive  jobs  are created  jobs are created  to employ  to employ  its   its  youngyoung  and     and well   ‐ educated well ‐educated   labor Mongolia needs to create an environment where more productive jobs  need    labor force.  force.   To     To revive     revive productivity   productivity     growth, growth,     Mongolia Mongolia   would   would   need     are macroeconomic macroeconomic created to employ   policies   policies its    mitigate   toyoung to  mitigate   the   the and erosive   erosive well-educated   impacts   impacts   of    the labor of   the resource   resource force.  Tocurse curse   revive   while   while   focusing   focusing productivity     microeconomic microeconomic growth, Mongolia   reforms   reforms would   on   enhancing on  enhancing need   competition, macroeconomic   competition,   securing  securing policies   investor  to investor   rights, mitigate   rights,   andthe   and creating   creating erosive   a  more   a  more impacts     level   playing level   playing   field   field   that     that enables  enables   productive of the resource curse while focusing microeconomic reforms on enhancing competition,  productive   firms   firms   to     to invest     invest and     andgrow.   grow.     Specific Specific   recommendations   recommendations     include include securing   (i)  establish   (i) investor establish   an   an  effective   effective rights, and   public   public creating ‐private ‐private a more   dialogue  dialogue level investor   on  playing   on  investor ‐friendly field ‐friendly   reforms that   reforms enables   and  and promote   promote productive     firms to invest and grow. Specific recommendations include (i) establish an effective 11  11  public-private     dialogue on investor-friendly reforms and promote effective collaboration on innovation; (ii) reform the business registration process to ease business entry; (iii) 12 COUNTRY ECONOMIC MEMORANDUM 2020 strengthen the competition framework; (iv) facilitate trade across borders by reducing the cost and time for border clearance; (v) systematically review laws and regulations to identify and eliminate inconsistencies and discrepancies among them; and (vi) enhance investor protection. I.3.3 Expanding endowments Mongolia’s growth process has over relied on mines and underutilized its minds. Human capital has been grossly underutilized, while institutional capital has deteriorated. Such inability to diversify the country’s endowments has resulted in limited diversification of outputs and exports and has further amplified its vulnerability to the swings of the global commodity markets. Mongolia’s failure to better utilize its human capital is largely the result of its inability to create adequate well-paying jobs. Mongolia has done well in dealing with the supply side of the labor market (investing in the health and education of its labor force), but less well with the demand side complements such as an enabling business environment, access to markets and complementary inputs, and well-functioning public services. There is also a mismatch between the supply of skills from the educational institutions and the demand from employers. The lack of complements has reduced the ability of the economy to produce enough jobs to absorb the new entrants to the labor market. Consequently, there is human capital flight, the majority of which are skilled workers with college degrees. Mongolia also lacks a sound public investment management system to effectively and efficiently allocate resource rents. These problems have been compounded by weak control of corruption and rule of law. Mongolia’s pathway to diversification is through expanding its intangible endowments by improving the functioning of its labor market, attracting and retaining talent, strengthening public investment management practices, and radically increasing the transparency of policymaking. Specifically, the report calls for (i) improving the quality and utilization of human capital and leveraging an effective migration policy to attract and retain talents; and (ii) strengthening the quality of institutions through improved transparency and public investment efficiency. For detailed policy recommendations, see table 1.1. OVERVIEW 13 Table 1.1 Mines and Minds: Policy Recommendations Areas Policy reforms Institutional changes I. Seeking stabilization (Responsible agencies: MoF, BoM, Parliament, and the Cabinet) Fiscal policy • Simplify fiscal rules (public understanding and • Re-establish the Fiscal Stability escape clause and sanction). Council (FSC) to limit political • Prioritize debt reduction and functionality of the influence. Fiscal Stabilization Fund (FSF). • Adopt a legal framework for GoM’s • Accumulate savings in the medium-to-long-term response to FSC findings on key in the Future Heritage Fund (FHF). budget documents. Monetary, • Limit FX intervention and allow more flexibility of • Strengthen the independence and exchange rate, the nominal exchange rate. governance of BoM (including and financial • Strengthen prudential countercyclical prudential supervision and financial sector policies measures (capital buffers, loan-to-value, stability functions). and debt-to-income ratios). II. Boosting productivity (Responsible agencies: MoF, BoM, NDA, and Parliament) Macro • Strengthen sterilization policy during the boom • Focus on anchoring inflation and management and busts. addressing external imbalances. to mitigate the • Discourage dollarization and reduce FX. • Strengthen debt management resource curse indebtedness through macroprudential tools. focusing on reducing FX share and deepen domestic bond market. Business • Approve a revised national competition policy. • Establish an effective Public-private environment • Reduce cost and time for border clearance. Dialogue (PPD) on investor-friendly reforms • Enhance access to credit (e.g., credit bureaus). reforms. Attracting high • Support a Linkages Program to foster • Enhance investor protection quality FDI connections between FDI and domestic firms to (implementation of investment increase overall in-country value addition. protection guarantees and SIRM). III. Expanding endowments (Responsible agencies: MoESC, MLSP, MoMHI, MoFA, the Cabinet) Labor market • Design a human resources development plan • Establish a strict control system for reforms and focusing on education quality and STEM. quality of education and training. migration policy • Redesign school curriculums to match future • Leverage the private sector for needs. better skills matching. • Provide high quality affordable childcare service. • Create a nodal agency for diaspora. • Improve census of Mongolian migrants. • Encourage diaspora’s involvement in the Mongolia’s economic development. Investing in • Revise existing laws and regulations in the • Improve transparency in contracts, institutions mineral resource sector (e.g., a new EITI and licensing, and disclosure of (transparency/ mineral law. ownership (including politicians). accountability/ • Improve management and governance of public • Adopt an integrated/holistic PIM) investment projects (planning, parliamentary approach of digitalization of public approval). sector. • Reexamine the rationale of the state holding equity in all mining companies considering conflict of interests of being an owner as well as a regulator. Leveraging • Provide incentives for developing manufacturing • Leverage existing and potential comparative industries (meat and cashmere) consistent with trade agreements and cooperation advantage diversification away from mining. (e.g., Japan, USA, China, Russia). • Develop infrastructure selectively to unlock specific value chains. 14 COUNTRY ECONOMIC MEMORANDUM 2020 II. SEEKING STABILITY 15 II. SEEKING STABILITY Mongolia’s macroeconomic environment is one of the most volatile in the world. This is partly due to increased reliance on the mineral sector, which makes Mongolia prone to frequent commodity price swings. But worryingly, Mongolia’s macroeconomic – fiscal, monetary, and exchange rate – policies are found to amplify the external shocks rather than mitigate them. To maintain stability and lessen the corrosive impacts of the resource curse, macroeconomic policies should aim to smooth consumption over the business cycle rather than maximize current consumption. This calls for countercyclical fiscal policies anchored in transparent fiscal rules and underpinned by a credible and autonomous fiscal council and well-functioning stabilization and heritage funds. Prudent monetary and financial sector policies, and a more flexible exchange rate rooted in greater central bank independence would also help reinforce a stability-oriented macroeconomic policy framework. II.1 Volatility is the norm not the exception Macroeconomic volatility in Mongolia is not only elevated among its peers but has increased substantially in the past two decades. In addition to exacerbating an already fragile financial sector, such heightened volatility is also observed at the level of household consumption and business revenues and investment (box 2.1). Box 2.1 Cost of macroeconomic volatility The cost of macroeconomic volatility is assessed in the literature chiefly in terms of its impact on economic efficiency, investment, and growth as well as on inequality. Households and firms´ spending and investment decisions are typically disrupted by increased volatility. Volatility creates uncertainty. Financial institutions hesitate to transform liquid financial instruments into long-term capital investments, as households and businesses become uncertain about future prospects and thereby reluctant to enter into long-term contracts. Macroeconomic volatility hurts efficiency and growth, especially during crises. The inverse association between the first and second moment of per capita growth is documented in Ramey and Ramey (1995), Hnatkovska and Loayza (2005), Loayza et al. (2007), and Rancière et al. (2008), among others. Cross-country evidence reveals that heightened volatility (a one-standard deviation increase) during crisis episodes will cut the long-term rate of growth per capita by 2.2 percentage points (Hnatkovska and Loayza 2005). Further, this impact is often transmitted through reduced investment (Aghion and Banerjee 2005): specifically, about one-third of the impact of volatility on growth is explained by lower investment spending (Fatás 2002). Source: Compiled by World Bank staff based on World Bank (2015a) II.1.1 Mongolia’s macroeconomic variables are uncommonly volatile Mongolia’s output and consumption are more volatile than many of its peers. Mongolia’s output growth volatility was higher than the East Asia and Pacific and world averages during 1998–2019. This is not unexpected given Mongolia’s status as a commodity producer, which exposes the country to frequent and large swings in global commodity 16 COUNTRY ECONOMIC MEMORANDUM 2020 markets. But it is worrisome that even among its peers of commodity producers, Mongolia has one of the highest growth volatilities (figure 2.1). The degree of volatility in aggregate consumption growth is particularly striking, where Mongolia exceeds all but Guyana, the United     Arab Emirates (UAE), and Qatar (figure 2.2).7 The volatility in consumption is more troubling than production, as government policies can significantly influence the former through exceeds  appropriate exceedsall    but all   Guyana,   but macroeconomic   the   Guyana,   United   the   Arab   United  policies.   ArabEmirates   (UAE),   Emirates   and   (UAE),   Qatar   and   (figure   Qatar      (figure 2.2). 7 2.2).7  The The  volatility volatility  in    consumption consumption  is more is more  troubling  troubling  than  than production,  production, as  government  as  government  policies  policies  can  can significantly  significantly  influence influence  Figure 2.1 Figure 2.2 the  former   through   appropriate  macroeconomic the former through appropriate macroeconomic policies.    policies.    exceeds Mongolia’s   but  Guyana,   alloutput growth is   the   United elevated   Arab  Emirates relative   (UAE), …its   and  Qatar consumption   (figure growth   2.2). is even 7 more  The  volatility  in  Figure  2.1 Figure consumption to many   peers… Mongolia’s  2.1   Mongolia’s  output growth  output growth is more troubling    is  elevated  than  production,   Figure is elevated    as   Figure  government volatile2.2  …its  consumption  2.2 …its consumption  policies can  growth  growth  is  is   even    even  significantly more more    influence   relative   relative to   many to  many  peers…   peers…    the former through appropriate macroeconomic policies.   volatile volatile    Figure 8 8  2.1Economic  growth Economic  Mongolia’s  volatility  growth (1998–2019)   growth  volatility  output  (1998–2019)  is elevated  Figure 1010  2.2 …its consumption United United   Emirates  Arab  Arab growth  Emirates  is even more  Qatar 99 Qatar relative   to  many   peers…   volatile    %):   (std dev, %):  Real consumption growth (std dev, %):  7 7 ASEAN 8 ASEAN 8 Standard deviation (%) Guyana  (%)  deviation (%) Guyana 6 6 Mongolia Mongolia EAP EAP 77 5 5 Economic growth volatility (1998–2019) WORLD WORLD 6 610 United Arab Emirates 8 4 4 Kazakhstan Kazakhstan Qatar 55  growth 9 1998–2019 1998–2019 7 3 3 44 Chile Chile Armenia Standard ASEAN 8 Russia Armenia Guyana Peru Russia Peru Mongolia  dev, 6 2 2 33  consumption EAP 7 Standard deviation Australia Ecuador 5 1 1 22 Australia Colombia Ecuador Colombia WORLD  (std 6 1 Malaysia 4 0 0 1 5 Canada Malaysia Kazakhstan Canada  growth 1998–2019 3 00 Chile 4 0 Russia 6 Armenia 22 44 8 Real 0 Peru 6 8 2 3     Real consumption Real  GDP  growth  (std Ecuador  dev, %): 1998–2019 1 2 AustraliaReal  GDP Colombia growth  (std  dev,  %): 1998–2019 Sources: Sources: 0  NSO,  NSO,  EIU,  EIU,  WDI;  WDI;  World  World  Bank  Bank  staff  staff  estimates  estimates     Sources: Sources:  1  NSO; NSO;  World  World  Bank  Bank  staff Malaysia  staff  estimates  estimates    Canada Sources: NSO, EIU, WDI; World Bank staff estimates 0 NSO; World Bank staff estimates Sources: Even   more   troubling Figure  2.3  Surprisingly,  non ‐mining  sectors  are 0 are   2 4 6 8 Even   more   troubling    is is the the    heightened heightened      Figure more  2.3    Surprisingly, volatile  than Real  the  non   GDP growth ‐mining mining  sector  (std   sectors   dev, %): 1998–2019 Even volatility more   in   in   the troubling   non ‐mining is  the   sector   relative   to  more  volatile than the mining sector  volatility Sources:  NSO, the EIU,    non WDI; ‐mining  World  Bank  staff heightened sector   relative estimates     to  Figure Sources:2.3  NSO; World Bank staff estimates  the the   mining   mining volatility   sector.   sector. in the   non-mining  Non Non ‐tradeable ‐tradeable     sectors sector sectors     Surprisingly, 0.25 0.25   ‐19 (std dev,%):  non-mining sectors are more volatile Sectoral growth (std dev,%):  associated associated   with  with     higher higher     employment employment     changes changes     Figure 0.2 0.2 relative Even   more to the   troubling  mining is    the sector.  heightened Non-    than the 2.3   mining sector  non‐mining sectors are  Surprisingly, such such  as    as   construction construction     and and   trade, trade,     saw saw     their their   more   volatile 0.15 0.15  than  the mining sector  tradeable sectors associated with 2004‐19 output  in volatility   the  non volatility mining  sector   ‐increase during   relative   2004–19,   to   0.1  growth 0.1 output higher   volatility employment   increase changes  during   2004–19, such as     2004 the   mining exerting   an    sector.additional   Non ‐tradeable   stress   on  household  sectors 0.05 0.25 0.05 exerting   an   additional   stress   on   household    dev,%): Sectoral growth (stdSectoral construction welfare   (figure associated with and   higher trade,   2.3). saw their  changes   employment output   0.2 0 8   In  fact,  consumption  8 0 welfare volatility   (figure   2.3).   In   fact,   consumption   such   as  increase volatility construction   is  policy‐ during   and induced 2004-19, trade,   while   saw   mining exerting   output their  0.15 volatility   is   policy ‐ induced   while   mining   output   2004‐19 an output additional is   not,   since stress   volatility the     increase latter on household   is   during  2004–19,   responding  welfare to  global  0.1 is   not, (figure   since  8the  latter  is  responding  to  global  price2.3). exerting   an  additional  cycles  In that fact,  Mongolia consumption   stress  has  no on   household  controlvolatility over.  0.05   price is   cycles policy-induced  that   Mongolia while   has  no mining  control   over. output   Sources:   NSO; 0  World Bank staff estimates    welfare  (figure  2.3).   In  fact,  consumption  Sources: NSO; World Bank staff estimates  8 is     not, since volatility   is  policy the ‐inducedlatter   while is responding   mining  output to   globalII.1.2price   Mongolia’s cycles  macroeconomic that Mongolia  volatility has no  has increased over time  is   not, II.1.2     since Mongolia’s   the  latter   is  responding  macroeconomic   to  global  volatility  has    increased over time  control price over.  cycles that  Mongolia  has no control  over.  increased Mongolia’s  output  and consumption  volatility Sources: Sources:  during NSO;  NSO;  theBank World  World  mining  boom staff estimates  period.    Mongolia    Mongolia’s output and consumption volatility increased  during  the  Bankmining  staff  estimates  boom  period.  Mongolia   alongalong with a few comparators (including Armenia, Chile, and Qatar), experienced increasing output   with  abetween volatility  few comparators   macroeconomic 1998  and  (including and   2003  volatility  Armenia,   volatility 2006   and  Chile,   2019 and  Qatar),   (figure  experienced   2.4),   while   more  increasing   peers  saw   their    output II.1.2 II.1.2 volatility  Mongolia’s Mongolia’s   between  macroeconomic   1998   increase and  2003   and  2006   has   and   has increased   2019   (figure increased  over  2.4), time over     while time   more   peers their   saw  2.5). consumption  volatility  including  Chile,  Guyana, and the  United  Arab  Emirates  (figure    Mongolia’s consumption volatility output  and increase consumption  including Chile, volatility  Guyana, and increased  the United during  Arab Emirates the mining  (figure boom 2.5).  Mongolia’s period.  output and Mongolia along  consumption with a few  volatility comparators  increased  during the (including  mining boom Armenia, Chile,  period. Qatar),   and  Mongolia along with a few experienced  comparators increasing output  (including volatility  Armenia, between  Chile,  and Qatar), 1998-2003  experienced and 2006-2019  increasing 2.4),   (figure output volatility while more   between peers  1998 saw  their and  2003 consumption   and  2006volatility   and  2019   (figure  2.4), increase   while Chile, including more  peers Guyana,   saw  andtheir  consumption  volatility United Arab Emirates (figure   increase the                                                               including 2.5).   Chile,   Guyana,   and  the  United  Arab   Emirates  (figure   2.5).                                                                 7 The high volatility of Mongolia’s GDP growth has  coincided with a volatile macroeconomic environment in terms of current account  balance, 7 The  credit growth,  high volatility  inflation,  of Mongolia’s  and  GDP  fiscal balance.  growth    has coincided  with a volatile macroeconomic environment in terms of current account  8  The  median  welfare  cost  of  aggregate  fluctuations  in  developing  countries  is  at  least  10  times  the  cost  of  that  in  the  United  States,  balance,  credit growth, inflation, and fiscal balance.  7 8The high while volatility  the average of Mongolia’s  benefits fromGDP growth has  consumption coincided  stabilization with a to  amount volatile macroeconomic  a perpetual environment  increase in per in terms  capita income of current  of at least account  0.34 percent     The  median  welfare  cost  of  aggregate  fluctuations  in  developing  countries  is  at  least  10  times  the  cost  of  that  in  the  United  States,  balance, while(World  thecredit growth,  Bank,  average 2015a).    from consumption inflation,  benefits and fiscal balance.  stabilization amount to a perpetual increase in per capita income of at least 0.34 percent  8 The median welfare cost of aggregate fluctuations in developing countries is at least 10 times the cost of that in the United States, (World  Bank, 2015a).   15    stabilization amount to a perpetual increase in per capita income of at least 0.34 percent                                                             while the average benefits from consumption (World 7 The    high Bank 2015a).  volatility  of Mongolia’s GDP growth has coincided with a volatile macroeconomic environment in terms of current account 15      balance,  credit growth, inflation, and fiscal balance.  8  The  median  welfare  cost  of  aggregate  fluctuations  in  developing  countries  is  at  least  10  times  the  cost  of  that  in  the  United  States,  SEEKING STABILITY 17 while the average benefits from consumption stabilization amount to a perpetual increase in per capita income of at least 0.34 percent  (World Bank, 2015a).   15    Figure 2.4 Figure 2.5     Output volatility increased after major mining Consumption has also become increasingly discovery volatile Figure Figure  2.4  2.4  Output  Output  volatility  volatility  increased  increased  after  after  major  major     Figure  2.5 Figure  Consumption  2.5  Consumption  has  has  also  become  also      become mining mining  discovery  discovery     increasingly increasingly  volatile  volatile    Output  growth Output  (std  growth  dev,  (std  %) %)  dev, Consumption Consumption  growth  growth  (std  (std  dev,  dev, %) %) 8 8 12 12 Qatar Qatar Qatar Qatar 10 10 UAE UAE 6 6 Armenia Armenia Guyana Guyana 8 8 2004–19 2004–19 Mongolia Mongolia Mongolia Mongolia 2004–19 2004–19 4 4 6 6 Armenia Armenia UAEUAE Kazakhstan Kazakhstan Russia Russia Chile Chile Ecuador Ecuador 4 4 Chile Chile Kazakhstan Kazakhstan 2 2 World World Peru Peru EAP EAP Guyana Guyana 2 2 Australia Australia Malaysia Malaysia Ecuador Ecuador Malaysia Malaysia Qata Qata ASEAN ASEAN 0 0 Australia Australia 0 0 Colombia Canada Colombia Canada 0 0 1 1 2 2 3 3 4 4 5 5 6 6 0 0 2 2 4 4 6 6 8 8 1998–2003 1998–2003     1998–2003 1998–2003     Sources: Sources:  NSO,  NSO,  EIU,  EIU,  WDI;  WDI;  World  World  Bank  Bank  staff  staff  estimates  estimates     Sources: Sources:  NSO,  NSO,  EIU,  EIU,  WDI;  WDI; World  World  Bank  staff  Bank  estimates  staff      estimates Sources: NSO; EIU; WDI; World Bank staff estimates Sources: NSO; EIU; WDI; World Bank staff estimates II.1.3 II.1.3    Heightened Heightened  macroeconomic  macroeconomic  volatility  volatility and  and  financial  financial sector  sector  fragility  fragility  are  are  intertwined  intertwined     II.1.3 Heightened macroeconomic volatility and financial sector fragility are While While   macroeconomic   macroeconomic intertwined   volatility   volatility   may   have   may   contributed   have   to   contributed   to   the   the   fragility   fragility   of   the   of   the   financial   sector,   financial       sector, procyclical procyclical   credit   credit   policies   policies   have   have   exacerbated   exacerbated   volatility.   volatility.   Mongolia   Mongolia   credit   credit   growth   growth   has   has   been   highly   been       highly While volatile volatile macroeconomic   since   since   the  the   onset   onset   of  volatility   of   the the   mining   mining may   boom   boom have   (figure   (figure contributed  2.6).   2.6).   Commodity   Commodity to the  fragility price   price of the   fluctuations   fluctuations financial   influence   influence     sector, bank bank procyclical   profitability   profitability   and  and credit   business   business policies   viability.   viability.   have The  The exacerbated   evolution   evolution   of   commodity   commodity   of volatility.   prices   prices Mongolia   has  has  a  adirect credit   direct   impact   impactgrowth   on   on     has the the been  financing  financing highly  of  of  the volatile  the  mining  mining since  sector,  sector, the but  butonset  also also of  indirectlythe  indirectly mining  affects  affects boom  the the  rest (figure  rest  of  its  of  loan  its2.6).  loan Commodity  portfolio  portfolio  including price  including     fluctuations retail. retail.  Figure  Figure influence  2.7 2.7  shows  shows bank  the  the profitability  relationship  relationship  between and business  between  commodity  commodity viability.  prices  prices  The  andand  bank evolution  bank  profitability,  profitability, of commodity  including  including     prices failed failed has  banks.  banks. a direct  Rapid  Rapid impact on  the  deterioration  deterioration of  of the financing the  domestic  domestic of the mining  economy  economy  due due sector,  to  to  the the  global  global but financial also  financialindirectly  crisis  crisis affects  resulted  resulted     the   the inin  rest the   of   closureclosureits   loan   of of   two portfolio   two   Mongolian   Mongolian including   banks   banks retail.   within   within Figure   less   less   2.7   than than   shows two   two   years. the   relationship   years. 9 9 Given   Given   high   high  between   levelslevels   of       of commodity macroeconomic macroeconomic prices   volatility, and bank   volatility,   banks   banks profitability,   should   should   maintain including   maintain   prudent   prudent failed   banks. capitalization   capitalization Rapid deterioration   levels   levels   to  to  cushion   cushion of     the domestic economy macroeconomic macroeconomic  shocks.  shocks.  However,due to  However,  weakthe  weak global  credit  credit financial  standards,  standards,  crisis questionable  questionable resulted  business  business in the  models  models closure and and  of  related two related     Mongolian party party   lending   lending banks   have   have within   contributed   contributed less   to   than to   financial   financial two  sector years.   sector   fragility 9 Given   fragility   and high   and levels   credit   procyclical   procyclical of macroeconomic   credit   policies   policies   have   have     exacerbated exacerbated volatility, banks  macro  macro ‐financial should ‐financial  risks. maintain  risks.  A  A notable  notable prudent    feature feature capitalization  of  Mongolia’s  of  Mongolia’s levels  financial  financial to cushion  sector  sector  in  this  in  this macroeconomic  regard  regard  is  is  the the shocks.  high  high  ratio  ratio However,  of  of weak indebtedness,  household  household   indebtedness, credit standards,  which  which  increased  increased questionable  dramatically  dramatically business  in  the  in  the  last models last  10  10 years  years and  on  on  the related  the    back back   of   of     the the   subsidized   subsidized     mortgage mortgage     program, program, party lending have contributed to financial sector fragility and procyclical credit policies     reaching reaching     close close   to   to   35  35    percent percent   of   of   gross   gross     domestic domestic     product product     (GDP). (GDP). have  In  fact,  In exacerbated  fact,  household  household  loans macro-financial loans  make  make  up  up 50  50 risks.  percent  percent A notable  of  of  total  total  credit  credit feature  outstanding  outstanding of Mongolia’s  and and  are  are  concentrated financial  concentrated sector     in   in   overleveraged overleveraged   borrowers.   borrowers.     Although Although in this regard is the high ratio of household indebtedness, which increased dramatically in     NPLs NPLs   on  on  individual   individual   loans   loans     currently currently     standstand   at    at   only only     3.7 3.7   percent,   percent,     potential thepotential last 10   losses   losses years   from   from on   the these   these back   loans   loans of  the could   could   hurt   hurt subsidized   bank   bank  mortgage   profitability profitability   and   and program,   combined   combined reaching   with   with   the close   the   high   high to 35    household household    leverage, leverage,   could  could     exacerbate exacerbate percent of gross domestic product (GDP). In fact, household loans make up 50 percent     financial financial    sector sector    vulnerability. vulnerability.    10 10    total ofFigure Figure  2.6 credit  2.6  Financial  Financial outstanding  sector  sector  is is and  are  strongly strongly correlated concentrated  correlated     Figure Figure in  2.7 overleveraged  2.7 Commodity  Commodity  prices  prices borrowers.  are are  associated  associated Although     NPLs withwith on  volatile individual  volatile  growth  growth loans  during  during  currently  mining mining  boom,  boom, stand  2004–19  2004–19 at  only  withwith 3.7  bank bank percent,  profitability  profitability potential       losses from these loans 35 35 could hurt bank profitability and combined 1.51.5 with the high household leverage,600 could 600 30 30 400400 exacerbate financial sector vulnerability. 10 Credit growth (std dev, %) Credit growth (std dev, %) 25 25 1 1 200 200 20 20 2.8422x y = y  + 8.617  = 2.8422x  + 8.617 15 15 R² =  0.3976 R²  = 0.3976 0 0 0.50.5 10 10 Savings Savings  Bank  Bank ‐200 ‐200 5 5 Anod Anod  Bank  Bank Zoos Zoos  Bank  Bank Capital Capital  Bank  Bank 0 0 ‐400 ‐400 0 0 05 Apr‐05 07 Apr‐07 09 Apr‐09 11 Apr‐11 13 Apr‐13 15 Apr‐15 17 Apr‐17 19 Aug‐19 Dec‐04 Dec‐04 06 Apr‐06 Dec‐06 08 Apr‐08 Dec‐08 10 Apr‐10 Dec‐10 12 12 Dec‐12 14 Apr‐14 Dec‐14 16 Apr‐16 Dec‐16 18 Apr‐18 Dec‐18 0 0 2 2 4 4 6 6 8 8 10 10 ‐ Aug Aug Aug Aug Aug Aug Aug Aug Aug Aug Aug Aug Aug Aug Aug Apr Dec Dec Dec Dec Dec Dec Dec Output Output  growth  growth  (std  (std  dev, %) %)  dev,     Composite Composite index:  index:  LHS  LHS Bank Bank  profit/loss:  profit/loss: RHS  RHS                                                                                                                               9 In 9 In  addition addition such  to to  common  such  common  exposure  exposure commodity  to to  price  commodity  fluctuations,  price  the  fluctuations, the  cycles  cycles real  of of  business  real  and  business  the  and  the  financial  financial market  market  often  often  drive  drive     each each  other  other  and  and  result  result in in deeper  deeper  and  and  painful  painful  recessions.  recessions.      The  The 10 10  NPLs  NPLs  for  for  corporate  loans  corporate  loans  represent  represent  about  15  about  15  percent.      percent. 16     16 9     In addition to such common exposure to commodity price fluctuations, the cycles of real business and the financial market often drive each other and result in deeper and painful recessions. 10 The NPLs for corporate loans represent about 15 percent. 18 COUNTRY ECONOMIC MEMORANDUM 2020 the the  high  high  ratio  ratio  of  of  household  household   indebtedness,   indebtedness,  which  which  increased  increased  dramatically  dramatically  in  in  the  the  last  last  10  10  years  years  on  on  the  the    back back   of   of   the   the   subsidized   subsidized   mortgage   mortgage   program,   program,   reaching   reaching   close   close   to   to   35   35   percent   percent   of   of   gross   gross   domestic   domestic   product   product    (GDP). (GDP).  In  In  fact,  fact,  household  household  loans  loans  make  make  up  up  50  50  percent  percent  of  of  total  total  credit  credit  outstanding  outstanding  and  and  are  are  concentrated  concentrated    in in  overleveraged  overleveraged  borrowers.  borrowers.  Although  Although  NPLs  NPLs  on  on  individual  individual  loans  loans  currently  currently  stand  stand  at  at  only  only  3.7  3.7  percent,  percent,    potential potential Figure 2.6    losses losses from    from these    these loans    loans could    could hurt    hurt bank    bank Figure profitability    profitability 2.7    and and combined    combined    with with    the the    high high   household household Financial  leverage,  leverage, sector  could  could is strongly  exacerbate  exacerbate correlated with  financial  financial  sector  sector  vulnerability.  vulnerability. Commodity prices are 10      associated with bank 10 volatile growth during mining boom, 2004–19 profitability Figure Figure  2.6  2.6  Financial  Financial  sector  sector  is  is  strongly  strongly  correlated  correlated    Figure Figure  2.7  2.7  Commodity  Commodity  prices  prices  are  are  associated  associated    with with  volatile  volatile  growth  growth  during  during  mining  mining  boom,  boom,  2004–19  2004–19 with     with  bank  bank  profitability  profitability      35 35 1.5 1.5 600 600 30 30 400 400 Credit growth (std dev, %) Credit growth (std dev, %) 25 25 11 200 200 20 20 y y = = 2.8422x  2.8422x 8.617  + + 8.617 15 15 R² R² 0.3976  = = 0.3976 00 0.5 0.5 10 10 Savings Savings  Bank  Bank ‐200 ‐200 55 Anod Anod  Bank  Bank Zoos Zoos  Bank  Bank Capital Capital  Bank  Bank 00 ‐400 ‐400 00 Aug‐05 Aug‐05 Aug‐07 Aug‐07 Aug‐09 Aug‐09 Aug‐11 Aug‐11 Aug‐13 Aug‐13 Aug‐15 Aug‐15 Aug‐17 Aug‐17 Aug‐19 Aug‐19 Dec‐04 Dec‐04 Apr‐06 Apr‐06 Dec‐06 Dec‐06 Apr‐08 Apr‐08 Dec‐08 Dec‐08 Apr‐10 Apr‐10 Dec‐10 Dec‐10 Apr‐12 Apr‐12 Dec‐12 Dec‐12 Apr‐14 Apr‐14 Dec‐14 Dec‐14 Apr‐16 Apr‐16 Dec‐16 Dec‐16 Apr‐18 Apr‐18 Dec‐18 Dec‐18 00 22 44 66 88 10 10 Output Output  (std  growth  growth  (std  dev,  dev, %)  %)    Composite Composite index:  index:  LHS  LHS Bank Bank  profit/loss:  profit/loss: RHS  RHS    Sources: NSO; EIU; WDI; World Bank staff estimates Sources: BoM; World Bank staff estimates                                                                                                                           99  In  In  addition  addition  to to  such  such  common  common  exposure  exposure  to  to  commodity  commodity  price  price  fluctuations,  fluctuations, the  the  cycles  of  cycles  of  real  real  business  and  business  and  the  the  financial market  financial  often  market  drive  often     drive each each  other  other  and  and  result  result  in  in  deeper  deeper  and  and  painful  painful  recessions.  recessions.    II.2 Macroeconomic    for policies amplify rather than dampen volatility 10  The  The 10  NPLs  NPLs  for corporate  corporate  loans  loans  represent  represent  about  about  15  15  percent.  percent.    Mongolia’s macroeconomic policies amplified rather than mitigated the impact of external 16 16    Sources: NSO; EIU; WDI; World Bank staff estimates  Sources: BoM; World Bank staff estimates  shocks    on   its economic performance. 11 This section makes the following complementary points to explain Mongolia’s increased macroeconomic volatility. II.2  Macroeconomic policies amplify rather than dampen volatility  (i) Mongolia’s increased reliance on mining has naturally brought macroeconomic Mongolia’s volatility   macroeconomic given   policies  amplified its link to fluctuating   rather  prices. commodity than  mitigated   theas In fact,   impact   of  external a country becomes  shocks  on   its   economic   performance. 11   This   section  makes   the   following tightly linked to the world markets of goods and assets, it becomes exposed to frequent   complementary   points   to   explain  Mongolia’s external  increased macroeconomic volatility.   shocks.   (ii) However, macroeconomic 1. Mongolia’s policies   increased  reliance fell short   on  mining in mitigating   has  naturally the external  shocks.   brought  macroeconomic The volatility  given   its consumption fact that link to fluctuating volatility  commodity exceeds  prices. Inoutput volatility  fact, as a implies  country becomes that  macroeconomic  tightly linked to the world  and  of markets policies  goods and assets, financial  it becomes markets exposed are  not  to frequent external smoothing  shocks.   in Mongolia consumption (see However, 2.Section   macroeconomic  policies  fell  short  in  mitigating  the  external  shocks.  The  fact  that  2.1). consumption  volatility  exceeds  output  volatility  implies  that  macroeconomic  policies  and  evidence Empirical financial  markets are indicates  not smoothing that consumption Figure 2.8  in Mongolia (see Section 2.1).   policy shocks are the second most External and policy shocks explain most of importantEmpirical factor   evidence explaining  indicates   that  policy  output Mongolia’s Figure  2.8 External variance  and policy shocks explain most of  in Mongolia shocks  are  the GDP variance, following external second  most  important  factor    output variance in Mongolia   shocks. explaining   Mongolia’s First, Mongolia’s   GDP  variance,  100% macroeconomic 30% 100% following  external  shocks.  First,  Mongolia’s  11% 1% 6% volatility hinges on its strong dependence 20% 6% macroeconomic volatility hinges on its strong  50% 21% on mining and limited dependence export   on  mining   and destinations,   limited  export  5% 0% which have both of destinations, intensified   both   of  which  have over time.     intensified China's GDP Exchange rate (supply side) Commodity expenditure Money supply Other factors Total variance of FDI Cost push growth prices Our analysis indicates that policy shocks Fiscal over  time.  Our  analysis  indicates  that  policy  output monetary, (fiscal, shocks and exchange   (fiscal,  monetary,   and  exchange rate)  rate)  are the aresecond   the  second most   most important   important factor   factor  Sources: BoM; Batsuuri et al. 2020    explaining   output   variance,   accounting   for   Sources: BoM; Batsuuri et al. 2020 explaining output variance, accounting for Note:  Variables used used in  estimation  include  China’s  GDP  growth;  12 Note: Variables in estimation include China’s GDP nearly   20   percent   of   nearly 20 percent of the output volatility. the   output   volatility. 12   prices of growth;  copper, prices of  coal, andcoal,  oil; real copper, and  GDP; oil;  consumer real GDP;  price  index  consumer (CPI);  ratio   of   seasonally External  shocks  including  FDI  inflows,  price index (CPI); ratio of seasonally adjusted FDI to GDP;   adjusted   FDI   to   GDP;   ratio   of   budget   External shocks including FDI inflows, expenditure ratio of budget GDP; M2 money;  to expenditure to  outstanding GDP; M2  loan; and money;   outstanding commodity  prices  (mainly  copper  price),  and  exchange rate  commodity prices (mainly copper price), China’s  GDP  explain  close  to  50  percent  of  loan; and exchange rate and China’s GDP explain close to 50 Mongolia’s  output  volatility.  Building  on  these  empirical  findings,  the  following  subsections  will  of Mongolia’s percentdiscuss  the underlying output  causes volatility. Building on  of the predominant these  external  and empirical  policy shocks findings,  (figure the 2.8).   following subsections will discuss the underlying causes of the predominant external and policy shocks II.2.1 2.8).  of the mining sector is the source of much of the macroeconomic volatility    Dominance (figure 11 The  economic  significance  of  the  mining  sector  since  in  the  mid‐2000s  has  increased,  surpassing  Note that erratic and unsustainable fiscal and monetary policies have led Mongolia to face twin deficits (Fatas and Mihov 2013). 12 We used the the  traditional   livestock in variance decomposition sector.   Following the Bayesian   the Vector   discovery (BVAR) Autoregression of  new to  major   mineral determine factors  resources that explain  (coal  output deposits variance. Policy shock is a     and gold‐copper combined   ore), impact importance   the expenditure of budget as  of   the share of  mineral sector and GDP, M2  money, nominal  exchange increased substantially. rate. 13  In  SEEKING STABILITY 19                                                              11 Note that erratic and unsustainable fiscal and monetary policies have led Mongolia to face twin deficits (Fatas and Mihov 2013).  12  We  used  the  variance  decomposition  in  the  Bayesian  Vector  Autoregression  (BVAR)  to  determine  factors  that  explain  output  II.2.1 Dominance of the mining sector is the source of much of the macroeconomic volatility The   economic significance of the mining sector since in the mid-2000s has   increased, surpassing the traditional livestock sector. Following the discovery of new fact, major  relative mineral  to  structural resources   and (coal deposits   aspirational   peers, and   Mongolia gold-copper  has,  since since ore),  2005, 2005, the  had had importance  the highest of the  highest the ratio  ratio fact, mineral  relativesector  to   structural increased and aspirational substantially. peers, 13 In Mongolia fact, relative has,   to   structural     and aspirational   of of    natural natural  resource  resource  rents rents  has,    to  GDP, to GDP,   averaging averaging  about  30 30  percent    of  GDP GDP  (figure (figure  2.9).2.9).14   14 peers, Mongolia since 2004, had  about the highest percent ratio ofof  natural resource rents to GDP, averaging The    increased about 30 percent of  GDP   dependence (figure 2.9). 14 The increased dependence   on on  the the   mining mining   Figure  Figure 2.9   2.9  Mongolia’s Mongolia’s  resource resource  rents rents  exceed exceed  peers peers    sector Thesector   is increased  associated   with dependence   increased  volatility the mining on volatility   50 sector is associated with increased    is associated  with increased   50 Growing importance  of mining since  Growing importance of mining since  in   output in  outputin volatility   and   and   output consumption.   consumption. and consumption.   Mongolia’s   Mongolia’s  Mongolia’s   40 Mongolia Mongolia 2004 growth volatility is strongly 2004 40 Structural peers growth fact,   volatility   relative   tois    strongly structural     associated and   aspirational   with     peers,  Mongolia Structural peers   has,  since  2005, had the highest ratio of   GDP associated growth  volatility with the fluctuations   is  strongly   associated  with of   Figure Aspirational  peers  GDP 30 2.9 Aspirational peers 30 the   fluctuations natural resource   of   commodity  rents  to GDP,   prices  averaging   (figure  about     30 percent of GDP (figure 2.9).14   of commodity the   fluctuations prices of (figure commodity 2.10). prices In the (figure  of Percent Percent    Mongolia’s resource rents exceed peers 20 2.10). absence 2.10).     In In  of  the the    absence sound absence    of macroeconomic of    sound sound 20 The  increased  dependence  on  the  mining  Figure  2.9 Mongolia’s resource rents exceed peers  macroeconomic policies macroeconomic to mitigate    policies the policies    to impact to    mitigateof shocks, mitigate    the the     10 10 sector is associated  with  increased  volatility 50 Growing importance of mining since  the impact economy’s impact  of in   of  shocks, output shocks,   and exposure  the  the   economy’s economy’s   consumption. to commodity   exposure exposure   Mongolia’s   to to     00 Mongolia 2004 40 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 shocks commodity led   shocks to  led external  to   external imbalances  imbalances   1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Structural peers commodity growth  volatility shocks led   is to  external strongly  imbalances   associated   with       Percent of GDP Aspirational peers and macroeconomic volatilities given Sources: 30  NSO, MoF, BoM; World Bank staff estimates  and and macroeconomic    the macroeconomic   fluctuations  of     commodity volatilities   prices volatilities given given   (figure the       the Sources:   NSO,   MoF,   BoM;   World   Bank   staff   estimates   the heavy heavyheavy   dependence 2.10). dependence dependence   In  the   on on    commodity commodity on absence    exports. commodity exports. of   sound   Figure Figure      2.11 2.11  20   shows shows    the the   positive association  between positive  association between   exports. real consumption    macroeconomic Figure 2.11    growth  growth policies also    and shows   to   commodity mitigate  the the    price      volatility. The   higher   The higher   regression regression   coefficient coefficient   real consumption and commodity price volatility.  10 positive between association  consumption   growth between real between impact  of  consumption  shocks,  the growth  volatility   economy’s volatility  and  exposure and commodity price volatility (0.70) compared   to   0 compared  with with  the the   consumption growth and commodity price   1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 commodity coefficient   between  shocks    led output  to  external   growth coefficient  between  output  growth  volatility Sources: NSO, MoF, BoM; World Bank staff  imbalances   volatility   and   commodity   price   volatility   (0.18)    (0.18)   shows   shows  that        that volatility.and   As Loayza et macroeconomic   al. (2007) volatilities   given have   the   estimates  commodity commodity     prices prices    areare more   closely    more closely    related related  with Sources:  consumption NSO; MoF; BoM;   thanWorld output   output Bank staff estimates    This volatility.    volatility. This   found, heavy consumption  dependence volatility   on   commodity represents   exports.   Figure   2.11   shows   the   positive   association   between     reinforces the  point    that  policy that   exacerbates exacerbates rather than reduces volatility. As Loayza Loayza  et al.  (2007) et  al. (2007) a reinforces net real welfare  the   consumption  loss point because policyhouseholds’   growth  and   commodity  price  volatility.  The  higher  regression  coefficient    have andhave  found,  found, firms’  consumption  consumption spending and     volatility volatility  represents investment represents decisions  a net are  welfare typically  because households’  lossdisrupted households’ in an environment   and and  firms’ firms’   between  consumption growth volatility  and commodity  price volatility  (0.70)  compared  with the  spending spending with heightened    and and   investment investment volatility.   decisions decisions 15 Hence   are are  typically improving typically   disrupted  in  an  environment macroeconomic environment management with   with in heightened   Mongolia heightened    coefficient   between   output   growth   volatility  and   commodity  price   volatility  (0.18)   shows   that  volatility. volatility. 15    Hence Hence   improving improving    macroeconomic macroeconomic   management  in  Mongolia  would would   have have   a a   direct direct    This    15 would have commodity a direct   prices positive   are  more welfare   closely impact.   related  with  consumption   than  output  volatility. positive positive   reinforceswelfare  welfare  the  impact.  impact.  point that     policy exacerbates rather than reduces volatility. As Loayza et al. (2007)  Figure 2.10 Figure 2.11 have Figure Figure  found,     2.10 2.10  consumption     Mongolia’s Mongolia’s growth    is  volatility growth  represents    volatility volatility    is   a  net welfare  2.11  … Figure loss  because  households’  Mongolia’s consumption consumption  and  firms’   growth growth        is is Mongolia’s growth volatility strongly … Mongolia’s consumption growth is also spending strongly strongly associated     associated associated with   and   investment    with commodity with    commodity commodity prices  decisions    are volatility…   typically prices prices     disrupted also positively   in   an  positively linked   environment linked with   with commodity  with commodity commodity price  heightened price       price volatility volatility. volatility… volatility…      15   Hence   improving   macroeconomic   management volatility    in   Mongolia   would   have   a  direct  positive welfare impact.  99 12 88 Output growth (std dev, %) Output growth (std dev, %) consumption growth (std  77 10 0.191x  + y = 0.191x +  2.9124 2.9124 Figure y y = 2.10  +   0.1775x  =  0.1775x  +Mongolia’s  0.8258  0.8258   growth  volatility  is  Figure 2.11 … Mongolia’s R² =  consumption growth is  =  0.1328 0.1328 66 55 strongly R² R²  =    =  0.3498 associated  0.3498   with  commodity  prices  also 8 positively linked with commodity price  volatility…   volatility 6   %) dev,  %) 44 Real  consumption 9 dev, 33 12 4 8 22 Output growth (std dev, %) Real consumption growth (std  7 10 2 y = 0.191x + 2.9124 11 y = 0.1775x + 0.8258 R² = 0.1328 6 R² = 0.3498 00 08 Real 5 00 55 10 10 15 15 20 20 0 60 5 5 10 10 15 15 20 20 dev, %) 4 Growth Growth 3  in  in  commodity  commodity  prices  prices  (Metals  (Metals  &  &  Minerals,  Minerals,  std  std   dev dev  %) %)   Growth  in Growth in  commodity prices  (Metals commodity  prices (Metals  & &   Minerals, std Minerals,  dev  std dev %)  %)    4 Sources: Sources: Sources:  NSO; NSO;  NSO; 2  MoF;  MoF; MoF;   BoM;  BoM; BoM;   World  World World  Bank  Bank Bank    staff   staff staff estimates   estimates estimates Sources: Sources: Sources:   NSO; NSO; NSO;  MoF;   MoF;  BoM; MoF; BoM;   World BoM; World World   Bank Bank Bank  staff staff   estimates estimates staff    estimates 2 Note: Note: Note:   TheThe 1 standard deviations are three‐year moving   Thestandard  standarddeviations  deviationsare  three‐year  arethree-year  moving  moving Note: Note: Note:   The  The The   standard  standard standard  deviations  deviations deviations  are  are are   three  three ‐ year ‐year moving three-year   moving   moving  average average average   0 0 average average average  over  over over  1998–2019  1998–2019 01998–2019 5     10 15 20 over over  1998–2019 over 1998–2019 1998–2019     0 5 10 15 20 Growth in commodity prices (Metals & Minerals, std dev %)                                                               Growth in commodity prices (Metals & Minerals, std dev %)                                                                  14  The Sources: NSO;  estimates  of  MoF; BoM;  natural  resources World  rents Bank  staff are  estimates  as the difference Sources:  NSO; MoF;  BoM;  World  Bank staff estimates   average cost of  13 14  The Erdenet  estimates copper Note:  The of  was  natural  standard opened  resources in 1974  deviations  are rents and for  three  are calculated   calculated ‐quite year some time  moving   as the was  difference one Note:of The largest    between the between  standard  the the copper   price price  deviations a a  commodity of   are   of mines commodity  in the‐year three world. and  the   and  moving the  average  average    cost of  14 producing The estimates producing    it. it.    This This of     is natural is    done done    by   resources by   estimating estimating rents   the the are   world world calculated   price price    of of as     units the units     of difference of     specific specific     commodities between commodities the    and price and   subtracting of a subtracting commodity    estimates and estimates   of the  of  average   average average  unit    costs cost unit of      costs average over 1998–2019  over 1998–2019  of producing of  extraction  extractionit. This or or  harvesting  is done by  estimating harvesting  costs costs  (including  (including the world   aa  normalprice  return normal return of units on   on of  capital). capital).  commodities specific These  These unit   unit  rents and rents   are   then subtracting are then  multiplied estimates multiplied by  the   by of the   physical average physical quantities    unit costs     quantities ofcountries extraction countries or harvesting  extract  extract  or or  harvest  harvest costs  to  (including determine                                                              to  determine  a   the  normal the rents return   rents  for each for  each on capital). These   commodity commodity   as as  a a  unit share share rents    of are   of  GDP. GDP.  then multiplied by the physical quantities countries 15  We   extract also   found or that harvest  the  to high determine   concentration the rents   of   for flows FDI each  commodity to   the   mineral as  a share sector   of  GDP. has been   another 15 We 14  also The  found  estimates that  the  high concentration of natural  resources rents  of  FDI  are  flows to  calculated  the  as  the  mineral  difference  sector  has been  between  the price  another  of a    source source  of commodity and the average   of  macroeconomic  macroeconomic  of      volatility,  volatility, cost 15 We also found evidenced   by   that the   the high positive   concentration association  between of FDI  real flows  GDP   to the mineral growth  volatility sector  and   has FDI   been another volatility.  This   source of has relationship macroeconomic  been  more   volatility,   pronounced evidenced producing  by the  it.   This  positive   is  done    associationby  estimating  between  the   world  real GDP  price  of  growth  units  of  specific  volatility  commodities  and FDI  volatility.  and  subtracting  This  relationship  estimates  of  has been  average  more   unit  costs  pronounced     evidenced for  Mongoliaby the positive  relative  to association  aspirational between   and real GDP  structural  peers growth since since volatility 2010,  2010, and FDI the  reflecting reflecting volatility.  dominant This role relationship has been more pronounced for   of extraction Mongolia   relative harvesting  or  to  aspirational  costs  and(including   structural  a normal peers  return   on     capital).    These  the unit    rents are   dominant then  role of of    multiplied   the the   mineral  by the mineral    sector  physical sector  in  in the   quantities  the  economy.  economy.   for Mongolia relative to aspirational and structural peers since 2010, reflecting the dominant role of the mineral sector in the economy. countries extract or harvest to determine the rents for each commodity as a share of GDP.  18   We also found that the high concentration of FDI flows to the mineral sector has been another source of macroeconomic volatility,  18  20 15 COUNTRY   ECONOMIC MEMORANDUM 2020   evidenced by the positive association between real GDP growth volatility and FDI volatility. This relationship has been more pronounced  for Mongolia relative to aspirational and structural peers since 2010, reflecting the dominant role of the mineral sector in the economy. 18    II.2.2 Policies magnified rather than reduced volatility Mongolia’s higher consumption volatility relative to output volatility indicates the ineffectiveness of macroeconomic policies and financial markets to smooth consumption. Moreover, the fact that non-mining activities experienced higher volatility than mining activities also reinforces our argument that policies may have magnified the impact of II.2.2 Policies magnify rather than reduced vola�lity external shocks. Mongolia’s higher consump�on vola�lity rela�ve to output vola�lity indicates the ineffec�veness of Fiscal, monetary, and exchange rate policies macroeconomic policies and financial markets to smooth consump�on. Moreover, the fact that non- mining ac�vi�es experienced Macroeconomic policies higher tended tha have vola�lity mining ac� ton amplify vi�es also rather reinforces than dampen our argument volatility. that policies may have magnified the impact of external shocks. Figure 2.12 shows that fiscal, monetary, and external sector policies tend to be generally insensitive to business Fiscal, monetary, cycles. and exchange fact, during years of boom and bust, macroeconomic Inpolicies rate policies move broadly in the same direction and almost in the same magnitude.16 Macroeconomic Mongolia’s policies fiscal tended to have seems policy toamplify haverather been than dampen vola�lity. sensitive Figure 2.12 shows to the business cycle. that fiscal, mone tary , and exter nal sector policies tend to be generally insensi�ve Figure 2.12 shows that the fiscal balance worsened during busts as an increase in public to business cyc les. In fact, during years of boom and bust, macroeconomic policies move broadly in the same direc�on spending was coupled with a decrease in revenue during busts. Interestingly, public debt and almost in the same magnitude.16 also increased more during busts (61 percent of GDP compared to 57 percent). Mongolia’s fiscal policy seems to have been sensi�ve to the business cycle. Figure 2.12 shows that the fiscal balance worsened during busts as an increase in public spending was coupled with a Figure 2.12 decrease in revenue during busts. Interes�ngly, public debt also increased more during busts (61 Evidence points to the procyclicality of macroeconomic policies percent of GDP compared to 57 percent). Figure 2.12 Evidence points to the procyclicality of macroeconomic policies Panel A Panel B Panel C Monetary policy (%) 70 Fiscal policy (% GDP) External sector (%) 40 61 15 13 Boom Bust 34 60 57 11 35 10 50 6 30 5 2 25 40 0 21 19 32 31 33 0 20 28 30 14 -5 15 11 12 13 -4 20 10 -10 6 10 5 0.40 -15 -12 0 -14 0 -20 -10 -5 Source: BoM; MoF; WB staff estimates Note: Boom years are identified based on movement in commodity prices. Boom years: 2004–08, 2010–12, 2017–19. Bust years: Source: BoM; MoF; WB staff estimates 2009, Note: 2013–16. Boom yearsCAB/GDP = current are identified account based balance/gross on movement domestic prices. in commodity product; TB/GDP Boom = trade years: balance/gross 2004–08, 2010–12,domes tic product 2017–19. Bust years: 2009, 2013–16. CAB/GDP = current account balance/gross domestic product; TB/GDP = trade balance/gross Mongolia’s domestic monetary policy is broadly insensi�ve to business condi�ons. Figure 2.12 shows product that all the selected indicators move in the same direc�on irrespec�ve of booms or busts. However, the magnitude over the cycles does seem to be materially different. For instance, credit growth increased on average by 14 percent during busts compared to 34 percent during booms. Exchange rate policy has been sensi�ve to the business cycles, but not sufficiently to avoid losing foreign 16 Macroeconomic policies in developing countries are generally procyclical; thus, interest rate hikes and government spending cuts are implemented during downturns (Kaminsky, Reinhart, and Végh 2005). 16 Macroeconomic policies in developing countries are generally procyclical; thus, interest rate hikes and government spending19 cuts are implemented during downturns (Kaminsky, Reinhart, and Végh 2005). SEEKING STABILITY 21 Mongolia’s monetary policy is broadly insensitive to business conditions. Figure 2.12 shows that all the selected indicators move in the same direction irrespective of booms or busts. However, the magnitude over the cycles does seem to be materially different. For instance, credit growth increased on average by 14 percent during busts compared to 34 percent during booms. Exchange rate policy has been sensitive to the business cycles, but not sufficiently to avoid losing foreign reserves. The central bank intervened in the foreign exchange market to mostly ease the depreciating pressure. The tugrug depreciated by 13 percent during busts relative to only 2 percent during booms, as one should expect. Significant foreign reserves intervention by the central bank during busts suggests depreciation would have been larger without it.17 There are good reasons     why the central bank may wish to limit exchange rate fluctuations, including a high level of dollar-denominated external debt, and the limited price elasticity of mining exports to reserves. reserves.   The   central   The   central   bank   bank   intervened   intervened in  the   in  the   foreign   foreign   exchange   exchange   market   market   to   to mostly   mostly  ease   the   ease       the changes in  the depreciating depreciating tugrug-dollar pressure.  pressure. The  tugrug  The rate.  depreciated  tugrug Nonetheless,  depreciated  by  13 by percent by  reducing 13 percent  during during  busts foreign  busts  relative  exchange  relativeto only  to only  2 buffers,  2 percentpercent    the “fear during during of   booms,floating”   booms,  as  one leaves   should as  one   should Mongolia   expect.   expect. exposed   Significant   Significant to   foreign   foreign the accumulation   reserves   reserves   intervention   intervention of external   by  the by  the   centralpressures,   bank   central       bank which during duringmay  busts lead  busts to disorderly  suggests  suggests  depreciation  depreciation adjustment,  would  would  have as been  have  been last  happened larger  larger  without  without  itin 2016,  (figure  it  (figure for  2.13). instance  2.13). 17  There 17  are  There (see  good  are also      good Gopinath reasons reasons 2019).  why  the  why  the  central  bank  central  may  bank  wish  may  wish  to   to limit limit  exchange  exchange  rate rate  fluctuations,  fluctuations,  including  including  a high  a high  level  of  of   level dollar Takendollar ‐denominated ‐denominated together,   external Mongolia’s  external   debt,   debt,  and fiscal,   the   and   limited   the monetary,   limited   price  price and   elasticity   elasticity exchange   of  mining of  miningrate   exports   exports policies   to  changes   changes tohave   in     in  been   tugrug thethe   tugrug ‐dollar ‐dollar   rate.  rate.   Nonetheless,   Nonetheless,   by  by   reducing reducing   foreign   foreign   exchange   exchange   buffers,   buffers,   the   the   “fear   “fear of  floating”   of  floating”     procyclical and therefore unable to smooth high volatility in consumption. Figure leaves leaves   Mongolia   Mongolia   exposed   exposed to  the   to  the   accumulation   accumulation   of  external of  external   pressures,   pressures,   which   which   may   may   lead   to  disorderly   lead to  disorderly     2.13 indicates that Mongolia’s policies have been positively correlated with output variance adjustment, adjustment,  as   last as last  happened  happened  in 2016,  in 2016,  for for instance  instance  (see  also  (see  also  Gopinath Gopinath  2019).  2019).       during booms and busts, suggesting that macroeconomic policies have been procyclical. This finding Taken Taken together, is also  together, confirmed  Mongolia’s  Mongolia’s  fiscal, by  fiscal, the monetary,  monetary, positive  and  andassociation  exchange  exchange  rate between  rate  policies policies  have macroeconomic  have been  been  procyclical  procyclical policies  and      and and external therefore therefore   unable shocks,   unable   to  smooth which to  smooth   high  indicates   volatility high   volatility  that in   in these consumption. consumption. policies  Figure  Figure have   2.13   2.13 rather   indicates   indicates amplified   that   that   Mongolia’s external   Mongolia’s     shocks policies policies in   haveboth   have   beenbooms   been   positively   positively and busts   correlated   correlated (figure   with   with 2.14).   output  output variance  18 The   variance same   during  during result   booms   booms applies   and   and   busts, to  consumption   busts,   suggesting suggesting     that that   macroeconomic volatility.   macroeconomic The procyclicality   policies   policies   have of   have  been economic  been   procyclical.   procyclical. policy   This has   finding   This   finding led to  is short-term also   is  also  confirmed   confirmed   by  the economic by  the   positive  positive volatility,     association association     between between     macroeconomic macroeconomic thus hindering long-term development. Even though Mongolia has fiscal and monetary     policies policies   and   and     external external   shocks,   shocks,     which which     indicates indicates   that  that   these   these    policies policies   have   have     rather rather    amplified amplified   external   external   shocks institutions to manage macroeconomic volatility on paper, namely fiscal rules, stabilization  shocks   in   both   in   both   booms   booms   and   and   busts   busts    (figure (figure  2.14).  2.14). 18 18   The     The same   same    result result funds, applies  fiscal applies to consumption  to  consumption responsibility  volatility. laws,  volatility. and  The The a  monetary  procyclicality  procyclicality  of   policy of  economic economic committee  policy  policy  has along  has  led the  led to short  short to lines term ‐of ‐many term     economic economic   volatility,   volatility,   thus   thus     hindering hindering   long   ‐ long resource-rich countries, the implementation of countercyclical policy measures apparentlyterm ‐ term    development. development.   Even   Even  though   though   Mongolia   Mongolia   has   has     fiscal   fiscal and     and   monetary monetary   institutions   institutions   to    to manage   manage   macroeconomic   macroeconomic   volatility   volatility   on     on   paper, paper,   namely   namely   fiscal   fiscal  rules,   rules,     has not been effective enough. stabilization stabilization   funds,   funds,   fiscal   fiscal   responsibility   responsibility   laws,   laws,   and   and   a  monetary   a  monetary   policy   policy   committee   committee   along   along   the   lines   the   of   of    lines many many   resource Figure 2.13   ‐ resource ‐ rich   countries, rich   countries,  the     implementation the   implementation   of    of   countercyclical Figure 2.14 countercyclical    policypolicy     measures measures     apparently apparently      not hashas  been  not  been  effective  effective  enough.  enough.       Policy amplifies volatility during booms and …Policy and external shocks are positively busts… correlated during booms and busts Figure Figure   2.13   2.13   Policy   Policy   amplifies  volatility   amplifies   during   volatility  during     Figure Figure  2.14  2.14  …Policy  …Policy  and and  external  shocks  external  are  are   shocks booms booms  and and  busts…  busts…       positively positively  correlated  correlated  during  booms  during  and  booms  busts  and      busts 2.5 2.5 2.5 2.5 BoomBoom yearsyears (output (output deviation) deviation) Boom yearsyears Boom (output (output deviation) deviation) Bust years Bust years (output (output deviation) deviation) Bust years Bust years (output (output deviation) deviation) Policy shock (fiscal, monetary & Policy shock (fiscal, monetary & Policy shock (fiscal, monetary & Policy shock (fiscal, monetary & 2.0 2.0 2.0 2.0 exchange rate policies), % exchange rate policies), % exchange rate policies), % exchange rate policies), % 1.5 1.5 1.5 1.5 1.0 1.0 1.0 1.0 0.5 0.5 0.5 0.5 0.0 0.0 0.0 0.0 -0.5 -0.5 -0.5 -0.5 0 0 2 2 4 4 6 6 8 8 10 10 0 0 1 1 2 2 3 3 4 4 5 5 Output Output variance variance (%) (%) Variance Variance of external factors of external (%) (%) factors         Sources:  World Sources:  World  Bank  staff  Bank  staff  estimates;  Batsuuri  estimates;  Batsuuri  et  et al.      al. 2020  2020 Sources: Sources:  World  World  Bank  staff  Bank  staff  estimates;  estimates;  Batsuuri  Batsuuri  et al.  et 2020      al. 2020 Sources: World Bank staff estimates; Batsuuri et al. 2020 Sources: World Bank staff estimates; Batsuuri et al. 2020 Weak Weak  corporate  corporate  governance  governance  in the  in the  financial  financial  sector  sector  amplifies  amplifies  business  business  cycle  cycle  conditions  conditions     17 Mongolian Mongolian Consistent with  fall  banks  banks the Law    on short fall  short Central in  mitigating  in mitigating Banking, keeping risks risks the  associated  associated nominal  with exchange with  rapid rate as rapid stable  economic  economic  expansion as possible been  essential expansion  has  triggered triggered to     avoid social unrest and build the central bank’s reputation, and was often politicized for reputational gains. 18 by   commodity by   commodity     price   price   booms   booms and    and   are are     slow slow   to   to   adjust   when adjust    whenthe     tide the   tide     turns. turns.     Foreign Foreign     capital capital Like most of its structural peers, Mongolia exhibits fiscal and monetary policy procyclicality. The fiscal and monetary policies are     inflow inflow     generally procyclical in structural peers, while countercyclical in aspirational peers.                                                                                                                            22 COUNTRY 17 17  Consistent   Consistent ECONOMIC   with   the  Law   with the  Law MEMORANDUM   on on  Central  Central   Banking,   Banking,  2020   keeping   keeping the  nominal   exchange the  nominal   rate  rate   exchange   as  stable as  stable   as  possible   as  possible   has  been has  been   essential   essential   to  avoid   to  avoid     social social  unrest  unrest and build and build  the  central bank’s the central  reputation,  bank’s reputation,  and was and was  often often  politicized  politicized  for reputational  for reputational  gains.    gains.   18  Like 18  Like most   of  its   most   structural   of   its  structural   peers,   peers,   Mongolia   exhibits   Mongolia   fiscal   exhibits   fiscal   and  and monetary   monetary   policy   policy   procyclicality.   procyclicality.   The  The fiscal   fiscal   and  and  monetary monetary   policies   policies   are   are  generally generally  procyclical  procyclical  in structural  peers,  in structural  peers,  while  while  countercyclical  countercyclical  in aspirational  peers.  in aspirational      peers. 20  20  Weak corporate governance in the financial sector amplifies business cycle conditions Mongolian banks fall short in mitigating risks associated with rapid economic expansion triggered by commodity price booms and are slow to adjust when the tide turns. Foreign capital inflow during a commodity super cycle is likely to boost both bank assets and liabilities (Avdjiev et al. 2018). In this case, banks turn increased liquidity to credits, and increased domestic demand results in greater but not “genuine” deposits. However, while doing so, banks often fail to conduct proper assessment of the risks, and with increased opportunity to invest in the mining sector, they tend to increase their exposure asymptotically to the mineral sector.19 Persistent governance weaknesses exacerbate macro-financial risks emanating from the banking sector. Although Mongolia carried out a detailed Asset Quality Review (AQR) in 2018 to identify capital shortfalls in the banking sector and thus identify measures needed to strengthen its resilience, the subsequent recapitalization process has remained incomplete in the face of resistance from existing bank owners. Indeed, the BoM’s efforts to strengthen its regulatory and supervisory framework have been plagued by significant forbearance, such that existing regulatory standards are not strictly enforced and lack of transparency is tolerated to hide underlying prudential concerns. High levels of concentration in bank ownership exacerbate governance weaknesses and reduce market pressures to change existing practices. The main areas for improvement in corporate governance of Mongolia’s commercial banks include business policies and procedures, the professional qualification of directors, involvement of committees in technical matters, the role of independent directors, and internal reporting lines. Moreover, credit risk management and control need to be further strengthened, especially regarding project finance and the selection of collateral. For instance, in the mining sector, which naturally accounts for a significant share of corporate exposure, banks are not familiar enough with specific project finance techniques or able to effectively differentiate between fully enforceable collateral in practical terms and collateral that is valuable only on an ongoing concern basis. II.3 Policy priorities - Escaping from the procyclicality trap Mongolia’s macroeconomic management has improved considerably during the past three years. Particularly, the country’s fiscal stance has improved substantially following two consecutive years of budget surplus, leading to a significant reduction in the public debt-to-GDP ratio during this period prior to the COVID-19 shock. Successful debt issuance, taking advantage of enhanced policy credibility and good market conditions, also contributed to reserve accumulation. However, there are areas where policy improvements are needed. The diagnostics on the sources of Mongolia’s macroeconomic volatility reveal that fiscal, monetary, and exchange rate policies have been ineffective in mitigating volatility brought by the increasing dependence on the mining sector, which has exposed Mongolia’s macroeconomy (output and consumption) to commodity price fluctuations. Financial sector fragility induced by factors including weak corporate governance and systematic regulatory forbearance has exacerbated the strong association between financial and business cycles. Accordingly, the main thrust of the policy recommendations on these issues is that sound macroeconomic policies should aim to smooth consumption rather than production. More specifically, the report proposes policy and institutional strengthening measures articulated around 19 Once the system is overleveraged during a commodity boom, it becomes difficult to adjust to a deleveraging process when local politics becomes unfavorable and commodity prices start to decline. SEEKING STABILITY 23 fiscal policy (for example, fiscal rules credibility); monetary (including exchange rate) and financial sector policies (for example, an independent and accountable central bank); and the role of stabilization funds, intergenerational sovereign wealth funds, and debt sustainability (for example, prioritizing debt reduction). II.3.1 Fiscal policy Mongolia passed the Fiscal Stability Law in 2010 to make fiscal policy more predictable in the face of volatile mining revenue and to ensure debt sustainability.20 However, the implementation of the law has encountered a series of issues since 2013. These include: (i) Noncompliance with the rule parameters mainly due to ambitious budget submissions or weaker economic outturns. Since 2013, the effectiveness and compliance with the rules weakened as governments did not abide by the original parameters in the law (National Resource Governance Institute 2019; IMF 2019). (ii) Frequent amendments to the debt limit and deficit ceiling (2015-17), and flexible present value terms, which are subject to manipulation. The authorities repeatedly changed the parameters in the law through four amendments to the debt limit and the deficit ceiling in 2015-17 (for example, the debt ceiling was lifted permanently in 2016 from 40 percent to 60 percent of GDP in present value terms), whereas the law states that budget balance targets shall be reestablished every four years. (iii) No stipulation on the length of suspension or correction mechanism for the post-suspension period. The Fiscal Stability Law has a clause allowing for a temporary suspension of the fiscal rules, but it does not stipulate the length of the suspension or any correction mechanism for the post-suspension period. (iv) Absence of a credible and capable Fiscal Stability Council. As legally established under the Budgetary Standing Committee of the Parliament, Mongolia’s Fiscal Stability Council is not likely to be independent. Its current staffing structure (two permanent staff at the secretariat office) makes it difficult to monitor structural balance targets. The fiscal policy recommendations proposed to build on best practice principles including simplicity, wide coverage, flexibility, and enforceability. Box 2.2 presents lessons from Peru’s fiscal rules. Box 2.2 Peru’s fiscal rules – Lessons for Mongolia Best practice suggests that formal, numerical fiscal rules can enhance the credibility of fiscal policy and reduce procyclicality. Fiscal rules should be simple to calculate and easy to monitor and enforce, especially in countries where there is no established oversight actor with strong technical capacity. They also require effective public finance management institutions to ensure consistency between the proposed budget and the fiscal rule, appropriate reporting and corrective action during budget execution, and adequate and transparent enforcement mechanisms. The lack of an independent oversight body with adequate capacity makes it difficult to scrutinize the technical assumptions supported by the rules. 20 Key fiscal objectives include fiscal balances, expenditure, public debt, and assets of the Fiscal Stabilization Fund. Three fiscal rules became effective in 2013. The law requires the budget proposal for each fiscal year to comply with these rules and is complemented with a medium-term budget framework intended to incorporate policy objectives and guide expenditure beyond the initial budget year. Macroeconomic forecasts covering three years are produced at least once a year. 24 COUNTRY ECONOMIC MEMORANDUM 2020 Peru’s exception rules: Congress can suspend the application of the fiscal rules for up to three years in cases of national emergency or international crisis with considerable impact over the national economy, by request of the executive. In the request, the executive should specify the limits to be applied for the fiscal deficit of the non-financial public sector (NFPS), and for the annual increase of NFPS spending. For instance, if real GDP is decreasing, the deficit of the NFPS should be between 1 percent and 2.5 percent of GDP for up to three consecutive years. However, under the exception rule, the fiscal deficit should decrease by 0.5 percent of GDP every year until it is below 1 percent of GDP. Peru’s fiscal rules for election years, which could be considered in Mongolia, stipulate that the nonfinancial expenditure of the general government executed in the first seven months of the year cannot exceed 60 percent of the budgeted nonfinancial expenditure for the whole year. These rules also indicate that the fiscal deficit of the NFPS in the first half of the fiscal year cannot exceed 40 percent of the budgeted deficit for the whole year. Source: World Bank 2012 Fiscal rules Simplify the objectives so the public can understand and monitor them. (i) Use objectives such as the overall fiscal balance instead of structural balance, which is difficult to explain. Introducing expenditure ceilings calibrated to rapid debt reduction can operate as an automatic stabilizer.21 More specifically, the following can be explored: • An expenditure rule committed to a predetermined nominal growth rate of public expenditure would curb the tendency to increase public spending in good years, while allowing automatic stabilizers to operate on the revenue side. It is also easy to communicate and monitor. However, it may not address procyclical tax cuts. • A non-mining balance rule could be calibrated to achieve debt sustainability. This is easy to observe and monitor, and it also mitigates some cyclicality. • An overall balance rule with deficit calibrated to achieve debt sustainability is also easy to observe and monitor. However, it is inherently procyclical. (ii) Consider reducing the debt ceiling from its current level given Mongolia’s high level of debt and ideally measured not in Net Present Value terms.22 (iii) Consider introducing a rule for election years inspired by the Peru’s example (box 2.2). Legally specify the escape clause for abandoning the rules. Peru’s fiscal rules include an escape clause that allows deviations from numerical targets during periods of low growth. Mongolia can follow the example of Peru in specifying its escape clause in terms of duration of temporary suspension and the modalities of the post-suspension period (box 2.2). 21 Another option is Botswana’s 1994 Sustainable Budget Index, which rules that the ratio of non-education and non-health recurrent spending to non-mining revenue should not exceed unity. This policy prevented excessive spending and ensured fiscal sustainability in anticipation of the future depletion of diamond deposits (World Bank 2016). 22 Calculation of the debt ceiling in present value terms is likely to open doors to manipulation through the interpretation of the discount rate. SEEKING STABILITY 25 Implement sanctions such as parliamentary censure in case of violation of the rules. Absence of an independent, accountable, transparent, and capable fiscal council makes it difficult to conduct credible assessments of any violation of the fiscal rules and trigger sanctions mandated under the law. Strengthen the Medium-Term Fiscal Framework (MTFF) Law to better align the public investment budget with strategic priorities and budget constraints. This involves (i) estimating sustainable levels of public investment spending, separate from proposed public investment spending levels, and publishing it in the MTFF; (ii) publishing project appraisal and selection criteria; (iii) expanding the MTFF and annual budget narrative to highlight maintenance needs and the allocation in the budget for routine maintenance, capital repairs, ongoing investment projects, and new investment projects; and (iv) specifying in the MTFF an appropriate balance among saving, consumption, and investing mining revenue, including in the Fiscal Stabilization Fund in a context of depleting mineral reserves. Debt reduction and sustainability Adopt a debt policy that aims to (i) establish clear rollover, interest, and exchange risk parameters; and (ii) create a sufficiently strong and independent treasury/debt department function to carry out the policy. Moreover, publishing consolidated information on state majority-owned and state-owned enterprise liabilities (debt, guarantees, and obligations for public-private partnership projects) would be critical. Fiscal Stability Council The following policy actions are recommended to strengthen the role of the Fiscal Stability Council for efficient fiscal policy management (box 2.3). Re-establish the Fiscal Stability Council (FSC) through a law to limit political interference. This will require abolishing the existing relevant parliamentary resolution, which created this institution under the Budget Standing Committee. Improve public trust in the FSC to fulfill its mandate to monitor fiscal discipline. A fair and competitive appointment process of FSC members and an appropriate communication and dissemination strategy will be critical in this regard. Consider adopting a framework that requires the government to respond to recommendations and conclusions by the FSC on budget proposals, the Medium- Term Fiscal Framework, and budget laws. In relation to the fiscal rules, the FSC could take on the new role of reviewing and evaluating potential modifications in fiscal rules or issues related to the escape clause (for example, the length of suspension and correction mechanism after the suspension) (IMF 2019). Strengthen the capacity of the FSC to assume its mission effectively. This will require (i) sufficient staff and independence in hiring, (ii) adequate budget resources to fulfill its tasks independently, and (iii) full access to all necessary information that has a significant impact on fiscal sustainability. 26 COUNTRY ECONOMIC MEMORANDUM 2020 Box 2.3 International practices suggest independence is a key condition for the effectiveness of the Fiscal Stability Council The independence of the newly created Fiscal Stability Council (FSC) of Mongolia has been questioned in several forums. Given the history of independent oversight actors in Mongolia and elsewhere, the existing framework for the FSC in Mongolia has several weaknesses related to its independence, ability to influence the budgeting process, the quality of work the FSC is able to provide given limited resources and staff, and the political context related to gaps and overlaps in the work of the FSC and other existing institutions. In fact, Mongolia’s FSC currently has insufficient staffing (only two employees are allowed under the current arrangement) and limited independence in hiring. A key concern is the FSC’s ability to champion transparency and promote public engagement in fiscal policy debates. The most successful fiscal councils foster independence and transparency, promote a culture of macroeconomic stability, and provide nonpartisan advice regarding the budget process. However, because politics has often played a role in the budget process, a fiscal council with a greater degree of independence should be considered. While more traditional institutions have relied on reputation and established practice, a more common feature of the new generation of institutions has become strict legal independence. The ability to operate independently should also be considered, as the adequate availability of resources would enable the FSC to effectively fulfill its technical mandate. A larger proportion of new fiscal councils around the world has also guaranteed legal access to information and has benefited from safeguards on their budget. To promote public engagement in the policy debate, it is important for the FSC to maintain a strong media presence in its assessment of the government’s fiscal policy. It is particularly important when FSCs need to raise the alarm, for example, when proposed budget documents are not in line with stated objectives, when forecasts are unreasonable, when unsustainable spending or tax policies is being debated, or when fiscal outturns are significantly different than projected. International best practice suggests that effective communication by an FSC is crucial for fiscal sustainability. The Dutch experience through the 2000s provides a good example of effective communication, with the council increasing its public activity, as evidenced by spikes in media reports, at the specific times where fiscal policy was going off course. Source: IMF 2013; World Bank 2018f Stabilization and sovereign wealth funds Mongolia has mechanisms such as stabilization and sovereign wealth funds, as in many other resource-rich countries. The Fiscal Stabilization Fund (FSF) was established in 2010 and went into effect in 2013 to cushion the impact of revenue downturns caused by falls in commodity prices and to help sustain expenditure during such periods. In terms of savings, the Future Heritage Fund (FHF), which is aimed at providing financial savings for future generations, was established in 2016 and came into effect in 2017. According to the relevant law on the Future Heritage Fund, no withdrawals from the fund, other than management fees, are allowed until 2030.23 23 These funds are only useful if they are predicated on a robust fiscal framework. There is no use in accumulating savings if the savings are effectively financed by running up debt. The fiscal rule is the prerequisite for the funds to operate as intended. SEEKING STABILITY 27 Box 2.4 Sovereign wealth funds as effective instruments for stabilization and saving for future generations Some countries have used sovereign wealth funds (SWFs) as an instrument to save part of mineral revenues. Nonetheless, challenges could arise if the SWF’s accumulation and withdrawal rules are somewhat rigid and disconnected from overall fiscal targets. In fact, after the oil price collapse of 2014, commodity exporters that had buffers in their SWFs (Algeria, Azerbaijan, Iran, Kazakhstan, Kuwait, Qatar, and the United Arab Emirates) used them to smooth the adjustment and avoid exchange rate pressures, but this use was not always governed by clear fiscal rules. Given issues such as capital scarcity, absorption constraints and volatility of commodity and asset prices, Van der Ploeg et. al 2014 argue for three types of fund: an intergenerational fund to smooth consumption across generations, a liquidity (or stabilization) fund to collect precautionary buffers to hedge against residual, non- diversifiable risk, and an investment fund to park funds until the economy is ready to absorb new spending on investment projects. The national wealth should be managed according to the following guidelines: (i) Net saving of non-resource assets by the nation, whether an accumulation of net foreign assets, capital, infrastructure, or human capital, should react to the temporary component of natural resource revenue. (ii) Consumption should be a fixed proportion of the nation’s total wealth. Specifically, consumption should react to the equivalent permanent value of natural resource income and not to current natural resource revenue. (iii) If a country has access to international markets to finance infrastructure and human capital, and runs current account deficits for that purpose, then the size of such investments should be independent of the size of the natural resource windfall. (iv) Besides an intergenerational sovereign wealth fund, a resource-rich country should have a liquidity fund to channel the precautionary buffers necessary to cover commodity price uncertainty. (v) Sovereign wealth fund managers of resource-rich countries should hold bigger shares of risky assets, go short in risk-free assets, and invest more in assets that are negatively correlated or not correlated with returns on natural resources, and gradually undo this position as resources are depleted, and accumulate precautionary saving buffers to deal with residual non-diversifiable risk. Building an intergenerational fund to smooth consumption helps to smooth the (vi) real exchange rate and smooth Dutch disease effects. Rather than having lots of deindustrialization all at once, which reverses when the natural resource windfall and spending stop, there will be a smaller amount of deindustrialization over a longer time. To relieve absorption problems, it is wise for resource-rich countries to park some of the resource windfall in an investment fund until the economy is ready to absorb an extra demand for non-tradable goods and services. Source: Van der Ploeg and Wills 2014 28 COUNTRY ECONOMIC MEMORANDUM 2020 On paper, the existing framework has countercyclical and intergenerational functions, but there are some concerns, mostly about implementation. The Fiscal Stabilization Fund receives transfers from the budget when actual revenue from mining exceeds government estimates. In practice, however, when the fund accumulated a modest amount in savings, the government relaxed withdrawal rules to finance its persistent budget deficit. As a result, accumulation of net financial wealth was marginal. While the Future Heritage Fund on paper was set up purely for the purposes of accumulating savings for future generations, in practice, withdrawals to close existing budget deficits have also happened under this fund, which thus acts as a secondary stabilization fund.24 The following recommendations are proposed: (i) Prioritize debt reduction and functionality of the Fiscal Stabilization Fund (FSF) over immediate accumulation in the sovereign wealth fund. • Prioritize bringing Mongolia’s debt to a sustainable level, as large debt hinders Mongolia’s access to the international capital market. A model simulation of an increased accumulation in the FSF indicates that the external debt premium could drop due to the signaling effect, thus contributing to debt sustainability (box 2.5). • Undertake rigorous implementation of the FSF’s deposit and withdrawal rules consistent with effective smoothing of consumption (box 2.4, above). (ii) Target saving in the Future Heritage Fund only in the longer term. This will require: • Reassessing the management and operational framework of the Future Heritage Fund. • Simplifying its framework, reducing its operational and administrative costs through professional foreign management arrangements. Box 2.5 Model simulation of a partial saving rule for mining revenue A dynamic general equilibrium (DGE) macroeconomic model was used to simulate the partial saving rule of mining revenue in the Fiscal Stabilization Fund (FSF) and its impact on total public debt. The fundamental role of this policy is to accumulate a fiscal buffer to allow the government to smooth spending in bad times, that is, in periods when there are unfavorable shocks to mining prices. More specifically, simulation consists of a permanent increase from 2021 of (i) the share of mining revenues allocated to the FSF from zero percent to 10 percent, and (ii) the fraction of the stabilization fund’s resources transferred to the budget from zero percent to 4 percent. Simulation results indicate that, at horizon 2046-50, the total public debt decreased, by about 4.1 percentage points of GDP (figure 2.15), which is entirely due to a decrease in external debt. This is because there may be benefits from asset accumulation in the FSF - 24 The Future Heritage Fund’s rules dictate that the government can only withdraw for expenses related to administration and independent audit of the fund until 2030. However, a transitory law (2018) made it possible to finance the budget deficit from the fund until 2022, and it is also used to repay the debt of the Human Development Fund. As a result, the fund received revenue of 2 trillion tugrug during 2017-19, while it transferred about 1.4 trillion tugrug for above-mentioned purposes. SEEKING STABILITY 29 rule  of   mining rule   revenue   of  mining   revenue   in  the   Fiscal   in Stabilization   the  Fiscal   Stabilization   Fund  (FSF) Fund  and (FSF)   and   its   impact   its  impact   on  total total  public   on  public The    The    debt.  debt. fundamental fundamental   role  of   this   role   of   policy   is  to  accumulate   this  policy is  to  accumulate  a  fiscal   a  fiscal buffer   to  allow   buffer   to  allow the  government   the  government   to  smooth     to  smooth   spending spending   in  bad   in   times,   bad  times,   that   that  is,   in  periods is,  in  periods   when  when are  unfavorable there  there   are  unfavorable   shocks   shocks   to  mining   to  mining   prices.   More  More    prices. specifically, specifically,  simulation  simulation consists  consists  of a permanent  of a permanent  increase  increase  from  2021 from  of 2021  of (i)  (i) the  share  the  share of mining  of mining  revenues    revenues   allocated allocated   to  the   FSF   to   the  from   FSF  zero from    zero  percent percent   to  10  to percent,   10  percent,   and  (ii)   the   and   fraction   (ii)   of  the   the  fraction   of   stabilization   fund’s   the  stabilization     fund’s   resources resources  transferred  transferred  to the  budget  to  the budget from  zero from  zero percent  percent  to 4 percent.  to 4 percent.     with a signaling effect that lowers the cost of borrowing abroad (the external debt premium     Simulation falls bySimulation   results 0.1  results   indicate percentage that,  at   indicate  points   at that,   at horizon   horizon horizon  2046–50,   the  total 2046–50,  2046-50   the  public due total debtsignaling to  public  the debt  decreased,   decreased,  effect), by  about  and 4.1   lower   by  about 4.1  percentage percentage   points   points   of  GDP   of GDP  (figure    (figure   2.15), which    2.15),   which   is  entirely   is  entirely   due   due  to   to  a  decrease   a  decrease   in  external   in  external   debt.  debt.   This This  is     is  debt service because payments  there there may be because  may (figure  benefits  be benefits 2.16). from accumulation  from  asset asset accumulation  in the  in FSF  the FSF –  – with  with  a  signaling  a signaling  effect effect     that lowers that lowers     the the  cost   cost   of   borrowing   of  borrowing   abroad   (the  external   abroad   debt  premium   (the  external debt  premium   falls  by   falls   by   0.1   0.1  percentage   percentage   points   points   at  horizon     at  horizon   Figure 2.15 Figure 2.16 2046–50 2046–50  due to  due  the  signaling  to  effect),  the signaling  effect),  and lower debt service  and  lower  payments  debt service  payments  (figure  2.16).     (figure 2.16).       public Total debt Assets in FSF  2.15 Total FigureFigure Total public  2.15 public  debt                                 debt                                   2.16 Assets  FigureFigure  in FSF  2.16 Assets  in  FSF                                                                                      70% 70% Total Total public  (percent  debt  public  debt (percent  of GDP) of GDP) 30% Assets in 30%  stabilization Assets  in stabilization  fund (percent  fund (percent  of GDP) of GDP) 25% 25% 65% 65% 20% 20% 60% 60% 15% 15% 10% 10% 55% 55% 5% 5% 50% 50% 0% 0% 2020 2025 2020 2030 2025 2035 2030 2035 2040 2045 2040 2050 2045 2050 2020 2025 2020 2030 2025 2035 2030 2035 2040 2045 2040 2050 2045 2050 Baseline Baseline Scenario Scenario with partial  with  partial  saving  rule  saving rule Baseline Baseline Scenario with  with  partial Scenario  saving  partial  saving    rule rule                                                                                                                                  24  The  24   The  Future Future Heritage   Heritage   Fund’s  Fund’s rules  dictate that  the   rules   dictate   government   that   the  government   can  only   can   only  withdraw   withdraw   for  expenses   for  expenses   related    to  administration related   and    and    to  administration Thus, there independent independent  audit is  of thedynamic  a  audit  of the  until  fund  2030.  fund resource  until However,  2030. However, distribution  a transitory  a transitory  law  law (2018) effect: (2018)  made  it putting  possible  made  it possible  to finance more  the resources  to finance budget  the  budget deficit   fromin the deficit the  fund  from fund    fund   the today raises until until  2022,  and   itthe   2022,   is   and  primary   also is  also it  used   to  useddeficit  repay   to   the  repay immediately,   of   the   debt   the  Human   debt of  the  Human but   Development tomorrow,   Development   Fund.  As   a as   Fund.   As result,assets   a  the   fund result, in   the the received fund  received   fund   revenueaccumulate,   of  2  trillion   revenue   of  2  trillion  tugrug 2017–19, tugrug during during 2017–19,  while it  while  transferred  about 1.4  it transferred  about  trillion  1.4 tugrug trillion for  above tugrug  for ‐ mentioned above‐mentioned  purposes.    purposes.   more resources can be transferred back to the budget, thereby mitigating the initial increase 27  27  in  the deficit.   The higher the share of mining revenues allocated to the stabilization fund, the starker this trade-off will be. Source: World Bank staff estimates based on DGE model (Agénor 2019) II.3.3 Monetary and financial sector policies – independence and professionalization of the central bank and the prudential supervisory function An amendment to the Central Bank Law strengthened the independence of the Bank of Mongolia, but further improvement is needed. The 2018 amendment introduced notable changes including (i) restriction of the bank’s involvement in quasi-fiscal spending and direct lending to the government, (ii) legalization of the Monetary Policy Committee and qualifications of its members, and (iii) expansion of policy instruments.25 Meanwhile, several recent incidents have highlighted that the central bank’s independence still remains limited, both de jure and de facto. In a resolution to write off pension-backed loans in early 2020, the parliament temporarily reversed the clause in the central banking law that limited its quasi-fiscal involvement. In addition, the governor is appointed by the parliament based on the speaker’s proposal, and the appointment of governors has become closely linked with the election cycles, even though the term of a governor is legally defined as six years. Although the central bank is transitioning to an inflation targeting framework, its objective is vaguely set as “stability of the national currency tugrug” in the law, and consequently the public and the politicians often pressure the bank to stabilize the nominal exchange rate, reduce interest rates, and increase money supply, and criticize the bank for not maintaining good coordination with fiscal policy. Unfortunately, attempts by the central bank to improve its de jure independence faced strict opposition both from politicians and the general public. Several concerns remain about the independence and governance of the central bank in Mongolia: 25 Previously, the governor appointed members of a Monetary Policy Council, which basically had a role to consult the governor in policy decisions. The Council was established by the governor’s decree but was not included in the Central Bank Law. 30 COUNTRY ECONOMIC MEMORANDUM 2020 (i) Legally, the central bank remains dependent of the parliament to set its policy objective. The parliament still approves the inflation target each year, which complicates the setting of a longer-term objective for monetary policy. (ii) The independence of the Bank of Mongolia’s (BoM’s) supervision function is undermined by several laws. For example, the Infringement Law requires some supervisory measures to be executed by the general prosecutor, instead of allowing the BoM to require these measures directly from banks.26 (iii) A lack of supervisory independence results in ineffective bank supervision and encourages forbearance. For example, prompt preventive and corrective action for weak banks is complicated in an environment where major bank shareholders are politically connected, and thus expose the BoM supervisory staff to intimidation. (iv) The BoM’s multiple functions have, at times, conflicting policy objectives, weakening the effectiveness of its instruments. The BoM is in charge of multiple policy objectives, including financial stability, monetary policy, micro- and macroprudential supervision, bank resolution, and anti-money laundering/ countering the financing of terrorism, to name a few. Bringing different objectives under one roof does not eliminate the potential for tensions among those policies but internalizes them (D’Hulster and Unsal 2019). These interrelations among the BoM’s functions could be even more challenging and complex in crisis times, when critical decisions encompassing all the financial stability functions must be made quickly. The following recommendations regarding prudential rules and governance are warranted. Prudential rules Adopt prudential countercyclical measures to mitigate the volatility of bank balance sheets and returns due to macroeconomic factors. Commodities exports have an important direct impact on the financing of the mining sector, but also affect bank balance sheets. Countercyclical measures, such as capital buffers, loan-to-valuation ratios, and debt-to-income ratios, should be adequately used by the BoM to mitigate the impact of macroeconomic factors on the banking sector. Governance Strengthen the governance of the Bank of Mongolia and ensure its stronger legal and de facto independence and accountability. The governance of the BoM needs to be assessed and strengthened in accordance with international standards and practices (box 2.6). The different policy functions (including monetary policy, micro-and macroprudential supervision, resolution, financial stability) should have clear mandates in both normal times and crisis times. However, strong opposition from the public and of elected officials could make it difficult for the central bank to strengthen its independence by law at this stage. Strengthen the independence of the prudential supervision and financial stability functions housed in the BoM. Many politically connected persons own banks in Mongolia, which reinforces the need to have independent bank supervisors overseeing them. 26 Similarly, the registration of regulations by the Ministry of Justice should be strictly limited to ensuring conformity with higher laws, without allowing banks to lobby the ministry for changes, and legal protection for supervisors needs to be significantly strengthened. SEEKING STABILITY 31 A first effective step could be to improve its de facto independence, especially when it comes to funding government programs and the prudential supervision function. To place checks and balances on independence, the BoM must be accountable, which means that it is able to “justify and explain” to external stakeholders, such as the parliament, the government, and the public, how its actions have contributed to accomplishing its mandate. Accountability and independence go hand in hand, as increased transparency functions as a restraint on government involvement and strengthens independence (Amtenbrink 2008). Moreover, through better public outreach and financial education, the public and politicians will be more informed about the BoM’s mandate and the importance of an independent central bank. Reserves management and exchange rate policy The BoM should limit its foreign exchange intervention and allow more flexibility of the nominal exchange rate. Reserves are likely to fall to a precarious level if the central bank continues to intervene to support the local currency. While the level of gross international reserves appears high, the level of net reserves is modest and inadequate to mitigate a large external shock.27 Defending the exchange rate amidst growing balance- of-payments pressure could erode international reserves to a level where Mongolia will be exposed to the risk of a currency crisis. In the previous three crises (the 2009 Global Financial Crisis, 2013 commodity price, and 2016 domestic demand), the central bank spent US$0.6 to US$3.7 billion on FX intervention. However, the nominal exchange rate depreciated by 7.9 to 36 percent while the FX reserves declined by 39 to 67 percent, from peak to trough.28 Box 2.6 Independence and governance of the central bank The minimum requirements for independence for the prudential supervisory function are laid out in the Basel Core Principles for Effective Banking Supervision (2012), Principle 2 “Independence, Accountability, Resourcing and Legal Protection for Supervisors.” A central bank is considered more independent if (i) the governor is appointed by the central bank board rather than by the government, is not subject to dismissal, and has a long term of office; (ii) policy decisions are made without government involvement; (iii) the policy objective is set by the bank and the number of objectives is limited; and (iv) there are limitations on the government’s ability to borrow from the central bank (Cukierman 1992). There are four essential dimensions in the independence of the prudential supervision function: regulatory, institutional, supervisory, and budgetary. Greater central bank independence has significant implications for macroeconomic stability and improved performance, in both developing and transition economies (Dumiter 2011). In the case of a central bank dependent on the government, it is easier for elected politicians to be tempted by the short-term benefits of an expansionary monetary policy and to finance a budget deficit and complicate the central bank’s efforts to achieve long-term stability (Amtenbrink 2008). Source: Compiled by World Bank staff 27 It is also for the BoM to emphasize better reserve accumulation during upturns. 28 Peak to trough is considered July 2008–March 2009, January 2013–November 2014, and August 2015–February 2017. IMF Article IV 2019 also found that public debt as a share of GDP increased by 14 to 26 percentage points, while the reserves fell by 49 to 67 percent in these episodes. 32 COUNTRY ECONOMIC MEMORANDUM 2020 III. BOOSTING PRODUCTIVITY GROWTH III. BOOSTING PRODUCTIVITY GROWTH Mongolia needs to foster an environment where more productive jobs are created outside the mining sector to employ its young and well-educated labor force. Weak productivity growth reflects a resource allocation pattern that is driven by commodity cycles. While capital has gravitated toward the mining sector, labor has moved toward non-tradable services away from tradable goods and manufacturing, where the scope for productivity gains tends to be higher. At the same time, Mongolian firms have become more inward-looking looking and less prone to innovate and adopt new technologies. To revive productivity growth, Mongolia would need macroeconomic policies to mitigate the erosive impacts of the resource curse while focusing microeconomic reforms on enhancing competition, securing investor rights, and creating a more level playing field that enables productive firms to invest and grow. III.1 An environment marked by weak productivity growth and declining innovation Induced by the mining sector, inefficient allocation of labor and capital has hampered productivity growth in Mongolia for the past two decades. Moreover, declining innovation and limited technology adoption of Mongolian firms outside of the mining sector are not supporting productivity either. III.1.1 Productivity growth has been weak Over the past decade, Mongolia has experienced anemic productivity growth. Instead, growth was driven by extracting largely non-renewable natural capital and by accumulating physical capital – with the latter also largely being channeled into the mining sector to valorize and extract Mongolia’s abundant mineral resources. This resource- intensive growth pattern with limited productivity gains is confirmed by growth accounting, which suggests that total factor productivity has contributed negatively to growth for most of the recent decade (figure 3.1). As a consequence, Mongolia’s productivity gap with the global frontier has converged more slowly than in structural peers. By 2017, Mongolia’s total factor productivity was at only around 35 percent of U.S. total factor productivity, considerably lower than all structural and aspirational peers (figure 3.2). While labor productivity has risen gradually, it remains lower than in peer countries. Labor productivity growth varies greatly across sectors (figure 3.3). The mining sector remains capital intensive and thus exhibits the highest level of labor productivity. However, even in the mining sector, the level of labor productivity is lower than in structural peers (figure 3.4). For both manufacturing and services, labor productivity in Mongolia remains low compared to its peers and has stagnated in these sectors over the past decade (figures 3.5 and 3.6).29 29 The decline in labor productivity in manufacturing at the start of the 1990s reflects the shock of the dissolution of the Soviet Union. Mongolia lost its major market overnight and thus experienced a deep recession in its industrial sector. As figure 3.5 demonstrates, the manufacturing sector has not recovered the productivity level it had 30 years ago. 34 COUNTRY ECONOMIC MEMORANDUM 2020 Figure 3.1   Figure 3.2   Mongolia’s GDP growth has relied on factor ...while remaining below the global productivity Figure 3.1 Figure accumulation, not  3.1 Mongolia’s Mongolia’s  GDP growth productivity…  GDP  growth  has  relied  hasFigure  relied   3.2  Figure ...while frontier  3.2  ...while remaining  remaining  below the below the global   global   on factor accumulation, on factor accumulation,  not productivity…  not productivity…     productivity  frontier   frontier  productivity      to  growth Percentage Percentage contribution contribution to growth TFP: Annual average 1 TFP:   during Annual ‐17  during 2004‐17  average  2004 18 1 TFP relative to technology frontier (USA) 18  to technology frontier (USA) 14 14 0.8 Figure Figure  3.1  Mongolia’s  3.1 Mongolia’s 10  GDP  GDP growth  has relied  growth   Figure  has relied   0.8  3.2 ...while Figure  3.2 ...while  remaining  remaining  below  the global  below    the global   10 on factor on factor  accumulation,  accumulation, 6  not    not  productivity… productivity…     productivity   productivity 0.6 frontier 0.6   frontier     6   2   2 0.4 0.4 Percentage Percentage  contribution  contribution  to growth  to growth TFP: Annual TFP:  Annual average  during  2004  average ‐17 during  2004‐17 18 1 1 ‐18 ‐2 0.2  (USA) TFP relative to technology frontier (USA) 2 0.2 14Figure ‐14 ‐6 3.1 Mongolia’s Figure 6  3.1 Mongolia’s  GDP  has  GDP growth growth  has    relied  relied    3.2 Figure Figure  3.2 0.8  ...while  ...while remaining below the global  0 remaining below the global   relative 0.8  frontier 0 factor 10on‐ 10 10  accumulation, ‐10 on factor accumulation, not productivity…  not productivity…    productivity productivity 0  frontier 10    frontier 21   32 43 54 5 0.6 0.6 PPP  GDP  per 2011  (thousand  capita in  2017  2011 US$, log based) TFP 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 PPP GDP per capita  in 2017 (thousand US$, log based) 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 6 6 TFP relative to technology Percentage contribution to growth TFP: Annual average during 2004‐17 Percentage contribution to growth Capital Employment Employment 1 TFP: OECD OECD Countries Annual  Countries  average Other  during ‐17  countries  2004Other  countries Mongolia Mongolia 18 Human Capital Human Capital 1 0.4 0.4 TFP relative to technology frontier (USA) Capital 2 18 2 Armenia Colombia Colombia Ecuador Ecuador  frontier (USA) Armenia TFP14 TFP GDP GDP Kazakhstan Peru Peru Russia ‐2 14 ‐2   0.8 0.2   Kazakhstan0.8 0.2 Russia     10 10 Sources:   World   Bank   (2018e); Sources: World Bank (2018e); Penn World Table 9.1    Penn   World   Table   9.1   Sources: World Sources:    Bank (2018c); calculated based on Brandt et al. (2017)  et al. (2017)  World  Bank   (2018c);  calculated  based  on  Brandt Sources: ‐6 ‐6World Bank (2018e); Penn World Table 9.1 Sources:0.6 Note: World Bank (2018c); calculated based on Brandt  productivity  et 6 Note:0.6  PPP 0  PPP = 0  = purchasing  purchasing  power  parity;  TFP =  parity;  power  TFP = total factor  total factor   productivity 6 al. (2017) 1 TFP relative to technology ‐10 ‐10 0 0.4 0 1 2 2 3 3 4 4 5 5 2 0.4 Note: PPP = purchasing power parity; TFP = total factor 2 Figure 3.3 Figure  3.3  Labor  productivity  Labor productivity has risen    has   risen    Figure  3.4 Figure PPP GDP   per PPP 3.4  GDP  Even  capita  per  in  Even in the mining sector, labor    in  capita 2017  the  (thousand  in  2017 mining  (thousand  2011  sector,  2011  US$,  US$,  log    labor based)    log based) 1999 2000 1999 2001 2000 2002 2001 2003 2002 2004 2003 2005 2004 2006 2005 2007 2006 2008 2007 2009 2008 2010 2009 2011 2010 2012 2011 2013 2012 2014 2013 2015 2014 2016 2015 2017 2016 2017 ‐2 productivity 0.2 ‐2 Capital Capital EmploymentEmployment Human Human   Capital   Capital 0.2 productivity productivity OECD OECD Countries  is  lower than  Countries  lower  isOther  in  countries peer  than Other     in peer   countries countries countries Mongolia Mongolia  ‐6 ‐6 100 100 0 1000Armenia 0 Armenia 1000 Colombia Colombia Ecuador Ecuador TFP TFP GDP GDP Kazakhstan Kazakhstan 0 1 Peru 2 Peru 3 Russia 4 Russia 5 Figure‐10 3.3 ‐10 0 Figure 3.4 1   2   3 4 PPP GDP per capita in 2017 (thousand 2011 US$, log based) 5     1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Sources:Sources:  World Bank (2018e);  Bank (2018e);  World Penn World  Penn World 9.1   9.1  Sources:  Table  Table Sources:  WorldPPP  World   GDP  100 Bank (2018c);  Bank (2018c); per   capita  in    calculated 2017    calculated (thousand    based 2011   US$, based   on Brandt log    on Brandt based)  et al. (2017)   et al. (2017)   1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 100 Log Scale Log Scale Log Scale Log Scale OECD Countries Other countries Mongolia Labor productivity 10Capital 10 has risen Employment Capital Employment Human Capital Note: OECD Human Capital Note: PPP    Even =  PPP purchasing Countries in =   purchasing the Armenia  power mining Other  power    parity; sector, countries  parity;  TFP Colombia  =  TFP labor total  =  factor total factor productivity Mongolia   productivity Ecuador is    productivity lower   Armenia 10 10 Colombia Ecuador TFP TFP GDP GDP than in   Kazakhstan peer countries Kazakhstan Peru Russia Peru Russia   Figure Figure  3.3 Labor  3.3Sources:  Labor  World productivity  productivity   Bank  has  (2018e);  has  risen  Penn  risen  World      9.1      Table FigureFigure  3.4 Sources:  3.4  Even  World  Even  the  in  in (2018c); 1  Bank  mining  the  mining  calculated sector,  sector,  based labor   on     et al.  labor  Brandt    (2017)  Sources: World Bank  (2018e); Penn World Table 9.1  1  Bank (2018c); Sources: World  calculated based on Brandt et al. (2017)  1 1 Note: productivity productivity Note:  purchasing power parity; TFP = total factor productivity  1990  PPP =2018  PPP 1994 is  lower = purchasing 1990 1998 is      lower than power 1994 2002     than in   parity; 1998 2006   peer in  TFP 2002 2010 peer     =   factor countries   total 2006 2014 countries 2010 2018  2014   2018  productivity   1990 1998 1994 1994 1990 2002 1998 2010 2006 2006 2002 2014 2010 2018 2014 Canada Canada Australia Australia Malaysia Malaysia 100 100 1000 1000 Chile Chile Kazakhstan KazakhstanArmenia Armenia  Labor  productivity Figure 3.3Agriculture Figure 3.3 Labor productivity has risen   Mining  has  risen    Manufacturing Services Figure 3.4 Figure  3.4  Even  in  the  mining  sector,  labor     Even in the mining sector, labor    Mongolia Agriculture Mining Manufacturing Services Mongolia     100 productivity 100   is lower  than  in peer countries   productivity  is lower than peer  in  Bank  countries     Log Scale Log Scale Log Scale  World  Bank 100Sources: World NSO;  staff  Bank staff  calculations  Sources: NSO;  World  staff  calculations Log Scale Log Scale Sources: NSO;  calculations Sources: 1000  NSO; 1000 World Bank staff calculations  100 10  prices  2010 prices   prices  2010 prices  10 Note:  Thousand  US$ Note: Thousand  US$ per worker,    per worker, 2010 Note: 10 Note: Thousand 10  Thousand  US$  US$  per worker,   per worker, 2010 100 100 Log Scale Log Scale Log Scale 10Figure 3.5 Labor productivity in manufacturing1    3.61 1 Figure 10 1  3.5  Labor productivity in manufacturing  Figure  Figure 10  3.6 Labor productivity Labor productivity  in services  in  is  services also low     also low    is remains   low   10 1994 1994 1990   1990 2002 2002 1998 1998 2006 2006 2010 2010 2014 2014 2018 2018 remains   1990 1990 low   1994 19941998 1998 2010 2010 2002 2002 2006 2006 2014 2014   2018 2018 CanadaCanada Australia Australia Malaysia Malaysia     Chile 1 Chile Kazakhstan Kazakhstan Armenia Armenia Agriculture Agriculture 1 100 Mining Mining Manufacturing Services1 Manufacturing Services 1990 1 100 1994 1998 2002 2006 2010 2014 1990 2018 100 Mongolia 1994 1990Mongolia 1998 100 1994 Canada 1998 2002 2006 2002 2006 2010   Australia 2014 2010 2014 2018 2018 Malaysia       1994 19981990 2002 2006 2010 2014 2018 Canada Australia Malaysia Chile Kazakhstan Armenia Sources: Sources: Sources: NSO;  NSO; NSO;  World World  World  Bank Agriculture Bank  staff Bank staff   staff calculations  calculations Mining calculations   Manufacturing   Services Services Sources: Sources:  NSO; NSO; Chile Sources: World NSO;  World   Bank  staff    BankKazakhstan World Bank calculations staff staff   Armenia  calculations calculations   Agriculture Mining Manufacturing   Mongolia Mongolia     Note:  Note: Thousand  US$  Thousand  US$ US$ per  per worker,  worker,  2010 2010  prices    prices     Note: Note: Thousand  Thousand  worker,  US$ per  US$ US$  per worker,  2010 prices 2010   prices  prices   Log Scale Note: Thousand per worker, 2010 prices Note: Thousand per worker, 2010 Log Scale Log Scale Log Scale 10 Sources: 10 NSO; World Bank staff calculations  10  World Bank staff calculations  Sources: NSO; Sources: NSO; World Bank staff calculations  NSO; World Bank Sources: 10  staff calculations  Note: Thousand US$ per worker, 2010 prices  Note: Thousand US$ per worker, 2010 prices  Note: Thousand US$ per worker, 2010 prices  Note: Thousand US$ per worker, 2010 prices  Figure Figure  3.5 Labor  3.5 Labor  productivity  productivity in manufacturing  in manufacturing     Figure Figure  3.6 Labor  productivity  3.6 Labor  in services  productivity  is also  in services also  low    is low Figure 3.5 Figure 3.6 remains remains  low    low Figure 3.5   1  Labor productivity in manufacturing      Figure 3.61  Labor productivity in services is also low     Figure  3.5  Labor  productivity  in manufacturing Figure  2018 2014  3.6 1 1  Labor productivity in services is also low   Labor  productivity 1990 1994 in 1994 1998 manufacturing 2002 2006 remains2014 2010 low 2018 Labor   productivity in services 1998 1994 1994 1990 1998 2006 2002 is2006 also low 2018 2014 2014 2010 2018 remains remains 1990   low    low   2002 2006 2010 1998 Canada Australia Malaysia   Malaysia 1990 2002 2010 100 100 Canada Australia Canada Canada Australia Australia Malaysia Malaysia     Chile Chile Kazakhstan Kazakhstan Armenia Armenia100 100 Chile Chile Kazakhstan Kazakhstan Armenia Armenia Mongolia 100 Mongolia    Mongolia Mongolia     100 100 100  World  Bank Sources: Sources: NSO; World NSO;  staff  Bank staff  calculations   calculations Sources: Sources: NSO;  World  Bank World NSO;  staff  Bank staff  calculations   calculations Log Scale Log Scale Note: Thousand US$ per worker, 2010 prices  Note:  Thousand  US$     prices  2010 prices  per worker, Log Scale  Scale  Thousand US$ per worker, 2010 prices  Note:10 10 Note: Thousand  US$  per worker, 2010 10 10 Log Scale Log Scale Scale Log Log 10 Log Scale 10 10 10 32  32   1   1 1 1 1990 1990 1 1994 1994 1998 1998 2002 20022006 2006 2010 20102014 2014 2018 2018 1990 1 1990 1994 1994 2002 2002 1998 1998 2006 2006 2014 2014 2010 2010 2018 2018 1 1 Canada 1990 Canada1998 1994 1998 Australia 2002 Australia 2006 2010 2014 2018 1990 1994 1998 2002 2006 2010 2014 2018 1990 1994 2002 2006 2010 2014 Malaysia 2018Malaysia 1994 Canada 1990 Canada 1998 2002 Australia Australia 2006 2010 2014 2018Malaysia Malaysia Chile Chile Canada Kazakhstan Australia Kazakhstan Armenia Malaysia Armenia Canada Chile Australia Kazakhstan Malaysia Armenia Chile Canada Canada Chile Kazakhstan Australia Australia Kazakhstan Malaysia Malaysia Armenia Armenia Chile Mongolia Mongolia Kazakhstan Mongolia Armenia     Chile MongoliaMongolia Kazakhstan Kazakhstan Armenia Chile Armenia   Mongolia      Mongolia   Mongolia   Sources: Sources:  NSO; NSO;  NSO;  World Sources: World  Bank Bank  staff  World calculations     Bankstaff  calculations    staff  calculations     Sources:Sources:  NSO;  World Sources: NSO;  World NSO; World  Bank  staff  BankBank calculations    staff  staff  calculations  calculations      Sources: Sources:NSO;  NSO;World  World   Bank Bank staff calculations Sources: NSO; World   Bank staff  calculations Note:  Note: Thousand  US$  Thousand Note:    per  worker, US$ Thousand    per staff US$  calculations  2010  worker,   per   2010  prices worker,      prices 2010        prices Sources: Note:  NSO;  Note: World Thousand   Thousand Note: Bank   US$ Thousand   staff    perUS$ US$   calculations per  worker, per    2010  worker, worker,    prices 2010 2010          prices prices Note: Thousand Note:  Thousand US$  US$per worker,  per worker, 2010  2010 prices  prices   Note: Thousand Note: Thousand US$ per  US$ per worker, worker,  2010  prices 2010 prices 32  32 32     32          BOOSTING PRODUCTIVITY GROWTH 35     Productivity growth is hampered by the allocation of labor and capital III.1.2 III.1.2  Productivity growth is hampered by the allocation of labor and capital  Weak productivity growth reflects a resource allocation pattern that is driven by III.1.2  Productivity growth is hampered by the allocation of labor and capital  commodity cycles. Capital has gravitated toward the extractive sector, with the mining Weak  productivity  growth  reflects  a  resource  allocation  pattern  that  is  driven  by  commodity  sector Weakabsorbing   productivity a significant portion   growth   toward reflects a of the gross investments  in Mongolia,  indicating cycles.   Capital   has  gravitated    the resource   extractive   allocation   sector,   pattern with  the that   is  driven   mining   sector by   absorbing commodity   a   an uneven distribution cycles.  portion Capital  of has of capital   gravitated formation   toward  the (figure    extractive 3.7).    sector, Investment   with   the has   mining flowed mainly   sector  absorbing   a   significant  the  gross investments  in Mongolia, indicating  an  uneven  distribution  of capital into a small number significant  portion of  of  firms the   operating gross  investments in the   in   mining sector Mongolia,  indicating (figure  an   3.8). On uneven   the flipside, distribution   of  capital formation (figure investment outside  3.7).  Investment mining has  has more been flowed  mainly into limited,  a small number weakening the  of firms operating contribution of capital  in the   formation mining   sector (figure    (figure  3.7).   3.8). Investment   On  growth.  has flowed the  flipside,  mainly into   investment  a small   outside number    mining  of firms   has   been  operating   more  in the     limited, mining to deepening labor sector productivity   (figure   3.8).  On   the  flipside,According   investment to the  National outside  mining Statistics   has Office, been  more around   limited,  40weakening percent  ofthe   contribution  of  capital total   deepening   to   labor   productivity sector growth.   According   to  the  weakening   the  investments contribution  of were   capital allocated   deepening to  the manufacturing to  labor   productivity  growth. in the 1980s,   According   to  the  National but that   Statistics has declined   Office,   around   40   percent   of   total   investments   were   allocated   to  the  National   Statisticsto 4 percent   Office,   around over   40 the last decade.   percent   of  total Similarly,   investments the share   were of investment   allocated   to  the  inmanufacturing the agriculture  sector  in the sector  1980s, but declined from  that 14  has  declined percent to to 1  percent, 4 percent while over the  last decade. investment in  Similarly, Similarly, the   manufacturing  sector in  the 1980s,  but that  has declined  to  4 percent over the  last decade.   the  share mining sector   of  investment from in  the  agriculture   sector   declined   from  14   percent the  sameto  1  percent, period.   while while  the of  investment  in close   share increased to zero the  agriculture percent   sector  declined to 38 percent   from  14 over   percent   to  1  percent,   investment  in the mining  sector increased  from close to zero percent to 38 percent over the same   investment   in   the   mining   sector   increased   from   close   to   zero   percent   to   38   percent   over   the   same period. Figure 3.7  period.   Figure 3.8 Capital Figure is concentrated  3.7 in the mining sector  Capital is concentrated  in the  FDI is also Figure   3.8concentrated   FDI  is  also in the mining sector concentrated   in  the  Figure 3.7 Capital is concentrated in the  Figure  3.8  FDI  is  also  concentrated  in  the  mining  sector mining      sector mining mining sector     sector Gross  capital Gross  formation  capital  by sector  formation  by sector 200200 FDI stock FDI  (%  stock  of  (% of GDP)  GDP) Mining Mining 100% 100% Trade Trade 150150 Financial industry 50% 50% 100100 Hotels & recreation Constructi 50 50 on on 0% Manufact Manufact 0% uring 1980‐1987 2009 ‐2019 uring 1980‐1987 2009 ‐2019 0 0 Agriculture Mining Other Other Agriculture Mining ‐2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 1990‐2004 19902005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Manufacturing Construction sectors Manufacturing Construction real    and  and est. est. real sectors Trade & transportation Public admin and defence Total Trade & transportation Public admin and defence Total     Others Others    Sources: NSO; World Bank staff illustration  Sources: NSO; World Bank staff illustration  Sources: NSO; World Bank staff illustration  Sources: NSO; World Bank staff illustration  Note: Sources:  Data NSO;  chosen World  based Bank  on staff  availability  illustration   Sources: NSO; World Bank staff illustration Note: Data chosen based on availability  Note: Data chosen based on availability   While capital is concentrated in the mining sector, labor has moved toward less productive, non‐ While capital is concentrated in the mining sector, labor has moved toward less productive, non‐ While capital tradable is concentrated  services.  Outside the mining in the mining  sector,  labor sector,  has largely labor shifted has moved  toward  non toward ‐tradable less  services,  tradable productive,  services.   non-tradableOutside  the  mining services.  sector, Outside  labor the  has  largely mining sector,  shifted  toward labor   non ‐ tradable  services,  away  from   tradable  goods,   where  the   scope  for   productivity   gains  tends has to  be largely   higher  shifted (figure  3.9).  away toward   from   tradable non-tradable   goods, services,   where away   the   from scope   for   productivity tradable  goods,   gains where   thetends scope  to   be   higher   (figure   3.9).  Labor  has been moving  out of  the low ‐productivity agriculture  sector,  with  the for share productivity  of employment  Labor gains   has intends  been agriculture to be  moving higher  declining  out  of the  (figure from  low  42.6 3.9). ‐productivity  percent Labor has agriculture  in 1991 been  to 28.8 moving  sector,  percent  in  2017. out with of the  the  share of low-productivity  However,  has been    employment  labor in agriculture mostly sector, agriculture  declining absorbed with  by  from the relatively 42.6  low share percent of employment  in 1991  ‐productivity  toin 28.8  percent agriculture services in 2017.  share   whose declining   in  the However, from   labor 42.6  labor percent   force  has been     increased mostly in 1991 from   absorbed to 41 28.8  percent   by percent   relatively  in 1991 in  2017.   low to 52 percent ‐ productivity However,  in 2017.   labor services  Within   has  been whose services,   share mostly  thereabsorbed   in   the    has been limitedlabor   force job creation   by relatively   increased from in 41  percent   more low-productivity  services in 1991   productive  52 percent  towhose   services,   such share in  2017.    as transport in the  Within   and labor  services,  force communication, there has increased  been   which from    limited lost 41  percent job creation employment in   to   in  more 1991 lower to 52   productive ‐productivity percent in   services,  service 2017.  sectors,  such  as Within   transport such  services,  as public   and there  has communication,  administration. been limited  In contrast,   which  the job creation  lost   employment  employmentin more  share   to   lower productive ‐ productivity in the industry services,  service  sector such   sectors,  has remained as transport such   as  nearly  public    unchanged. and administration. communication, Even so, labor  In  contrast, which    productivitythe  employment lost employment  is comparatively    share to the in lower-productivity high  in the    industry sector has industrial  remained  sector, service  with sectors, nearly  value  unchanged. added  such per public  as  Even worker  so, labor  about  two  times administration. productivity In  contrast,  that of  services is comparativelythe  four    and  in the hightimes employment  industrial  that  of the share    in sector, agriculture the industry  with  value  sector. sector  added  Today, has  per  less   worker than remained  one about  nearly ‐fifth of  two  the unchanged. times  labor  that  force  of Even is services  employed so, labor  and in the     four times more productivity that  of  the  productive is  agriculture  industry sector, comparatively high   sector. Today, and in  industrial less than  especially the  one  manufacturing ‐fifth with sector, of  – the  labor added  a traditional value force  is   source employed per  ofworker  in the    high‐quality more   productive productive     jobsindustry   –  accounts  sector,  for   and only  especially   7  percent about two times that of services and four times that of the agriculture sector. Today, less   manufacturing of  total   employment.   –  a  traditional     source   of  high ‐ quality   productive than one-fifth  jobs of –  accounts the labor  force for only is 7  percent of employed in total the employment. more productive    industry sector, and   especially manufacturing – a traditional source of high-quality productive jobs – accounts   only 7 percent of total employment. for 33    33    36 COUNTRY ECONOMIC MEMORANDUM 2020 Figure 3.9 Figure 3.10     Labor has moved to lower-productivity …reducing the contribution of structural non-tradable services… transformation to productivity growth Figure Figure  3.9 Labor  3.9 Labor  has moved  has moved  to lower  to lower ‐productivity ‐productivity   Figure   Figure  3.10 …reducing  3.10 …reducing  the contribution  the contribution  of   of  non‐tradable non‐tradable  services…  services…     structural structural  transformation  transformation  to productivity  to productivity  growth  growth     60% 60% 8 8 Industry Industry Share of people employed in the sector Share of people employed in the sector 2011-2017 2011-2017 Agriculture Agriculture 7 Within‐sector 7 Within‐sector Structural Structural  change  change 50% 50% 1991-2000 1991-2000 Services Services 6 6 40% 40% 2001-2010 2001-2010 2001- 2001- 5 5 1991-2000 1991-2000 30% 2010 30% 2010 4 4 2011-2017 2011-2017 3 3 20% 20% 2011-20172011-2017 2 2 10% 10% 1991-2000 1991-2000 1 1 2001-2010 2001-2010 0% 0% 0 0 0 0 5000 5000 10000 1000015000 1500020000 20000 ‐1 ‐1 Value added per Value  worker  added per (in  worker  (in    constant 2010 US$) constant  2010 US$) 2001‐05 2001‐05 2006‐10 2006‐10 2011‐17 2011‐17     Sources: Sources:  NSO; Bank  NSO; World World staff  Bank  staff illustration  illustration     Sources: Sources:  NSO; Bank  NSO; World World  staff  Bank  staff calculations  calculations     Sources: NSO; World Bank staff illustration Sources: NSO; World Bank staff calculations      – axis: Note: YNote: annual  Y –  average  axis: annual  average  contributions  to growth  contributions  in labor  to growth Note: Y – axis: annual average contributions to growth in    labor   in productivity, productivity,  percentage  points points   percentage labor productivity, percentage points result, As  a As   a  result,   structural   structural   transformation   –  defined   transformation   –  defined   as  resources   as  resources   moving   from   moving lower    from   lower   to  higher     to  higher   productivity productivity  activities  activities  – has  –  contributed  negatively  has contributed  negatively  to productivity  to productivity  growth  in recent  growth  years.  in recent  years.  While    While   As a result, structural transformation - defined as resources moving from lower to the  labor the  labor   reallocation   reallocation   into  higher into  higher ‐productivity   sectors ‐productivity   sectors   generated   generated   about   35  percent   about   35  percent   of  the   of the  labor    labor     higher productivity productivity productivity  growth  between  growth activities  between - has and 2010,  2001  2001 contributed  and 2010,  its growth  its growth negatively  contribution  contribution  turned to productivity  negative  turned  negative  during  during  2011– growth  2011– recent in17 17 (figure  (figure years.  3.10).    While  3.10).    the labor reallocation into higher-productivity sectors generated about 35 percent of the labor productivity growth between 2001 and 2010, its growth By  limiting By  limiting   the  creation   the  creation   of  high   of‐ quality   high‐quality   jobs  and jobs and  opportunities,   opportunities,   the  shift   the  shift of  resources   of  resources   away   from   away   from  contribution turned negative during 2011-17 (figure 3.10). the manufacturing the manufacturing  sector  sector  is choking  is choking  off  off an  important  an important  source  source  of human  of human  capital  capital  and organizational  and organizational     By limiting capital capital  the  development. creation development.  Aside  of  Aside fromhigh-quality   from  the immediate the immediate jobs  effect  and effect opportunities,  of diminishing  of diminishing  thethe  the contribution shift  contribution of of resources structural  of  structural     away from the transformation transformation  tomanufacturing  to productivity  productivity  growth, sector  growth,  the erosion  the is choking  of manufacturing  erosion off an  of manufacturing important  and  and export  export source  competency  competency of human  means    means   the economy capital the  economy and  creates  creates  limited organizational  high‐  limited  jobs high‐quality  quality capital   jobs and development.  and opportunities.  opportunities. Aside This jeopardizes This jeopardizes  from long‐ term the  immediate growth long‐ term  growth   of effect   potential potential   by   failing   by     to failing     useto    Mongolia’s use     Mongolia’s   existingexisting   human   diminishing the contribution of structural transformation to productivity growth, the erosion   humancapital     capital   effectively   and effectively    and   discouraging discouraging   further     further   ofhuman  capital human manufacturing  capital  formation  formation and (whichexport (which  is  is also discussed   also discussed competency  in means more  detail  in more  in Chapter  detail the  in Chapter economy this  IV ofcreates  IV  of  this report).  report).   limited   high- quality III.1.3 III.1.3   jobs Low and   ‐productivity Low opportunities. ‐productivity  growth  growth This  is  rooted  is also jeopardizes also  rooted  in declining long-term  innovation  in declining growth  and technology  innovation  and potential  technology by  adoption failing  adoption     to Mongolian by Mongolian by Mongolia’s use  firms    firms existing   human capital effectively and discouraging further human capital formation (which is also discussed in more detail in Chapter 4 of this report). The The low level  low  level of productivity  of productivity  growth  growth  is also  is  linked also linked  to weaknesses in innovation  to weaknesses  in innovation  and the  and  the adoption  adoption    III.1.3 Low-productivity of  new new   technologies of  technologies   (box  3.1). growth (box  3.1).  Outside Outside   the is mining   the also   mining rooted   sector,   sector,   results  in from   results declining   from enterprise innovation   enterprise   surveys   surveys   indicate   and   indicate   technology   innovative declining declining adoption  behavior   innovative  by Mongolian behavior   among   among firms   smaller   smaller   firms.   World   firms.   Bank   World    Bank Enterprise   Enterprise   Surveys   conducted   Surveys   in    in    conducted Mongolia Mongolia   suggest   that  the   suggest that   percentage   the  percentage   of  firms   of  firms that  produce   that  produce 30 30   a  new new  product   a  product   has  fallen   from   has  fallen 66    66    from The low level of productivity growth is also linked to weaknesses in innovation and percent   in  2009 percent to  44   in   2009   to   percent   44  percent   in  2019.   in  2019.   Firms’   Firms’   capacity   capacity   to  generate   to  generate new  processes   new  processes   is  also   is  on also   on   the     the  the adoption decline.   The    decline. share of   of The  share new   firms technologies   of  firms   adopting   a  new   adopting (box   a  process 3.1). new  process Outside   has  decreased the   has  decreased mining   from  from 61  percent sector,   in  2013   61  percent results   in  2013 to  39   to from     39  enterprise percent percent  in 2019 surveys (figures  in  2019 indicate  (figures  3.11 and 3.11 declining  and 3.12).  3.12).    innovative    behavior among smaller firms. World Bank Enterprise Surveys conducted in Mongolia30 suggest that the percentage of firms   produce that   a new product has fallen from 66 percent in 2009 to 44 percent in 2019. Firms’ capacity to generate new processes is also on the decline. The share of firms adopting a new process has                                                              decreased                                                              from 61 percent in 2013 to 39 percent in 2019 (figures 30 World 3.11 30 Bank World and Enterprise  Enterprise  Bank 3.12).  Surveys  are firm  Surveys ‐level  are  firm  surveys ‐level surveys  that  collect  that collect  a representative a representative  sample  sample  of an economy’s  of an economy’s  private  sector and  private  cover sector  and    cover  a  range a  broad range broad  of   indicators   of  indicators   on  the business   on   environment,   the  business   environment,   such  as   such   access to  finance,   as  access   corruption,   to  finance,   corruption,   infrastructure,   infrastructure,   crime,  crime,   competition, competition,     innovation innovation  and technology,  and technology,  and performance  and performance  measures.  measures.  For Mongolia,  For Mongolia,  three of  three waves waves  of  data  for data  the for     the years  years  2009,   2013, 2009, and     2019 2013,  and  2019  were    were  collected. collected.     34  34      30 World Bank Enterprise Surveys are firm-level surveys that collect a representative sample of an economy’s private sector and cover a broad range of indicators on the business environment, such as access to finance, corruption, infrastructure, crime, competition, innovation and technology, and performance measures. For Mongolia, three waves of data for the years 2009, 2013, and 2019 were collected. BOOSTING PRODUCTIVITY GROWTH 37   Figure   3.11 Figure 3.12     Mongolian firms innovate less today than …and are not as creative as they used to be Figure 10  3.11 Figure years    Mongolian 3.11 ago…  firms  Mongolian  innovate  firms  less  innovate     less Figure  3.12 …and are Figure are  not not   asas  creative  creative  as  as  they  they  used  used  to      to Figure  today today Figure  than 3.11   Mongolian than  3.11 10 10  years  years  Mongolian ago…  firms ago…  firms   innovate  innovate  less  less  be   be  Figure Figure  3.12  3.12  …and  are not  …and as creative are not  as creative  as they  as they  used  to   to   used today today  than  10 years  than  10    ago… years Share  of   ago…   firms     creating  new   Share of firms creating new products products be  80% be  Share Share of  of firms  firms creating  new  creating  processes  new  processes 80% 80%80% 66% 61% 66% Share Share of  of  firms  creating  firms creating  new products  new products 61% Share of  firms Share  of creating  firms creating  new processes  new processes 60% 80% 80% 60% 80% 60% 80%60% 66% 66% 44% 44% 61% 61% 39% 39% 40% 60% 60% 40% 60% 40% 60%40% 44% 44% 39% 39% 20% 20% 20% 40% 40% 40% 20% 40% 0% 0% 0% 0% 20% 20% 20% 20% 2009 2019 2013 2019 2009 2019 2013 2019 0% Source: 0%  World Bank Enterprise Survey  0% 0% Source:  World Bank Enterprise Survey  Source: Source:  World  Bank WorldBank 2009  Enterprise Enterprise 2009  Survey  2019 Survey 2019 Source:  World Source:  Bank World  Enterprise 2013 Bank 2013 Enterprise   Survey  Survey 2019 2019 Consistent Source: Source:  World  World with  Bank  the  macro  Enterprise  Bank  Enterprise perspective Survey  Survey      of declining  Source: non Source: ‐resource  World World  Bank  exports,  Bank Enterprise  fewer  Enterprise  Survey firms  Survey     are engaging  Consistent with the macro perspective of declining non‐resource exports, fewer firms are engaging  Consistent with the in export activities,  with macro  over 90 perspective of declining  percent of Mongolian  firmsnon-resource  focused on the domesticexports, market. fewer  Overfirms   in export activities, with over 90 percent of Mongolian firms focused on the domestic market. Over  are the Consistent engaging  past Consistent  with  decade  with  thein  export the activities,  percentage with  of firms over   using 90 percent  foreign ‐licensed of technology Mongolian firms  fell  from focused  are on  23  firms percent  tothe  5      the past domestic  decade market.   the themacro  macro  Over percentage the  perspective  perspective  of firms past  of  declining decade of using  declining  the  non foreign non ‐ licensed ‐resource percentage ‐resource  exports,  exports,  technology of firms using fewer  fell   fewer   from firms  23 percent foreign-licensed engaging are    toengaging  5  in  percent in exportexport  activities,   (figures activities,    3.13 with     with and over     3.14). 90 over    90  percent  percent  of    of  Mongolian Mongolian  firms     focused firms     focused on  the   on   domestic the  domestic    market. market.   Over      Over percent (figures technology fell 3.13 from 23 3.14).  and percent   to 5 percent (figures 3.13 and 3.14). past the the  decade  past Figure 3.13  the   decade Firms percentage  the  percentage  have  become  of  firms  more of firms  using inward  using  foreign    foreign ‐licensed Figure ‐licensed  3.14  technology  …with  technology  limited  fell from  technology  23 percent fell  from  23  percent diffusion  to 5    5   to Figure  3.13    looking… Firms have become more inward  Figure 3.14 …with limited technology diffusion  percent percent Figure (figures  (figures 3.13  3.13  3.13  and  3.14).  and  3.14).     Figure 3.14 looking…   Share of firms that sell in national market only Share of firms using foreign‐licensed technology Figure Figure  3.13 Firms  Firms  3.13 95% have  Firms become Share  have of  have  firms  become more  that   become  sell inward in  more  national  more  inward looking…  market only  inward     Figure Figure …with 25%  3.14 3.14  …with limited Share  …with technology  of  limited  firms  limited  using  technology  technology diffusion  foreign‐licensed  diffusion  technology  diffusion     95% 21% looking… looking…       92% 25% 20% 21% 92% 90% Share Share of  of  firms  firms  that 89%  that  sell  in sell  in national national  market  only  only  market 20% 15% Share of Share  firms  of using foreign  firms   ‐licensed ‐licensed using foreign  technology  technology 95% 95% 90% 89% 15% 10% 25% 25% 21% 21% 5% 92% 92% 10% 5% 20% 20% 5% 85% 0% 5% 90% 90% 89% 89% 2009 2019 15% 15% 2009 2019 85%   0%   2009 10% 10% Source: World Bank  Enterprise Survey  2019   Source: 2009  World Bank  Enterprise Survey  2019 5% 5% 5% 5%   Source: World Bank Enterprise Survey  Source: World Bank Enterprise Survey  85% 85% Box 3.1 Factors leading to innovation 0% 0% in Mongolian firms  2009 2009 2019 2019 2009 2009 2019 2019 Firm ‐ level   regression Box  3.1 Factors   results   indicate  leading to  innovation    in Mongolian  firms       Source: Source:  World Source: World  World Bank Bank  Bank Enterprise  Enterprise Enterprise Survey  Survey    Survey     that  exportSource:   orientation, Source: Source: World  World   management  WorldBank  Bank  Enterprise  BankEnterprise   capabilities,  Enterprise Survey  Survey     access  Survey     to  finance,  and  a  female  top  manager  have  positive  and  statistically  significant  effects  on  innovation.  Firm‐level  regression  results  indicate  that  export  orientation,  management  capabilities,  access  to  The regression deploys a panel dataset created by Enterprise Surveys, including three waves: 2008–09,  finance,  and  a  female  top  manager  have  positive  and  statistically  significant  effects  on  innovation.  2012–13, and 2018–19. Box Box 3.1 The 3.1   Factors  Factors  findings  leading  leading  suggest  to  that  to  innovation innovation  investments  in  in Mongolian in  Mongolian  research  firms  and  firms       development,  being an  The regression deploys a panel dataset created by Enterprise Surveys, including three waves: 2008–09,  exporter,  being  a   manufacturing Box  3.1 Factors   company, leading   access   to to investments innovation   a   broader   in market, Mongolian   experience firms   of   management,   Firm 2012–13, ‐level Firm ‐level  and 2018–19.   regression The  findings   suggest   that  in research    management  and  development,   being  an   ability   to  regression borrow,   results   results   and   indicate   having   indicate   female that   export   that   management   export   orientation,   orientation,   increase   the   management   likelihood   capabilities,   of  innovation   capabilities,   (table access  access   3.1).    to    to  exporter, finance, finance,Firm-level   and These      being a  female  and findings   a     a  female manufacturing  regression are  top robust  top manager  across   company, results   manager   have  different   positive   have   access indicate   positive  specifications     and to   a that    and statistically broader  of   export   market, statistically the  model.   orientation,   significant   significant   experience   effects   of management, management   effects    on   innovation. on  innovation.       ability   to  borrow, access capabilities, and  having to   female finance,   management and a  female increase  the top   likelihood manager   of  haveinnovation   (table  3.1). positive and   regression The The  regression  deploys  deploys Table  a panel a  panel  3.1  dataset Marginal  dataset  created  effects  created  of   by logit  by  Enterprise  Enterprise  regression  Surveys,  –  Surveys,  Random  including including  effects  three  model   waves:  three  waves:  2008–09,  2008–09,     These  findings statistically  are  robust significant   across   different effects on  specifications innovation.   of  the  model. The  regression   deploys a panel dataset 2012–13, 2012–13,  and  and 2018–19.  2018–19.   The   The findings   findings   suggest   suggest   that Dependent [binary] variable: whether firm innovates (Yes / No)      investments that   investments in   research   in   research   and     and   development, development,   being     an being    an  created exporter, exporter,   being by   a  manufacturing   being Enterprise Table  3.1 Marginal   a  manufacturing Surveys,   company,  effectsincluding company,   of  logit access three   regression   access to  a waves:   broader   to 2008–09,  – Random   a  broader   market,   market, effects2012–13,   experience  model   experience and 2018–19.    of  management,   of  management,     ability The ability   findings   to to  borrow,   borrow,   and suggest Dependent having   and   havingthat  [binary]   female  investments female  variable:   management   management Model 1 in   research whether   increase     firm increase and Model 2    theinnovates   development, likelihood the    (Yes likelihood Model 3     of/   No)   being of     innovation an innovation Model 4   exporter, (table     3.1). (table   3.1).     These being These  findings a  findings manufacturing company, access to a broader market, experience   0.0022   of management, Age are robust of  company are (years)  across robust  across  different different  specifications  specifications -0.0007  of the the model.  of model. 0.0020 ability to borrow, and having female Modelmanagement 1 Model increase 2 theModel likelihood 3 of innovation Model 4 (table Manager's 3.1). Table Table experience These  3.1   Marginal 3.1 findings  Marginal (years)  effects are  effects robust  of logit  of logit 0.0049 across  regression regression ** different  –specifications 0.0051  – **  Random Random  effects 0.0053  effects of  the model **  model model.    *** 0.0062 Age companyfemale of manager Top (years)(Yes) -0.0007 0.0743 0.0020 **  firm 0.0591 * 0.0022 * 0.0625 0.0631 * Dependent Dependent  [binary]  [binary]  variable:  variable:  whether  whether  firm  innovates  innovates  (Yes  / No)  (Yes No)  /       Manager's experience (years) 0.0049 ** 0.0051 ** 0.0053 ** 0.0062 *** 35  Top manager female (Yes) 0.0743 ** 0.0591 * 0.0625 * 0.0631 *   Model Model 1 1 Model Model 2 2 Model Model 3 3 Model Model 4 4 Age Age of company of company (years) (years) -0.0007 -0.0007 0.0020 0.0020 0.0022 0.0022 35    Manager's Manager's experience experience (years) (years) 0.0049 0.0049 ** ** 0.0051 0.0051 ** 0.0053 ** 0.0053 ** 0.0062 ** 0.0062 *** *** manager Top Top female manager female (Yes) (Yes) 0.0743 0.0743 ** ** 0.0591 0.0591 * 0.0625 * 0.0625 * 0.0631 * 0.0631 * * 38 COUNTRY ECONOMIC MEMORANDUM 2020 35  35      Table 3.1 Marginal effects of logit regression – Random effects model Dependent [binary] variable: whether firm innovates (Yes / No) Model 1 Model 2 Model 3 Model 4 Age of company (years) -0.0007 0.0020 0.0022 Manager’s experience (years) 0.0049 ** 0.0051 ** 0.0053 ** 0.0062 *** Top manager female (Yes) 0.0743 ** 0.0591 * 0.0625 * 0.0631 * Has a licensed foreign technology (Yes) 0.0518 0.0879 0.0937 0.0791 Percent of foreign ownership -0.0012 -0.0009 -0.0008 Invested in R&D 0.3573 *** 0.3771 *** 0.3820 *** 0.3839 *** Firm size: log(# of permanent employees) 0.0815 *** Has access to broader market (Yes) 0.0596 0.1046 *** 0.1095 *** 0.1112 *** Sector (Manufacturing) 0.1113 *** 0.1300 *** 0.1301 *** 0.1247 *** Exporter (Yes) 0.1471 0.1702 ** 0.1724 ** 0.1721 ** Exposed to informal competition (Yes) 0.0158 -0.0005 0.0085 Access to finance (has loan or credit line) 0.0638 * 0.0908 *** 0.0934 *** 0.0998 *** Tax administration is obstacle 0.0172 0.0248 0.0270 Tax rate is obstacle -0.0312 -0.0233 Political instability is obstacle -0.0068 0.0087 Corruption is obstacle -0.0204 -0.0267 Licensing and permits are obstacles 0.0482 0.0508 Courts are obstacles 0.0101 0.0242 Number of observations 754 754 754 754 Number of Groups 592 592 592 592 Wald chi-squared (statistic) 60.46 65.06 61.28 60.4 Wald chi-squared (p-value) 0.00 0.00 0.00 0.00 Log-likelihood -432.71 -445.1 -446.3 -448.1 Source: World Bank staff estimates based on Enterprise Survey data, various waves Note: * p < 0.05; ** p < 0.01; *** p < 0.001 Mongolia dedicates limited financial and human resources to research and development (R&D), impairing innovation capabilities. R&D expenditures averaged only 0.22 percent of GDP during 1995–2017, which was below all its structural and aspirational peers other than Kazakhstan and Peru (figure 3.15). In addition, R&D activities have been mainly funded by the government. In 2018, only 8.5 percent of the R&D expenditures were provided by business enterprises. This share is far below the Russian Federation (30.1 percent), Kazakhstan (41 percent), and Canada (41 percent). BOOSTING PRODUCTIVITY GROWTH 39 Wald chi-squared (statistic) 60.46 65.06 61.28 60.4 Wald chi-squared (p-value) 0.00 0.00 0.00 0.00 Log-likelihood -432.71 -445.1 -446.3 -448.1   Source: World Bank staff estimates based on Enterprise Survey data, various waves  Poor innovation Note: performance  * p < 0.05; ** is   also Figure 3.15  p < 0.01; *** p < 0.001 associated with a shrinking percentage of R&D expenditures as a percent of GDP Mongolia the labor force   dedicates involved   limited in R&D   financial   and  Figure 3.15 R&D expenditures as a percent of GDP   activities. R&D human personnel  resources to  research per   million   and  inhabitants (Average 1995–2017) development   (R&D), in Mongolia has decreased from 1,243    impairing   innovation 2 capabilities.  R&D  expenditures  averaged  in 1996 to 1,056 in 2017. A similar trend only  0.22  percent  of  GDP  during  1995– 1.5 EAP can be observed in the number of R&D 2017, which was below all its structural and  personnel per thousand aspirational   peers  other employed,   than  Kazakhstan which  1 and  Peru from has declined (figure 3.6 in   1996   3.15). In  addition, to 2.7   R&D in  0.5 Core R&D 2017. activities personnel has   have  been  mainly  funded  by  the  declined more dramatically. even government.   In  2018,  onlyAmong   8.5  percent R&D  of  0 personnel, the shares of core the  R&D  expenditures  were  provided  by    researchers AUS CAN MYS UAE QAT CHL MNG RUS ARM ECU COL KAZ PER   and technicians have fallen business enterprises.  Thisfrom  share80 percent  is far Source:  below  Source: Note: The  The UAE UNESCO  UNESCO = United Institute  Institute Arab for Statistics  for Statistics Emirates;   Armenia; Note:  UAE  = United  Arab  Emirates;  Armenia;  ARMARM = Armenia;  = Armenia;  AUS =  and 9.7the   Russianin percent   Federation 1998 to  55 (30.1 and  Australia;   percent), percent AUS = Australia;  CAN = Canada;CAN   =  = Chile;CHL Canada; CHL Chile; COL  COL = Colombia; =  = East   EAP Kazakhstan 7.4 percent in 2018,  (41  percent), respectively,   and  Canadawhile  that (41  Asia Colombia;  and the EAP Pacific;= East  ECU = Asia and the  Ecuador;  KAZ Pacific; ECU = MNG  = Kazakhstan; Ecuador;  =     KAZ = Kazakhstan; MNG = Mongolia; MYS = Malaysia; PER   percent).   Poor   innovation   performance   is of support staff has increased from 10.3   = Peru; QAT = Qatar; RUS = Russia  Mongolia;   MYS   =   Malaysia;   PER   =   Peru;   QAT   =   Qatar;   RUS  = Russia percentalso to associated 37.6  with a  shrinking  percentage   7.4 percent  in percent during 2018, respectively, this  while period.  that of support staff has increased from 10.3 percent to 37.6  of the labor force involved in R&D activities. R&D personnel per million inhabitants in Mongolia has  percent during this period.   III.2 decreased Constraints  from  1,243   in  1996  to  1,056 to productivity   in  2017.  A  similar  trend  can  be  observed  in  the  number  of  growth III.2  Constraints to productivity growth R&D   personnel   per   thousand   employed,   which    has  declined  from  3.6  in  1996  to  2.7  in  2017.  Core  Macroeconomic factors including a volatile R&D  personnel  has  declined  even  more  dramatically. exchange   Amongrate and   R&D microeconomic   personnel,   the  shares factors   of  core  such as limited  and researchers Macroeconomic competition  technicians   factors and  have   including a  a weak  fallen  from   volatile   overall business  80 percent exchange   rate and  9.7   and environment  percent in 1998   microeconomic are  to 55   factorsamong  percent   such  as the  and     most significant factors underlying weak productivity in Mongolia. limited competition and a weak overall business environment are among the most significant factors  underlying weak productivity in Mongolia.  36  III.2.1   The macroeconomic environment: An overvalued exchange rate and III.2.1  erode volatility competitiveness The macroeconomic and  investment  environment: An overvalued in non-resource exchange tradable  rate and volatility sectors  erode   competitiveness Mongolia’s  and investment macroeconomy is  non‐resource  inprone to Figure  tradable sectors  3.16 the resource curse, as is the case in other Mongolia’s  macroeconomy  is  prone  to  the Real Figure  3.16 Real exchange rate  exchange appreciates rate  appreciates boom   during periods resource-rich countries. This can resource  curse,  as  is  the  case  in  other  resource‐lead to a during  boom   periods   of  competitiveness lossrich countries.  This  can of non-resource lead   to  a  loss  of  30% Appreciation tradable sectors,  which competitiveness of  non are typically ‐resource   tradable a   20% source sectors, which  are  growth. of  productivity typically  Mongolia’s a  source  of  10% exchange real productivity rate tracks   growth. the  commodity   Mongolia’s real  exchange  pricerate  tracks As cycle. a result  price the commodity As a result   cycle. foreign of large 0% of   large   foreign   exchange exchange inflows related to both mining   inflows   related   to   both   ‐10% mining   revenue   and revenue and foreign direct investment  foreign   direct   investment   in   Inflation gap ‐20% Change in Nominal ER the  extractive in the extractive   sector, sector,  Mongolia’s real     real  exchange Mongolia’s Change in Real Exchange Rate rate appreciated during  the commodity boom of  ‐30% exchange rate appreciated during the 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2004–08, followed by a sharp adjustment in 2009  commodity boom of 2004-08, followed by reflecting  the  commodity  price  shock  during  the  Sources: Sources: Data from BoM; World Bank staff illustration.  Data from BoM; World Bank staff illustration a sharp adjustment global  financial  crisis. in 2009  While reflecting   the  nominal the   Note: Note: Nominal Nominal ER  ER=  =  nominal nominal  effectiveexchange  exchange rate effective rate.  exchange price commodity rate  shock rebounded during  in  the global 2010–11   as  financial commodity crisis. While  prices the nominal  recovered,  Mongolia exchange  experienced rate rebounded  continued in 2010–11  real depreciation as 2013–17  during commodity  in  prices recovered, a context  of more Mongolia  subdued commodityexperienced  prices continued  (figure 3.16). real   depreciation during 2013–17 in a context of more  curse The  resource subdued commodity   also  manifests prices   itself   in  wage (figure   growth3.16).   outpacing  productivity  growth.  Rapid  Thewage   growth,curse resource   especially also  during   periods  of itself manifests high  commodity in wage   prices, growth   is  driven   by  the  requirement outpacing productivity  to  compete growth.  for employees Rapid  in the miningduring  with jobsespecially wage growth,  sector. As  a consequence, periods of high  unit  labor costs have commodity  been  is prices, rising,  which  weighs   driven by the requirement to compete for employees with jobs in the mining sector. As  a on  the  competitiveness  of  non ‐extractive  sectors,  and  shifts  resources  –  capital and labor – away consequence, unit from labor tradable costs  have and import been ‐competing rising, which activities  (figures weighs  3.17 on the and  3.18).  competitiveness of non-extractive sectors, and Figure 3.17 Rapid wage growth…   shifts resources - capital and labor - away from Figure 3.18 …has exceeded productivity growth  tradable and import-competing activities (figures 3.17 and and 3.18).  eroded competitiveness    30% 450 Average ULC index (2001=100) 40 COUNTRY 25% ECONOMIC MEMORANDUM 2020 400 Average wage index (2001=100) 350 Productivity index (2001=100) 20% 300 15% 250 200 10% Mining 150 Other tradable 100 5% The The   resource   resource   curse   curse   also   also   manifests   manifests   itself   itself   in   in   wage   wage   growth   growth   outpacing   outpacing   productivity   productivity   growth.   growth.   Rapid   Rapid    wage wage   growth,   growth,   especially   especially   during   during   periods   periods   of   of   high   high   commodity   commodity   prices,   prices,   is   is   driven   driven   by   by   the   the   requirement   requirement   to   to    compete compete  for  for  employees  employees  with  with  jobs  jobs  in  in  the  the  mining  mining  sector.  sector.  As  As  a  a  consequence,  consequence,  unit  unit  labor  labor  costs  costs  have  have  been  been    rising,  which Figure which rising, 3.17  weighs  weighs  on  on  the  the  competitiveness  competitiveness  of  of  non  non ‐extractive ‐extractive Figure 3.18  sectors,  sectors,  and  and  shifts  shifts  resources  resources  –  –  capital  capital    and and  labor  labor  – –  away  away  from  from  tradable  tradable  and  and  import  import ‐competing ‐competing  activities(figures  (figures  3.17  and  3.18).    Rapid wage growth… exceeded  productivity …has activities  3.17  and growth  3.18). and eroded competitiveness Figure Figure  3.17  3.17  Rapid  Rapid  wage  wage  growth…  growth…     Figure Figure  3.18  3.18  …has  …has  exceeded  exceeded  productivity  productivity  growth  growth    and  eroded  competitiveness and eroded competitiveness        30% 30% 450 450 Average Average  ULC  ULC  index  index  (2001=100)  (2001=100) 25% 25% 400 Average  wage  index  (2001=100) 400 Average  wage  index  (2001=100) 350 350 Productivity  index  (2001=100) 20% 20% Productivity index (2001=100) 300 300 15% 250 250 15% 200 200 10% Mining Mining 10% 150 150 Other Other  tradable  tradable 100 5% 100 5% Non ‐ tradable 50 Non‐tradable 50 0% 0% 00 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 ‐5% ‐5%      Sources: NSO; World Bank staff illustration Sources: NSO; World Bank staff illustration Note: Annualized change in average wage relative to the Note: ULC = unit labor cost 37 37        level in 2000 Sources: NSO; World Bank staff illustration  Sources: NSO; World Bank staff illustration  Note: Annualized change in average wage relative to the  Note: ULC = unit labor cost  level in 2000  These problems are compounded Figure 3.19 These problems by large public sector  are compounded employment  by large  Figure 3.19 Mongolia has one of the largest public  Mongolia has one of the largest public sectors public   sector   employment which is diverting resources away  is  sectors    which diverting  resources  away  from  more  productive from more productive uses. Mongolia   uses.  Mongolia  has  a  large  14 Canada Wage bill (% of GDP): average  12 public has a largepublic sector,   sector,  for  its  levelfor especially   especially   of  per  10 Qatar Ecuador Australia its level of per   GDP.GDP. capita capita   Large Large   public public   sector  8 of 2016–18 Peru Mongolia 6 Armenia employment contributes sector employment contributes  to to  lowlow  4 Chile Malaysia Russia productivity   since   productivity productivity since productivity levels and   levels   and   2 Colombia Kazakhstan growth  rates  in  government  services  tend  0 growth rates in government services tend 0 10 20 30 40 50 to be low (figures 3.19).  to be low (figure 3.19).   Public employment as % of total employment: average of 2016–18   Finally,  as  discussed  in  Chapter  2,  Sources: ILO; Sources: ILO; IMF; IMF; World World Bank  staff Bank  estimates staff   estimates Mongolia’s  macroeconomic  environment  is  characterized  by  high  levels  of  volatility.  Mongolia’s  macroeconomic  management  has  Finally, as exacerbated discussed in   Chapter   rather than  dampened   volatility  emanating 2, Mongolia’s   from  commodity macroeconomic   price  fluctuations. environment is   Volatility is likely to affect investment decisions  as changes in macroeconomic variables (exchange  characterized by high levels of volatility. Mongolia’s macroeconomic management rate, interest rate, inflation, real wages) affect the expected return on investment and, hence, affect  the level rather has exacerbated than dampened of labor productivity volatility  in the economy.    emanating from commodity price fluctuations. Volatility is likely to affect investment decisions as changes in macroeconomic The  current  macroeconomic  environment  is  not  conducive  to  productivity  growth.  Most  variables (exchange importantly,  it hasinterest rate, rate,  stifled export inflation,  and real activity  manufacturing wages) affect  outside the  the expected  mining return  sector. As on  indicated  investment and, hence, affect the level of labor productivity in the economy. by the firm‐level evidence presented above, and by a large body of empirical literature, competing  in global markets can boost productivity by increasing scale, enhancing competition, and providing  The current macroeconomic environment is not conducive to productivity growth. access to more advanced technologies and sophisticated consumer preferences. In addition, export  Most importantly, firms  have been  stifled it   has shown  to export   generateand manufacturing   spillovers,   suggesting  activity that  the  outside the  mining effect  of  losing export  competencyby sector. As indicated the   in  the   nonfirm-level evidence ‐resource  sector presented   is  likely   to  contributeabove, and by   to  the  observed a  large   loss body in  aggregate   literature, of empirical productivity competing  growth.    in global markets can boost productivity by increasing scale, enhancing competition, III.2.2  The  microeconomic and providing  environment: access  Limited to more  competition,  high advanced regulatory burden,technologies  and  and sophisticated consumer insecure property rights  preferences. In addition, export firms have been shown to generate spillovers, suggesting that the effect of losing export competency in the non- Mongolia’s resource sector   macroeconomic is likely to contribute to  the   woes are  compounded observed loss   by  microeconomic in aggregate   constraints.   The  low productivity   level  growth. of private investment and job creation in sectors outside mining has been due to low returns, which  microeconomic III.2.2 The in   turn  are  the  result  of environment: lengthy  and  complex Limited competition,   regulatory  procedures, high   including regulatory   customs  and  trade  burden, and rules;   distortionary insecure   taxes;  and property   a  lack  of  competition,  with  high  ownership  concentration  and  entry  rights barriers. At the same time, poor financial intermediation has kept the cost of finance high and access  Mongolia’slow,macroeconomic  especially for small woes are compounded and medium by microeconomic ‐sized enterprises, which constraints.  constitute the vast majority  of firms  The low level of private outside  sector.   and job creation in sectors outside mining has been due investment  the mining to low returns, which  in Mongolia’s turn are business the result   environment   is of lengthy not and   conducive complex   to   fostering regulatory procedures, a  vibrant  and  productive  including customs enterpriseand trade  sector. rules;  Mongolia distortionary  ranks 81st among taxes; and  a 190 countries in lack of  competition, the 2020 World Bank Doingwith high  Business   rankings,  with  getting  electricity  (ranked  152),  resolving  insolvency  (150),  trading  across  borders  (143),  and  starting  a  business  (100)  being  particularly BOOSTING PRODUCTIVITY challenging  (figures GROWTH   3.20  and  3.21).  Across  41 many dimensions of the Doing Business ratings, Mongolia is performing better than upper middle‐ 38    ownership concentration and entry barriers. At the same time, poor financial intermediation has kept the cost of finance high and access low, especially for small and medium-sized enterprises, which constitute the vast majority of firms outside the mining sector. Mongolia’s business environment is not conducive to fostering a vibrant and productive enterprise sector. Mongolia ranks 81st among 190 countries in the 2020 World Bank Doing Business rankings, with getting electricity (ranked 152), resolving insolvency (150), trading across borders (143), and starting a business (100) being particularly challenging (figures 3.20 and 3.21). Across many dimensions of the Doing Business ratings, Mongolia is performing better than upper middle-income countries, yet firms in Mongolia still spend more time dealing with the requirements of government regulations than other countries in East Asia. Similarly, Mongolia is lagging compared to its peers such as Chile, Canada, and Malaysia     on control of corruption, rule of law, regulatory quality, and government effectiveness in the Worldwide Governance Indicators. And Mongolia ranks 93rd among 180 countries in income the  income latest countries, Transparency   yet  firms   countries,   yet in   Mongolia   International´s   firms   still  spend   in  Mongolia Corruption   still  more  time   spend more   dealing Perception   time  dealing  with Index.  the   with   requirements These   the  requirementsratings   of  reflect   of  government   regulations government     than regulations   other   than   countries   other     in   countries East    Asia. in     East Similarly,   Asia.     Mongolia Similarly,     Mongolia is   lagging   is     compared lagging     compared   that, despite progress, there are still significant regulatory barriers to business entry and to  its  peers   such to  its   peers   as   Chile,   such   as  Canada,   Chile,  Canada,  and  Malaysia   on  control   and  Malaysia   of  corruption,   on  control   of  corruption,  rule  of   law,   rule   of  regulatory   law,  regulatory     growth. Corruption and  government quality, quality, remains   effectiveness a pervasive   in  the   in barrier Worldwide for  Governance doing business   Indicators. and  And tilts  Mongolia the playing   field   and  government   effectiveness   the  Worldwide   Governance   Indicators.   And  Mongolia   in favor ranks   93rd well-connected, of  among ranks 180  countries   93rd  among   in  the  and older,   180  countries latest in  the bigger    Transparency establishments latest  Transparency   International´s that   International´s enjoy   Corruption   Corruption greater   Perception access     Perception   to credit, protection Index.  These Index.   ratings from reflect  that,   These  ratings insolvency, reflect   despite and  progress,   that,  despite forbearance   there  are   progress, there on regulations.   still   significant   are   still  significant Ultimately,   regulatory   barriers   regulatory this   to    to    barriersprevents reallocation business   entry of   resources and   growth.   to more Corruption productive   remains   a   firms. pervasive   barrier business  entry  and  growth.  Corruption  remains  a  pervasive  barrier  for doing  business  and  tilts   for   doing   business   and   tilts   the     the  field in favor playing playing  of field in  well   favor connected, ‐of  older,  and  well‐connected,  bigger older,  and  bigger establishments  that greater  that enjoy  establishments  access enjoy greater    access   to  protection to  credit, Figure 3.20   from  insolvency, credit,  protection   and  forbearance   from  insolvency,   on  regulations. Figure   and  forbearance 3.21   Ultimately,   on  regulations.   this  prevents   Ultimately,     this  prevents   reallocation While  of resources reallocation has of Mongolia made  to  more  resources progress  productive  to  more  firms.  firms.  productive in improving …the  regulatory burden on firms remains high aspects of its business climate… Figure 3.20  While Figure  Mongolia  3.20  has made  While Mongolia  progress  has  in   3.21  in  Figure  made progress  …the Figure  regulatory  3.21  burden  …the regulatory  on firms  burden  on   firms  improving  aspects of improving  its business aspects  climate…  of its business    climate…   remains  high   high  remains MNG MNG Percent of senior  management Percent  time spent  time  of senior management dealing  with  spent  the   with the   dealing Starting a Starting a business business requirements requirements  regulation regulation  of government  of government ARM ARM 35 35 Resolving Resolving Registerin Registerin KAZ KAZ insolvency insolvency g property g property 30 30 KGZ KGZ Mongolia Mongolia EAP EAP 25 25 CAN CAN Enforcing Getting Enforcing contracts Getting credit 20 20 contracts credit CHL CHL 15 15 MYS MYS Trading Protecting 10 Emerging & 10 Trading Protecting across across minority minority Emerging & borders borders investors investors Developing, IMF Developing, IMF 5 Paying Upper middle Upper middle5 Paying income income taxes taxes 0 EAP, excluding  high 0   EAP, excluding high income   income Overall Overall Small Small (5‐19) Medium  (5‐19)  (20 Medium (20‐99) ‐99)  Large Large (100+)  (100+)     Source: Source: World Source: World Bank  Bank  World  Bank Doing  Doing  Doing  Business    Business  Business Source: Source: Source:  World  World World  Bank  Bank Bank  Doing  Doing Doing  Business Business      Business Note: Data Note: DataNote:  Data  for the the  for   latest latest  the year latest year  year    available. available. available. Unit  of measure Unit  Unit of  of  is measure measure  the  theis  is the   Data Note: Note: Note: for   the Data Data  for  latest for  the the  latest  year  available latest year available  year    available Doing Doing Business Doing Business  Business  distance distance  to distance  the  frontier to the  frontier to the  frontier  (the(the  (the  larger,  larger,  the larger, the  better)  better) the    better)  The  competition The  competition   framework   framework weak,   is   and   is  weak,   and  several   several   sectors   sectors from   high   suffer   suffer from   high  levels   levels   of  ownership of  ownership     The competition concentration. framework  Competition is weak,  perception and several  indicators  measured sectors suffer from Forum’shigh levels   of concentration.  Competition  perception  indicators  measured  by the   by  the  World World Economic  Economic  Forum’s  Global  Global   ownership Competitiveness concentration. Competitiveness   Report    2019 Report 31  2019   suggestCompetition 31   suggest   Mongolia perception   Mongolia   performs   badlyindicators   performs badly   in   in    terms   termsmeasured of  the   of   the  perceived perceived  by the extent   World   extent   Economic of   Forum’s market   dominance,Global   Competitiveness intensity   of   local   Report competition, of  market  dominance,  intensity  of  local  competition,  and  effectiveness  of  antimonopoly  policies    and   2019 effectivenesssuggest   of   Mongolia antimonopoly   performs policies   badly compared in terms compared   to of the perceived  to its structural its  structural  and  and aspirational  aspirational extent  peers  peers of market  (figures  (figures 3.22 dominance, 3.22   and  3.23). intensity  and 3.23). Similarly,  Similarly,  the of  the   local competition,  BertelsmannBertelsmann    and Foundation’s effectiveness Foundation’s  Transformation  Transformation  Index32   of antimonopoly Index 32  policies also indicatesalso indicates  Mongolia’s compared  Mongolia’s to  antimonopoly antimonopoly policy  its structural  policy is less  effective. and  is less  effective. aspirational     Like Like Kazakhstan,   Kazakhstan,  3.22 Mongolia   Mongolia  has  one 31   has of   one   of   the   highest   levels   of   vested   cronyism,   discrimination   against   peers (figures foreign   firms,   and and   3.23) unfair   . the competitive  highest levels Similarly,   practices the   Bertelsmann of vested cronyism, (figure   3.22).   Faced    discrimination Foundation’s with   limited    against  Transformation competition,   the  foreign Index   firms, also   and  unfair indicates   competitive  practices Mongolia’s antimonopoly   (figure  3.22). policy   Facedis   witheffective. less   limited  competition, 32 Like   the  Kazakhstan, existing firms have less incentive to engage in innovation, while the potential higher‐productive and  existing firms have less incentive to engage in innovation, while the potential higher‐productive and  Mongolia has one innovative  firms of canthe highest  hardly  enter levels  the market of vested  and grow. cronyism,    discrimination against foreign innovative firms can hardly enter the market and grow.   firms, and unfair competitive practices. Faced with limited competition, the existing firms have   less incentive to engage in innovation, while the potential higher-productive and   innovative   firms can hardly enter the market and grow.   31 WEF 2019.    https://www.bti-project.org/en/home.html?&cb=00000. 32 42 COUNTRY ECONOMIC MEMORANDUM 2020                                                                                                                           31 WEF 2019.  31 WEF 2019. 32    https://www.bti‐project.org/en/home.html?&cb=00000.  32 https://www.bti‐project.org/en/home.html?&cb=00000.   39    39  Figure 3.22 Figure 3.23     Competition framework is weak… …and there are high levels of ownership   Figure 3.22 Competition framework is weak…  concentration in key Figure 3.23 …and sectors  there  are high levels of  Figure 3.22 Competition framework is weak…  Figure  3.23 …and ownership  there are high  concentration  levels  in key  of     sectors Effectiveness of anti‐monopoly policy, 1‐7 (best) ownership concentration  in  key   sectors   Figure 3.22 Competition framework is weak…  Effectiveness Extent of of     anti‐monopoly market  policy,  dominance,  1‐7 (best)  1‐7 (best) Figure 3.23 …and  there Ownership 2are  of    high  largest  levels of   shareholders Ownership of 2 largest shareholders 6 Extent  of market Intensity  dominance,  of local  1‐7 (best)  competition,  1‐7 (best) Intensity of local competition, 1‐7 (best) ownership 90% 90%  concentration in key sectors  Effectiveness of anti‐monopoly policy, 1‐7 (best) 85% 87% 6 Ownership of 2 largest 87% shareholders Extent of market dominance, 1‐7 (best) 70% 85% Perception level, 1‐7 (best) 5 70%90%  1‐7 (best) 5 Intensity of local competition, 1‐7 (best) 6 4 64% 4 50% 64% 85% 87% 50%70% 5 3  (best)  level, 3 30% 37% 4 2 64%  level, 1‐7 30%50% Perception 2 37% 1 3 10% 1 0 10%30% Perception 2 37% 0 MNG ARM KAZ CAN CHL MYS Bank 1 Bank 2 Bank 3 Bank 4 1 MNG ARM KAZ CAN CHL MYS   ‐10% ‐10% Bank 1 Bank 2 Bank 3 Bank 4   10%   Source: Source: 0 WEF  WEF   Compiled from Source:Compiled Source: from bank bank  webpages, webpages,  as May  of of as  2020 May     2020 Source: Note: Note: Data WEFis  for  is MNG   for   Data ARM   the  year the latest KAZ latest   year  CAN available. available. CHL   Indicators Indicators MYS   ‐10% Compiled Source:   reflect Bank from  1  bank  webpages, Bank  2 of May  as Bank  3  2020  Bank 4 Note:   Data  is  for perceptions reflect perceptions  on   the a on   latest  scale a scale   year  from   available.  1 (worst) from  to 7  to 1 (worst) Indicators (best)   7 (best)   reflect    perceptions on a scale from 1 (worst) to 7 (best)    Source: WEF  Source: Compiled from bank webpages, as of May 2020  Finally, Note:  Data   access   to is  for  the   year    finance   latest available.   Indicators   remains a  constraint     Figure 3.24 Firms face financing constraints    reflect Finally, Finally,   access to  finance  scale   remains constraint   a remains   Figure facing access perceptions firms,  on a  to 1 (worst)   especially  from finance   small  to 7   and (best)     medium ‐ Figure 3.24 3.24 Firms face financing constraints  a facing constraint  firms,  especially sized  enterprises. facing  firms,   According small  and   medium‐  especially to  the  2019  Firms face Percent of firms identifying access to finance as a major  Percent  of firms identifying financing access to finance as a major   constraint constraints sized Finally, small   and enterprises.   access medium-sized   According   to  finance   remains   to    a the   2019    Figure 3.24 Firms face   constraint   toenterprises. constraint Enterprise   Survey,   access   finance   was  the  50 Mongolia  financing  constraints  East Asia and Pacific Enterprise facing According   firms,  Survey, to     especiallyaccess the   2019   to small  finance   and    wasmedium   the   ‐ third  most   import business Enterprise environment  40 50 Mongolia East   Asia  and  Pacific Percent of firms identifying access to finance as a major  third sized     most enterprises.  import business    environment   According     40 Survey,constraint access   for to    finance small  and was   to  the medium thethird   ‐ 2019 sized   constraint constraint Enterprise   for   Survey,   small   access   and     to  finance medium   was‐ sized     the   30 50 30 most enterprises important   (SMEs)   in  Mongolia business   (figure environment   3.24). Mongolia East Asia and Pacific enterprises third   most   (SMEs)   import   in   Mongolia business    (figureenvironment   3.24).    Almost  40 constraint for   percent small   ofand   and  34  percent  of  20 40   smallmedium-sized 20 Almost constraint   40  percent for   of  small   small   and  and   34  identify   percent medium   of    ‐sized medium enterprises ‐ sized (SMEs)   enterprises in Mongolia     lack (figure   of  10 medium enterprises ‐ sized     (SMEs) enterprises   in   Mongolia  identify     (figure lack     of    10 30 3.24). 3.24). access Almost  to credit  as a major business and      constraint. access Almost  to  40 credit  studies percent as a  percent  40 major of  small  business of small   and 34  constraint.  among   percent   of   0 20 0 34 Several percent   of   suggest medium-sized   that,   enterprises   others, Overall Small (5‐19) Medium (20‐99) Large (100+) Several medium   studies     suggest   that, among   others,    identify   of   10 Overall Small (5‐19) Medium (20‐99) Large (100+) access‐   sized to  finance enterprises  is  a  major   constraint lack   for   access  lack identify to  finance of access   is  a to majorcredit as a major   constraint   for  Source: World Bank Enterprise Survey    access business  to credit   development, as a major    business and  most  constraint.   of  the   Source:  World Bank Enterprise Survey  business business  development, constraint.   Several and  most  studies of  the  0 Several demands   studies  are for   suggest  financing   that, current   among  assets.   others, Mongolia    has developed Overall  a  basic Small  (5‐19)  infrastructure Medium (20‐99)  (the  Pledge  Large (100+) demandsthat, suggestLaw   and  are for   among  financing collateral   others,  current assets. registry)   to access   enable  Mongolia   tolending  has developed a basic infrastructure (the Pledge    based   on   movable   properties   (for   example,   access  to  finance  is a  major  constraint  for  Source: World Bank Enterprise Survey Law  and finance is  a collateral major registry)  to  constraint   enable for business   lending  based Source:   World on  movable  Bank Enterprise   properties  Survey    (for  example,  receivables, business   development,   inventory,  equipment), and  most   of   the   which is  much     needed  by  SMEs  including  herder  families  (for  receivables,  inventory, development, and most   equipment), of of the   which  is  much  needed  by  SMEs  including  herder  families  (for  demands example, demands  are  livestock   for  financing is a type   current  inventory).  assets.    Despite these Mongolia   has  efforts, access  developed  a  basic  to  credit  remains hampered infrastructure (the Pledge    example, are for  livestock financing  is a type current  of inventory). assets. Mongolia  Despite has  these developed efforts, access a basic credit remains hampered  to infrastructure (the Pledge   Law in   part   and   by      collateral high   real       registry)interest   rates,   reflecting   macroeconomic   volatility,   and   bank   corporate   in   part   by high  real interest   rates, to  enable   reflecting   lending   based  on  movable   macroeconomic   volatility,   properties   and  bank    (for   example, corporate     Law and governance collateral  weakness registry)  equipment), that favors to enable  lending lending  practices based   that on  channel movable  credit  to properties  connected (for  parties. example,  In part   receivables,   inventory,   governance weakness that favors lending practices that channel credit to connected parties. In part (for    which   is   much needed   by   SMEs   including   herder   families   receivables, because example,  of  livestockinventory,  the  absence  is a  of type  equipment), of  a   functioning  of inventory). which  credit  Despite   is reportingmuch  these   needed system,  efforts,  the  access   by use    to SMEs of  moveable  credit remains including collateral herder    hamperedalso   because  of  the absence  a functioning  credit  reporting  system,  the  use of  moveable  collateral  also    in  remains familiespart (for   by  incipient,   example, high    limiting real   livestock interest  SME    rates, access is a   reflecting totype finance. of    macroeconomic inventory). Despite   volatility, these   efforts, and   bank access   corporate to   remains incipient, limiting SME access to finance.  credit remains hampered in part by governance weakness that favors lending practices that channel credit to connected parties. In part  high real interest rates, reflecting macroeconomic In the mining sector, the reliance on state equity participation is not only imposing fiscal costs but  volatility, because In  the mining and  of  the bank  absence  sector, corporate  the  of  a functioning reliance  on governance  state  credit  equity weakness  reporting  participation  system, that  is not favors  the  use  only  of lending  imposing  moveable  fiscalpractices  collateral  costs but  that also    also  deterring  productivity‐enhancing  private  investment.  In  principle,  the  State  Equity  Policy  is  channel remains also credit   deterring  incipient, to connected  limiting ‐SME   productivity parties. enhancing  access  toIn finance.   private part because     investment. of   Inthe absence   principle,   the  State   Equity  Policycredit of a functioning   is  intended to capture mineral resource rents for the benefit of the nation. In practice, state equity is  intended to capture mineral resource rents for the benefit of the nation. In practice, state equity SME reporting system, the use of moveable collateral also remains incipient, limiting is  In financed access the mining financed to  on a working interest  on  sector,  a working  the finance. interest  reliance  basis  basis on  that   state that requires  requires  equity  the  the state to finance  participation  state to finance  is not  a     a corresponding only corresponding  imposing  fiscal  share  share  costs  of  of the  the   but    cost also   of  developing   deterring   and  operating   productivity   mining ‐enhancing   assets.   private   Given  liquidity   investment.   constraints,   In  principle,   state   the   equity   State   has   Equity   been   Policy      is Incost the   of   developing mining financed  by   and  operating sector,  borrowing, the   mining reliance  either  directly   assets.  on from state   Given equity   liquidity   constraints,  state participation is not   equity only   has   been  imposing intended financed  by to    capture borrowing,  mineral   either  directly   resource    rents from   banks   for banks   the or  or    benefit by  by having  having  of   the the  the    state’s  In  nation. state’s   share share  carried  practice,  carried    by  state by  the  theequity  non    non‐ ‐ In  is  fiscalstate costs  equity   but also holders,   as  in  deterring the  case  of  the productivity-enhancing  Oyu  Tolgoi  copper  mining   private project.   investment. Mandatory  state  equity    financed state equity  on   a  working  holders,  interest   basis   that  requires  the  state  to  finance  a  corresponding   share  of   the principle, the State as  in the case Equity Policy  of the is Oyu  Tolgoi copper intended to capture  project. Mandatory  miningmineral resource state rents  equity for  the cost  of  developing  and  operating  mining  assets.  Given  liquidity  constraints,  state  equity  has  been 40    benefit of the nation. In practice, state equity is financed on a working interest basis 40that   financed   requires  by state the borrowing,  eithera to finance  directly  from banks corresponding  or by of share having the cost  the state’s  share carried of developing and  by  the non‐ operating   state equity mining assets.  holders, Given  in the case  asliquidity  of the Oyu Tolgoi constraints, state copper equity  mining has been  project.  Mandatory financed by  borrowing, state equity  either directly from banks or by having the state’s share carried by the non-state equity 40    BOOSTING PRODUCTIVITY GROWTH 43 holders, as in the case of the Oyu Tolgoi copper mining project. Mandatory state equity participation is also exposing the state to commercial risks, including cost overruns, while at the same time discouraging private investment in developing mining assets. III.3 Policy priorities - Addressing constraints to lift productivity growth Mongolia needs to create an environment where more productive jobs are created outside the mining sector. Without higher productivity growth, the creation of high- quality employment will remain elusive, despite Mongolia’s young and well-educated labor force. This will require alleviating the macro- and microeconomic constraints to productivity growth. To enhance macroeconomic management to mitigate the impact of the resource curse: (i) Strengthen macroeconomic institutions to enhance more countercyclical management. Policy settings should allow greater exchange rate flexibility to avoid real exchange rate appreciation while focusing monetary policy on anchoring inflation and addressing external imbalances. During boom periods with high commodity prices, some foreign exchange (FX) inflows should be sterilized by accumulating reserves accompanied by commensurate steps to mop up domestic liquidity. Macroprudential measures should discourage dollarization and FX indebtedness, while public debt management should focus on reducing the FX share in public debt, including deepening the domestic bond market. Fiscal policies should aim to support stabilization while securing long-term sustainability through the use of existing stabilization and savings funds. This should be underpinned by institutional reforms to strengthen the independence of the Fiscal Stability Council and the Bank of Mongolia. To create a business environment that supports firms to grow and invest: (i) Establish an effective public-private dialogue on investor-friendly reforms and promote collaboration of the agencies on innovation. The effective coordination of business environment reform remains limited. The public-private dialogue would help identify critical constraints and bottlenecks in general and in certain sectors. It would formulate reform recommendations and ensure an open channel of communication between the government and the private sector. To the extent possible, such a dialogue could also promote collaboration on innovation through leveraging the innovative power of large firms (box 3.2). (ii) Reform the business registration process to ease business entry. Implement an online system to verify uniqueness of company names; introduce standardized application forms and articles of association; and abolish the company seal. (iii) Strengthen the competition framework. More specifically, this reform will entail (a) approving a revised national competition policy to implement pro-competition intervention across both economy-wide and sector-specific policies (for example, public procurement, antitrust, state aid, state-owned enterprise strategy, public- private partnerships, price controls, and various network/input sectors), and (b) streamline rules on tender criteria and coordination among different government entities to promote entry and avoid collusion in public procurement, including adoption of penalties on collusive behavior, and modified standard tender documents to prevent coordination among bidders. 44 COUNTRY ECONOMIC MEMORANDUM 2020 (iv) Facilitate trade across borders by reducing cost and time for border clearance. Improve automation of the customs clearance process that will allow electronic submission of transport documents, payments for all border agencies, plus railway and the national air freight forwarder, Mongolian Airlines; develop a pre-arrival processing system by Customs; develop an Authorized Operators program IT system to support self-declaration and payment processes; establish a more robust risk assessment and management system to substantially reduce physical inspections; and implement Standardized Operational Procedures to streamline procedures and eliminate uneven performance. (v) Enhance access to credit by improving the credit reporting system and development of supply chain finance and expanded use of movable collateral and secure transactions. The government should allocate sufficient financial resources for the Bank of Mongolia to invest in the software and hardware required for the development of a real credit reporting system. The system should cover the entire adult population in Mongolia and include all types of creditors. It is one of the fundamental soft infrastructures for the economy to function efficiently. The authorities should also continue efforts to expand SME access to finance by focusing on the development of supply chain finance and expanded use of movable collateral and secure transactions. To attract high-quality foreign direct investment (FDI) to the mining and non- extractive sectors: (i) Shift Mongolia’s mining sector value capture from equity participation to fiscal instruments. Instead of direct ownership of mining assets – which is fiscally costly and also deters necessary private investment – a transparent and predictable fiscal framework with a competitive tax regime for the mining sector could be used to capture a portion of the resource rents. Royalties and profit taxes are more suitable instruments to capture resource value. This would not only relieve the government from having to make significant up-front capital investments but would be more conducive to mobilizing private sector investment in the mining sector. Any reassessment of the State Equity Policy will have to consider alternative models for developing the mining sector that are less reliant on public funding. Previous governments have tried a variety of approaches to gain access to private capital through the global capital markets and by offering concessions to private investors, including planned initial public offerings (IPOs). Several attempts to develop part of the Tavan Tolgoi coal complex via joint ventures with private consortiums were suspended. In relation to mining-related infrastructure, the past record of concessions issued to private entities to build road and rail on a build-operate-transfer (BOT) basis has been mixed, with several concessions cancelled. Close evaluation of why such approaches have faced challenges and how the mobilization of private capital could be approached in the future would be important. (ii) Systematically review laws and regulations to identify and eliminate inconsistencies and discrepancies among them. Consolidate in one legal instrument the current restrictions to foreign participation and consider reducing some of these restrictions. Review local content requirements on an economy-wide basis, and specifically those applied in the mining sector. Abolish the minimum investment requirement of US$100,000 for foreigners to establish a venture. BOOSTING PRODUCTIVITY GROWTH 45 (iii) Enhance investor protection. Investment protection guarantees that have been signed with key trading partners to provide legal predictability and local remedies should be fully implemented. In particular, the Investor Protection Council, established in 2016, should upgrade its capacity through training and more funding to enhance investor confidence. Fully implement the Systemic Investor Response Mechanism (SIRM) to address investor grievances while preventing some of these from escalating into full-fledged disputes by systematically handling and tracking cases, including a method to filter, analyze, and prioritize grievances. (iv) Support a linkage program to foster connections between FDI and domestic firms to increase overall in-country value addition. The extractive sector may be the most likely sector for some linkages in the short term, but the new strategy should also consider linkages in other sectors such as tourism or agribusiness. Box 3.2 Innovations of large firms Innovations of large firms usually (i) create new employment opportunities; (ii) generate positive spillover effects, especially along value chains and supplier networks; and (iii) engage with the academia and research communities, thus benefiting the education sector. To demonstrate the importance of innovation in large firms, two case studies are summarized below. The main takeaways are (i) investment in R&D leads to innovations that can reduce costs and provide competitive advantage by creating new products; and (ii) innovation can create a positive spillover effect on employment, economic activity, food safety, and the environment. Case 1. Premium Concrete LLC: Constructed several decades ago, Mongolia’s main power plants are still using technologies harmful to the environment and human health. In particular, the use of thermal coal for combustion produces a by-product of fly ash, which has severe implications for human health. Although the plants started to collect the fly ash before it leaked to the surrounding area, there were no proper disposal methods, which resulted in large stockpiles near rivers and animal vegetation regions. Prompted by the stockpile, Premium Concrete LLC, a local company that produces construction materials, adopted a new technology to mix the fly ash into construction materials. The company applied machine learning methods to determine the right proportions of fly ash in construction materials. In addition to substantially reducing leakages of this hazardous waste into the environment, the innovative technology significantly boosted the company’s competitiveness and demand in the market. In particular, the machine learning algorithm helped optimize the quality of the product (strength and durability) and reduce production costs. Case 2. Tumen Shuvuut LLC: Following the government’s measure to revive production of crops and vegetables in 2008, demand for fertilizer increased significantly in Mongolia. Spotting the increased demand, a local poultry producer, Tumen Shuvuut LLC, invested in R&D to transform its animal manure into organic fertilizer. The company’s decision to invest in innovation instead of expensive waste management and disposal helped turn its weakness into a comparative advantage. As a result, the company’s production costs declined, its competitiveness improved, and it has created a positive spillover effect on the agriculture sector in the country. Source: Compiled by World Bank staff 46 COUNTRY ECONOMIC MEMORANDUM 2020 IV. EXPANDING ENDOWMENTS 47 IV. EXPANDING ENDOWMENTS Mongolia’s overreliance on mines and underutilization of its minds, that is, its human and institutional capital, to generate growth is well established. Such inability to diversify its endowments has resulted in limited diversification of its products and has further     amplified its vulnerability to the swings of the global commodity markets. Mongolia’s pathway to economic emergence and diversification is through expanding its intangible IV. EXPANDING IV. EXPANDING  ENDOWMENTS  ENDOWMENTS endowments by improving the functioning of its labor market, attracting and retaining     talents, strengthening Mongolia’s Mongolia’s  overreliance public   overreliance   on   oninvestment mines   and   mines   and   management   underutilization   of practices, underutilization its of   its   and   minds, that minds,   making   that is,  is, its   itspolicymaking   human human   and   and     radically transparent. institutional institutional  capital,  capital,  to generate  growth  to generate  growth  is well  is well  established.  Such  established.  inability  Such  inability  to diversify  to diversify  its endowments  its endowments      resulted hashas  in limited  resulted  in limited  diversification  diversification  of  products  of its  and its products  and  has  further  has  further  amplified  amplified  its  vulnerability  to the its vulnerability  to  the  IV.1 swingsMongolia swings of   the   of  the  over global globalrelies on   commodity   commodity mines   markets.  and Mongolia’s   markets. underutilizes   pathway   Mongolia’s   pathwayits   to minds economic   to   emergence   economic   and   emergence       and diversification diversification   is  through   is  through   expanding   expanding its  intangible   its  intangible   endowments   endowments   by  improving   the by  improving functioning   the   of      functioning of   its  its An influx of FDI into the mining sector has supported rapid accumulation of private capital, labor labor   market,   market,   attracting   attracting   and   and   retaining   retaining   talents,   talents,   strengthening   strengthening   public   public   investment   investment  management   management     while production  and practices practices  and  making of policymaking  making public capital  policymaking has transparent. stagnated.  radically  radically  transparent. Unfortunately, Mongolia’s intangible       capital in terms of human and institutional capital endowments contributed little to growth. Its IV.1 IV.1   limited Mongolia   Mongolia  progress over  over  reliesin  reliesconverting  on   on mines  and  mines natural  and wealth into  underutilizes  underutilizes other minds  its its minds   of capital (assets  forms diversification) has also constrained its ability to diversify outputs and export. influx An An   of  FDI   influx of   FDI into   into   the   mining   the   sector   mining   sector   has   has   supported   rapid   supported   accumulation   rapid   accumulation   of  private of  private   capital,   while   capital,       while IV.1.1 Produced public capital has stagnated, while private capital has grown production production  of public  of public  capital  capital  has  stagnated.  has  stagnated.  Unfortunately,  Unfortunately,  Mongolia’s  Mongolia’s intangible  intangible  capital  capital  in terms  in terms  of   of  rapidly human human   and   and   institutional   institutional   capital   capital   endowments   endowments   contributed   contributed   little   little   to  growth. to  growth.  Its  limited Its  limited   progress   progress   in   in  The government’s converting converting  natural  natural wealth large  wealth  into  investment other  into  other forms  forms budget  of capital  of  capital  (assets has  (assets failed to  effectively  diversification)  diversification) has  has  also  also  constrainedmaterialize  constrained  its  its  into growing ability ability  to diversify  to diversify produced  outputs  outputs  and public  export.  and  export. capital     stock. Mongolia has one of the highest public investment budgets in the world, averaging 8.3 percent of GDP per year between 2004 IV.1.1 IV.1.1   Produced   Produced  public public  capital capital  has  stagnated,  has  stagnated,  while  private  while  private  capital  capital  has  has  grown grown  rapidly  rapidly     and 2017. Yet, the contribution of its produced public capital in the growth process seems have to The   government’s The  deteriorated government’s   large during large  investment   investment this period.   budget   budget While   has   has   failed Mongolia’s to  effectively   to  effectively   failed private capital   stock   materialize   materialize into is   growing   into broadly   growing     comparable produced produced to   public many   public   capital of   capital   stock. its peers,   stock.  Mongolia it   Mongoliais largely   has   one   has the   one result   of  the   highest of  the of massive   highest  public   public foreign   investment   investment investment   budgets   budgets   inin   in  the   the   the   mining world, world, sector.   averaging   averagingPublic   8.3  8.3 investment,   percent percent   of    of  GDP GDP however,   per   year   per   year   betweenhas  suffered   between 2004   2004   and from  2017.   2017.   and high   Yet,   Yet,costs   the   the and completion   contribution   contribution   of    of   its  its delays produced produced due to  public weak  capital  capital  public management  in the  in the growth  growth (figures  process  process  seems 4.1  seems to and  to have have 4.2). Considering  deteriorated  deteriorated  during  during  thisthe  this  inefficiencies period.  period.  While  While     Mongolia’s of Mongolia’s public  private investment  capital  private  capital and  stock  stock the  islow  is broadly  broadly level  comparable  comparable of population  to many  to many  of its density, its the  of  peers, peers,  itgovernment  is  it  largely  is largely the the   result  result should  of   of   be massive massive     foreign foreign     investment investment selective in the public capital investment.   in   the   in     the   miningmining     sector.sector.   Public     Publicinvestment,   investment,     however, however,   has     has   suffered suffered   from    from   high   costs high   and   costs   and   completion   completion   delays   delays   due   to  weak   due to  weak   management   management   (figures   (figures and   4.1  4.1   and   4.2).   4.2).   Considering   the   Considering       the inefficiencies inefficiencies Figure 4.1  investment  of public  of public  investment  and  and  the  low  the  low  level  level  of   of population Figure population 4.2  the  density,  density,  government  the  government  should  should     be selective be selective  in the in the  public  public  capital  investment.  capital  investment.     General government capital stock per …while private capital stock per worker Figure worker Figure General  4.1 4.1  General deteriorated…  government  capital  government  capital     Figure  stock  stock Figure …while  4.2 4.2  …while improved  private  capital  private  capital  stock  stock worker  per  per      worker worker per per  worker  deteriorated…  deteriorated…     improved improved     Countries OECD OECD  Countries Countries OECD OECD  Countries 6 6  countries OtherOther  countries 7 7  countries OtherOther  countries Mongolia Mongolia  (2004~2017)  (2004~2017) Mongolia Mongolia  (2004~2017)  (2004~2017) (thousand 2011 Int'l US$, log based) (thousand 2011 Int'l US$, log based) 5 5 6 6 Private capital stock per worker  Private capital stock per worker  (thousand 2011 Int'l US$, log based) (thousand 2011 Int'l US$, log based) Public capital stock per worker  Public capital stock per worker  5 5 4 4 4 4 3 3 3 3 2 2 2 2 1 1 1 1 0 0 0 0 0 0 1 1 2 2 3 3 4 4 5 5 0 0 1 1 2 2 3 3 4 4 5 5 PPP PPP GDP  GDP  per  per capita  capita  in 2017  in (thousand 2017 (thousand 2011  2011 US$,  US$,  log  log based)  based) PPP GDP PPP GDP  per  per capita  capita  in 2017  in (thousand 2017 (thousand  2011 US$, 2011  US$,  log  log based)  based) Source: Source:  PWT9.1,  PWT9.1,  IMF Investment IMF Investment  and Capital and Capital Stock  Stock  Dataset  Dataset   Source:    PWT9.1, Source:  IMF Investment  PWT9.1, IMF Investment  and Capital and Capital  Stock  Dataset  Stock    Dataset   Note: Source: Note:  PPP = PPP PWT9.1,  =  purchasing  purchasing IMF  power  power Investment parity and parity     Capital Stock Dataset Note: Source:  PPP = Note: PPP PWT9.1,  purchasing IMF    = purchasing  Investment power power  parity   and  parity   Capital Stock Dataset Note: PPP = purchasing power parity     Note: PPP = purchasing power parity 44  44      48 COUNTRY ECONOMIC MEMORANDUM 2020 IV.1.2 Growth has made little use of intangible capital Human     capital has been underutilized despite a relatively strong human capital endowment, while institutional capital has deteriorated, contributing little to Mongolia’s IV.1.2   Growth IV.1.2   Growth growth  has  made  has process.  made  little little  use  Mongolia  use of intangible of  intangible ranked  capital 51st       globally in the Human Capital Index,  capital higher than its income level ranking (92nd) largely due to its high educational attainment. Human Human While  the   capital capitaluse   has of   hasbeen   human  been   underutilized  capital underutilized slightly   despite   despite   a    improved a  relatively relatively during   strong   strong   human 1995-2014,   human   Mongolia’s capital   capital   endowment,   endowment, human     while while capital  institutional   institutional has remained   capital   capital   has   has underutilized   deteriorated,   deteriorated,   contributing   contributing in production,   little little as  evidenced   to  to Mongolia’s   Mongolia’s by the country’s   growth   growth   process.   process. status   as  Mongolia Mongolia   ranked   ranked   51st   globally   51st   globally   in  the in  the   Human  Human   Capital   Capital   Index,   Index,   higher   higher   than     than its   its income   income   level    level   ranking ranking     an outlier among its structural and aspirational peers (figure 4.3).33 Mongolia’s performance (92nd) (92nd)   largely   largely   due   due   to  to high its   its   high   educational   educational   attainment.   attainment.   While   While   the   use   the   use   of  human of  human   capital   capital   slightly   slightly     on the key components of social capital (for example, corruption control and rule of law) improved improved   during   during   1995–2014,   1995–2014,   Mongolia’s   Mongolia’s   human  human   capital   capital   has   remained   has   remained   underutilized   underutilized in  production,   in  production,     deteriorated during 1995–2014. Although, it exhibited a higher score than Ecuador, as evidenced as evidenced  by the by the  country’s  country’s  status  as  an  status an outlier as outlier  among among its structural  its structural  and  and  aspirational  aspirational  peers  peers  (figure  (figure     Kazakhstan, 4.3). 4.3).   Mongolia’s 33 33   Mongolia’s and Russia   performance   performance in  2014 on  on the on   key the those   components   key indicators,   components of it   of  social substantially   capital   social   capital   (for underperformed   (for   example,   example,   corruption   corruption vis-     à-vis control control all  and its aspirational   rule  and   rule of law)  of  law)  peers,  deteriorated deteriorated as its  during growth  during   1995–2014.   1995–2014. process  remains Although,  Although, dominated  it exhibited  it exhibited by  a higher  a  highernatural  score  score capital  than      than inputs Ecuador, Ecuador, (figure  Kazakhstan,  Kazakhstan, 4.4).  34,35 and  Russia  and  Russia  in 2014  in 2014 on on  those those  indicators,  indicators,  it substantially  it substantially  underperformed  underperformed à‐ ‐à‐  vis ‐vis vis vis  its  all all  aspirational Figure 4.3 its aspirational peers,  peers,  as its its growth  as  growth  process  remains  process  dominated  remains Figure 4.4 by natural  dominated  by  natural  capital  capital  inputs  inputs  (figure  (figure     4.4).     4.4). 34,3534,35 Mongolia has underperformed all its peers in the …and its social capital endowment has useFigure of 4.3 Figure   4.3 humanMongolia  has  Mongolia capital…  underperformed  has  underperformed  all  its all  its  Figure  4.4  4.4 Figure …and deteriorated  …and  capital  its  social its social  capital  endowment  has  endowment      has peers peers  in the  in the  use use  of human  of human  capital…  capital…     deteriorated deteriorated     70% 70% 70% 70% 2014 2014 2010 2010 2000 2000 2000 2000 2014 2014 2010 2010 60% 60% MONGOLIA MONGOLIA 60% 60% 1995 1995 1995 1995 Natural capital (Mines)a Natural capital (Mines)a 2005 2005 MONGOLIA MONGOLIA Natural capital (Mines)a Natural capital (Mines)a 50% 50% 50% 50% 2005 2005 40% 40% Kazakshtan Kazakshtan 40% 40% Kazakshtan Kazakshtan UAE UAEPeru Peru Peru Peru Qatar Qatar 30% 30% Ecuador Ecuador 30% 30% Armenia ArmeniaUAE UAE Qatar Qatar Chile Chile 20% 20% Ecuador Ecuador Chile Chile RussiaRussia Malaysia Malaysia RussiaRussia Armenia Armenia 20% 20% Australia Australia 10% 10% Colombia Colombia Colombia Colombia Malaysia Malaysia Australia Australia Canada Canada 10% 10% 0% 0% Canada Canada 0% 0% 20% 20% 40% 40% 60% 60% 80% 80% 100%100% 0% 0% ‐2 ‐2 ‐1 ‐1 0 0 1 1 2 2 3 3 Human Human capital  (Minds)  capital a  (Minds)a Quality Quality  of Institutions  of Institutions  (Minds)  (Minds) b b         Sources: Sources: Sources: World  World Bank  Bank  World (2018c);  (2018c);  Bank  (2018c);WDI;  WDI;  World  WDI; World  Bank  World Bank  Bank staff  staff      staff Sources: Sources: Sources:  World World  Bank Bank Bank (2018c);  (2018c);  (2018c);  WDI; WDI;    WDI; World World  World  Bank  Bank  Bank staff   staff  staff   calculations calculations calculations     calculations calculations calculations     Note: Note: Note: a.  a. Measured  Measured  a. Measured  asas  a a   as share  share  of of a share total  of total wealth  wealth  total      wealth Note:  b. Quality Note: Note: b.  b.Quality  Quality of  ofinstitutions  institutions  of institutions  is the is  the is the average average  score average score  score of  of  of Rule  Rule of   of   Rule Lawof   Law and Law andand Corruption  Corruption Corruption  Control Control  in the  Control in the  in  WGI the   WGI  WGI   IV.1.3 IV.1.3   Products   Products  are  are  scarcely  diversified  scarcely        diversified IV.1.3 Products are scarcely diversified Mongolia’s Mongolia’s Mongolia’s inability   inability  inability  to diversify    to to   diversify diversify   its assets     its   assets its   has assets   also   has  hasalso constrained  also   constrained   its constrained     its   outputs outputs   and its   exports   and outputs   exports     and diversification diversification exports   (figure   4.5).   (figure diversification   4.5).   A   A (figure strongstrong  4.5).  Apositive   positive strong association   association   positive   between   between association   asset   asset between  asset   diversity diversity   and   and diversity     exports/product exports/product     diversification diversification   is   shown   is   shown   in    in   figurefigure     4.6.   4.6.It and exports/product diversification is shown in figure 4.6. It indicates that Mongolia lags     It   indicates indicates     that that   Mongolia   Mongolia     lags lags   its  peers its     peers in    in  those  measures those  measures of economic  of  economic  diversity.  diversity.  In   fact,  exports  exports In fact,  have  become  have  become not  only  not  only  heavily  concentrated  heavily  concentrated     its peers in those measures of economic diversity. In fact, exports have become not only heavily concentrated in mining,                                                                                                                             but also to a single market. Exports to China represented around 20 percent of the total in 33  33  Human Human    capital capital   wealth   wealth   is    defined is  defined   as    theas  the present   present   the value  of early  valuefuture 2000s  of future  earnings for but  earnings the  for labor increased the labor  force  in The  force over 90 to  Changing Changing  in The  Wealth percent of Nations  Wealth since  2018  of Nations      2018 (World  Bank (World  2018c).  Bank  2018c).  In other  In other  words,  words,  it reflects  it reflects the projected  the projected  trajectory  trajectory  of wages  of wages  in the the country.  in country. wage  Low  Low  wage  levels  are  the  levels the corollary are  corollary  of a of a  limited limited  use of use  human  of human  capital.  capital.       34  34  Strikingly, Strikingly,  Mongolia’s  Mongolia’s  natural  natural  capital  capital  accounted  accounted  for 63  for  63 percent  percent  of its  of  total  wealth  its total  wealth in 2014,  the  highest  in 2014, the highest  among  its resource  among  its resource ‐dependent ‐dependent     peers.  However, peers.  However,  a significant  a significant  portion  portion  consists  consists  of non renewable  of ‐non ‐renewable  natural natural  capital,  as Mongolia  capital,  as Mongolia  focused  mostly  focused  mostly  on non  on ‐non ‐renewables renewables  in the in  the    two  two pastpast   decades. decades.   This dramatic   This   dramatic   expansion   expansion   of ‐non   of  non ‐renewable renewable   natural   natural   capital   capital   has  has led  to led   to   an   an  increase   increase   of  the   of  natural the  natural   capital   capital   rents   rents   that that     account 33 account Human  for  about capital  for about   30 percent wealth  30 is  of GDP percent defined  of   inthe GDP as  recent recent  years,  inpresent  years,  up from value of  future  up from  percent  7earnings  7 percent  of GDP of for GDP  in the  in  1990.   force  1990. labor   in The Changing Wealth of Nations 2018 35 The35  The  buildup buildup  of social  of social  capital  is  capital  an  important  is  anit important  driver driver  of  of economic  economic  growth, growth,  just as is  just    as the accumulation the country.  is  the accumulation  of human  wage of human capital,  levels  capital,  physical  physical  capital,   of a  capital,   (World Bank 2018c). In other words, reflects the projected trajectory of wages in Low are the corollary and  and limitednatural  of   natural use   capital. capital.   While human   While   the  buildup capital. the  buildup   and  and use  use   capital   of  physical of  physical   capital   boosts  boosts   growth  growth   directly,   directly,   human   capital,   human   social   capital,   capital,   social   capital,   and  and   natural natural     capital, 34 capital,  if judiciously Strikingly,  judiciously  ifMongolia’s  natural  managed, managed,  encourage encourage capital  growth accounted  growth  indirectly  indirectly for  by underpinning 63 percent  by ofunderpinning its total  efficiency wealth  efficiency in and 2014, technology.  and  technology. the highest   among   its resource-dependent     However, a significant portion consists of non-renewable natural capital, as Mongolia focused mostly on non-renewables in the peers. past two decades. This dramatic expansion of non-renewable natural capital has led to an increase of the natural capital rents that account for about 30 percent of GDP in recent years, up from 7 percent of GDP in 1990. 45  45    35   buildup of social capital is an important driver of economic growth, just as is the accumulation of human capital, physical capital, The and natural capital. While the buildup and use of physical capital boosts growth directly, human capital, social capital, and natural capital, if judiciously managed, encourage growth indirectly by underpinning efficiency and technology. EXPANDING ENDOWMENTS 49   36 This finding is confirmed by the Economic Complexity Index, which indicates that 2012. Mongolia’s   product basket is less complex/sophisticated than its peers.37 Nevertheless, in mining, Mongolia is  but to a  also to found  singlea have  market. revealed  Exports  to China represented comparative advantage  around in  several 20 percent  of the total  merchandise in   the in mining,   early   2000s  but also to   but   increased  a single market.   to   over  Exports to  90   percent  China   since  represented  2012. 36    aroundThis   finding    20 percent ofis   confirmed  the  total     by  the  sectors, including minerals, cashmere, and meat products, according to the Balassa’s Economic in  the  early   Complexity   Index,   2000s  but  increased   which   to  over   indicates   90  percent   that   since  2012.  Mongolia’s 36   product   basket     This  finding  is  confirmed  by  the    less  is revealed comparative advantage index 37 (box 4.1). 38 complex/sophisticated  than  its  peers.   Nevertheless,  Mongolia  is  found  to  have  a  revealed  Economic  Complexity  Index,  which  indicates  that  Mongolia’s  product  basket  is  less  comparative  advantage complex/sophisticated Figure 4.5   than several    its   in   merchandise   peers. 37   Nevertheless,   sectors,   Mongolia Figure 4.6   including   minerals,   is  found   cashmere,   to  have   a  revealed   and     meat  products, according comparative   advantage  to  the   in  Balassa’s   several  revealed   merchandise  comparative   sectors,  advantage   including   minerals, index  (box 4.1).   cashmere, 38   and      meat  Asset  accordingcan diversification products, facilitate  to the  Balassa’s revealed comparative Mongolia lags    advantage its peers index  (boxin asset  4.1). 38 and product    Figure product  4.5 Asset diversification can facilitate  diversification Figure 4.6 Mongolia lags its peers in asset and product  diversity Figure  4.5 Asset product     can facilitate   diversification diversification Figure  4.6 Mongolia diversity    lags its peers in asset and product  product    diversification   o Diversifies portfolio of national assets diversity    (inputs): o Diversifies natural portfolio assets capital, and produced of national 0.7 and intangible assets (human capital 0.7 Aspirational peers (inputs): natural and produced capital, Canada and institutions) 0.6 Aspirational peers and intangible assets (human   capital Asset diversification  0.6 Structural peers Canada o Changes and institutions) comparative advantage and Malaysia Asset diversification  0.5 Structural peers Product diversity hedges o Changes structural comparative risks  and advantage Malaysia UAE 0.5 Product diversity o Increase hedges flexibility, structural risks  resilience and Australia 0.4 UAE Russia o Increase flexibility, across productivity resilience and   economy Australia 0.4 Russia productivity across economy  Peru Armenia Colombia 0.3 Peru 0.3 Kazakhstan Armenia Colombia Chile Product o Diversifies outputs and exports away MongoliaKazakhstan Product 0.2 Mongolia Chile diversification  from outputs o Diversifies mining and exports through awayintensive energy Ecuador diversification  0.2 from mining through energy intensive Qatar Ecuador industrialization  y = 0.711x ‐ 0.2022 industrialization  0.1 0.1 y = 0.711x ‐ 0.2022 Qatar o Builds on current comparative R² = 0.5088 o Builds on current comparative R² = 0.5088 advantage and hedges cyclical risks  0 advantage and hedges cyclical risks  0 o Increases exposure to low-carbon 0.3 0.4 0.5 0.6 0.7 0.8 o Increases exposure to low-carbon 0.3 0.4 0.5 0.6 0.7 0.8 0.9 10.9 1 transition  transition  Asset diversity Asset diversity     Source: Source:  Adapted  Adapted  from  from  World  World  Bank  Bank  (2018d)  (2018d)     Source: Source:  World World Bank staff Bank  staff estimates  estimates     Source: Adapted from World Bank (2018d) Note: Source: Note: World Asset Asset  diversity  is Bank  diversity  is measured staff  measured  asestimates  the share  as the  of share non‐natural of non ‐natural  capital    capital  Note: in totalin  total  wealth;Asset anddiversity  wealth;  and product  product is measured  diversity  diversity  is measured as  is the measured  with share of non-natural with  the  Finger  the ‐  Finger‐ capital Kreinin  index. in Kreinin The total index. Fingerwealth;  The ‐ Kreinin Finger and  index ‐ product Kreinin  is a index diversity  relative  is a    index, is ranging relative measured  index,    ranging  from 0  (fullthe with Finger-Kreinin  diversification)  to 1 (no index. The Finger-Kreinin  diversification),  that compares index   is from 0 (full  diversification)  to  1 (no  diversification),  that  compares   a relative the structure   of   index, across exports ranging   from 0 countries   (full by   diversification) showing   the   extent   to  1 (no to the structure of exports across countries by showing the extent to  whichdiversification),  which the structure that compares  of exports  the structure  of   by product exports the of a  by  product structure  given of of exports  country  a given  differs  country   across  differs  countries from the   world   by showing average.   This   the extent indicator   is  to which the  structure reparametrized here   to   of from the world average. This indicator is reparametrized here to  meanexports 0 = no  0  mean by product and specialization  = no specialization of a  1given  =  and country differs full diversification.  1 = full diversification.  from the   world average. This indicator is reparametrized here to mean 0 =     no     specialization and 1 = full diversification Box 4.1 Mongolia’s comparative advantage   Box 4.1 Mongolia’s comparative advantage       Mongolia  has  a  comparative  advantage  in  several  non‐mining  sectors  (meat,  cashmere,  renewable  Mongolia   has   energy).  Mongolia’s  comparativea   comparative   advantage   advantage   in   several   as  the  second   non ‐‐ mining largest   sectors  (meat,   cashmere   cashmere,   wool  producer   the renewable   in      energy).   Mongolia’s   Box 4.1 comparative   Mongolia’s advantage   as   comparative the   second ‐ largest advantage   cashmere   wool   producer   in   the   world  has  been  underpinned  by  the  country’s  vast  grasslands  and  cold  climatic  conditions  that  are  world Mongolia   has   has been a   underpinned comparative   by   the advantage  country’s   in conducive to wool production, and related lower labor costs. In meat production, Mongolia’s advantage  vast   grasslands several   non-miningand   cold   climatic sectors   conditions (meat,   that   cashmere,are   conducive renewable energy). Mongolia’s comparative advantage as the second-largest cashmere stems   from    to its   wool capacity  production,   to   maintain   and    related significant  lower   numbers  labor  of  costs.   livestock  In  meat   on   its production,   vast     grasslands.Mongolia’s   Benefiting advantage     stems from wool its  from  rich  producer   its in  renewable capacity the   to  maintain  resources world  such has   significant  as been  solar,  wind, underpinned   numbers   of  and hydropower, by   livestock the country’s   on  its  vast  Mongolia  has   the vast grasslands.  potential grasslands   Benefiting  to  and cold   from boost    its its    rich renewable renewable   energy  resources   generation.  such    as solar, Mongolia   has wind,   270   and to    hydropower, 300   sunny   days  Mongolia   a   year,    has and    the potential around   10    to  climatic conditions that are conducive to wool production, and related lower labor costs. boost  of percent renewable its  the  total land   energy  area is classified as  “excellent”    generation. Mongolia  has  for wind 270 ‐ to   300 based    sunny generation. energy days  a  year, and has  It  also around     10  In meat percent the  potential production,  of  the  total land to generate Mongolia’s  area is classified  hydropower advantage  energy.  as  As  “excellent” stems   estimated by  for from  wind   the  United its ‐based capacity  States energy to maintain  generation.  National  Renewable  It also significant    has  numbers Energy   Laboratory the potential of livestock and  the   to  generate on its vast   Mongolian  hydropower grasslands.   National  energy.   Renewable Benefiting  As  estimated   Energy  by  Center, the from United its  States   the rich renewable combined   electricity  National  Renewable resources   such Energy solar, wind, as   Laboratory   andand hydropower,   the  Mongolian   NationalMongolia   Renewable has the potential   Energy   Center,  theto boost its   combined renewable   electricity   energy generation. Mongolia has 270 to 300 sunny days a year, and around 10 percent of                                                               the total land area is classified as “excellent” for wind-based energy generation. It also has 36 The limited product diversity of Mongolia is confirmed by the Economic Complexity Index, which indicates that its product basket is  the potential to generate                                                             also less complex/sophisticated compared to its peers.  hydropower   energy. As estimated by the United States National Renewable 36 The limited product diversity of Mongolia is confirmed by the Economic Complexity Index, which indicates that its product basket is  37 In  fact, countries  Energy that produceLaboratory  complex goods as and Mongolian the  products well as many National  are typically Renewable  more economically  developed orEnergy Center,  likely to grow  also more  less complex/sophisticated  rapidly  in future than countries  compared  producing  to  its peers.  fewer    complex products.   and less the 37 In combined electricity production output from wind and  more solar could reach as much as 38  fact, countries The  comparative  that  advantage  index  gives  produce complex  goods  a value  as well  greater  than  1  many  as  products for industries  are  that  typically  have  economically  a comparative advantage.    developed or likely to grow  15,000 more rapidly terawatt-hours  in future than countries per year,  fewer  producing which is  complex  and less enough to meet  products.   the Chinese total electricity 46  demand   in 2030.a 38 The comparative advantage  index gives a value greater than 1 for industries that have a comparative advantage.  46    36 The limited product diversity of Mongolia is confirmed by the Economic Complexity Index, which indicates that its product basket is also less complex/sophisticated compared to its peers. 37 In fact, countries that produce complex goods as well as many products are typically more economically developed or likely to grow more rapidly in future than countries producing fewer and less complex products. 38 The comparative advantage index gives a value greater than 1 for industries that have a comparative advantage. 50 COUNTRY ECONOMIC MEMORANDUM 2020 While there is significant untapped potential, important logistical, financial, and regulatory challenges need to be overcome to make these activities grow faster. Mongolia’s cashmere sector is still catching up due to several challenges. Though a few cashmere manufacturers like Gobi corporation produce cashmere yarn and knitted products, around two-thirds of cashmere manufacturers only produce preliminary processing products. In addition, small and medium-sized manufacturers have financial problems in buying raw cashmere or upgrading their processing capacity. The fragile ecological environment caused by overgrazing and climate change also hampers the growth of the cashmere sector in Mongolia. Mongolia’s meat-processing sector faces several challenges, including high market concentration and lack of competitiveness. Of the 123 slaughtering and meat-processing companies in Mongolia in 2017, 79 were in Ulaanbaatar or the central region, and 44 were located in the countryside. The large manufacturers like Max Impex remain leading actors in the meat-processing sector, whereas small and medium-sized players lack core competitiveness to brand their products and maintain viable market share. (For more on this, see box 4.6.) Tapping the renewable energy potential, however, will require significant investments. The Government of Mongolia has initiated policies to tap into this potential. For example, the Ministry of Energy has proposed privatizing the distribution and supply services and exporting energy to North Asian countries through high-capacity power lines. These proposals are akin to the actions taken by other renewable resource-rich countries like Australia, which is working toward exporting renewable energy to Asian countries. Comparatively, Inner Mongolia is the most wind resource-rich region of China and exports green electricity to provinces with rapidly growing power demand. Source: Compiled by World Bank staff a. Energy Research Institute National Development and Reform Commission 2015 IV.2 Explaining Mongolia’s limited progress in expanding its endowments Mongolia is highly resource dependent and generates a significant share of GDP each year in resource rents at the cost of rapid depletion. As Mongolia’s growth process is dominated by natural capital, its high depletion rate relative to peers endangers the sustainability of the current growth model. Mongolia’s depletion of non-renewable assets as a percent of Gross National Income (GNI) rapidly increased during 2006-10 and remained high, even with a rising GNI (figure 4.7). A global transition to low carbon that would affect the Chinese demand for Mongolian coal also motivates expanding endowments beyond mines. China’s coal share in electricity generation is targeted to decline from 64 to 30 percent and non- electricity generating coal consumption to decline by 19 percent from 2018 to 2050. A simulation using a computable general equilibrium (CGE) model suggests that a steady decline in China’s coal demand would reduce Mongolia’s exports by 1.1 percent and economic growth by 0.7 percent on average each year if the country continued to rely significantly on coal mines mining (figure 4.8). EXPANDING ENDOWMENTS 51 Figure 4.7 Figure 4.8 Natural resources in Mongolia are depleting China’s clean energy transition will adversely Figure Figure 4.7 4.7 Natural Natural resources resources Mongolia inin are Mongolia are Figure Figure 4.8 4.8 China’s China’s clean clean energy energy transi �on transi will �on will faster than in other countries affect Mongolia deple deple �ng �ng faster faster than than inin other other countries countries adversely adversely aff ffect aect Mongolia Mongolia P DP GDG Expo E ts xrports 0.60.6 0.40.4 0.20.2 0.00.0 -0.2 -0.2 -0.4 -0.4 -0.6 -0.6 -0.8 -0.8 -1.0 -1.0 2020 2020 2040 2040 -1.2 -1.2 Source: Source: Source: World World World Bank Bank Bank stasta staff estim ffestimates ff estim ates ates Source: World Source: Source: World World Bank Bank Bank sta sta ff estim staff estim ates ates ffestimates Note: Note: Note:Countries Countries toto Countries the toright thethe of right the rightof 45-degree of the the line saw 45-degree 45-degree lineline sawsaw Note: a a Note: Note: Changes Changes Changes in in in China’s China’sdemand demand demandfor coking forforcoking coal coking used coalcoal used used in in decline adecline declinein in in depletion, depletion, while depletion, while whilecountries countriesto the countries left to tothesaw left the a ft le saw saw in energy-intensive a a energy-intensive energy-intensive manufacturing manufacturi manufacturi activities: ngngactiacti vities : Initial vities :Initi rise Inal in risein in itialrise depletion depletion depletion increase. increase. Most increase. comparator Most Most compcomp countries arator arator countrieskept countries similar kept kept siilar sim demand milar demand demand for for coking coking for coking coal in coal coalin 2020 2020 in by 2020 by35 by 35percent, 35percent percentfollowed , followed by byby , followed non-renewable asset depletion percentages during 2011–18 demand changes that are 2.5 percentage points lower than non-renewable non-renewable asset asset deple deple tion tion percentages percentages during during 2011–18 demand 2011–18 demand changes changes that that are 2.5 are percentage 2.5 percentage points points lower lower than than thethe compared to 2000–05, with slopes close to 1 the year before compared compared 2020 to to 00–05, 00–05, with with slopes slopes close to to close 1 1 year year before before InInother words,expanding otherwords, expandingMongolia’s Mongolia’sendowments endowmentsbeyond beyondnatural naturalcapital capitalis isbecoming becoming In other increasingly increasingly words, urgent urgent expanding considering considering Mongolia’s the the subop�mal subop�mal endowments investment investment ofof beyond Mongolia’s Mongolia’s natural resource resource capital rents. rents. is Several Several becoming factors, factors, increasingly examined examined below, below, urgent areare among among considering thethe most most the important important suboptimal causes causes investment behind behind Mongolia’s Mongolia’s of Mongolia’s limited limited progress progress resource ininconver�ng conver�ngrents. its its Several natural natural factors, resource resource rents rentsexamined intointo other below, other forms forms are ofof among capital, capital, the namely, namely,most human important human andand socialcauses social capital. capital. behind These These Mongolia’s include include (i)(i) public limited public investment investmentprogress inin in human human converting capital capital is is not its not natural matched matched resource by byadequate adequate rents jobs jobs into andand other thus thus atat is is forms risk risk ofof of capital, namely, dissipa�ng dissipa�ng through through human migra�on migra�on andandandsocial declining declining capital. female female These labor labor include par�cipa�on; (i) public par�cipa�on; (ii)(ii) investment public public investment in investment human inin capital isis infrastructure infrastructure not is poorlymatched poorly managed, by adequate managed, leading leading totojobs lowlow and returns; returns; thusandand at is(iii) risk (iii) poorpoorof dissipating governance governance thatthrough that binds binds allall migration ofofthetheabove and above declining together. together. female labor participation; (ii) public investment in infrastructure is poorly managed, leading to low returns; and (iii) poor governance that binds all of the above IV.2.1 IV.2.1 together. Public Public investment investment inin human human capital capital is is notnot matched matched bybyadequate adequate jobs, jobs, which which is is exacerbated exacerbated IV.2.1 Public by by skills skills investment outmigra�on outmigra�on in human andand lower lower capital female female is not labor labor matched par�cipa� par�cipa� by on on adequate jobs, which is exacerbated by skills outmigration and lower female labor participation Inefficiency Inefficiency inin thethe labor labor market, market, including including thethe inability inability toto create create well-paying well-paying jobs, jobs, hashas hampered hampered Inefficiency thethe u�li u�liza�o za�onin nofthe of human labor human market, capital. capital. including Educa�onal Educa�onal the inability a�ainment a�ainment hashas to create increased increased drdr well-paying ama�cal ama�cal ly ly over over jobs, the the past past has decade decadehampered ininMongolia. Mongolia. the utilization The The ter �ary ter �aryof human capital. enrollment enrollment ra�o ra�o inin Educational 2018 2018 stands stands atatattainment 66 66 percent, percent, has thethe increased average average level level dramatically forforadvanced advanced over the past decade economies. economies. Whilein While Mongolia. a�ainm educa�onal educa�onal Thea�ainmtertiary ent enthasenrollment hasincreased, increased,ratiolack in 2018 lack ofofstands structural structural at 66 percent, the transforma�on transforma�on hashasaverage contributed contributed level toto for the theadvanced limited limited crea creaeconomies. �o �o nn ofof While jobs high-quality high-quality educational jobs andand attainment opportuni�es opportuni�es (see (see has increased, Chapter Chapter 3).3). lack of structural Consequently, Consequently, youth youth transformation unemployment unemployment ishas rising. is contributed rising. According According to totothe limited sta�s�cs sta�s�cs creation released released by of by thethe high-quality educa�on educa�on jobs ministry, ministry,and an opportunities an es�mat es�mat ed ed 40(see 40 Chapter percent percent ofof 3). higher Consequently, higher educa�on educa�on youth unemployment graduates graduates werewere unemployed unemployed is rising. According (Gantogtokh (Gantogtokh 2018). to 39 2018). statistics 39 Kazakhstanreleased Kazakhstan also also by the education exhibited exhibited aa similar ministry, similar performance an estimated performance inin ter ter 40 �ary �ary percent educa�on educa�on of higher education enrollment enrollment accompanied accompanied graduates by byaa decline decline wereinin unemployed youth youth employment, employment, (Gantogtokh butbutwaswas 2018).39 Kazakhstan subsequently subsequently able able toto reverse reverse alsothis this exhibited trend trend(figure a similar (figure 4.9)4.9)by performance expandingthe byexpanding inthetertiary voca�onal voca�onal education training training enrollment systemtoto system accompanied create createemployment by employment decline aopportuni opportuni in�youth �es es forforthe employment, the youth. youth. but was subsequently able to reverse this trend (figure 4.9) by expanding the vocational training system to create employment opportunities There There also is is also a mismatch a mismatch between between thethe supply supply ofof skills skills from from ed uca�on ed uca�on ins�tu�ons ins�tu�ons and and thethe demand demand for the youth. from from employers. employers. AA large large number number ofof Mongolia’s Mongolia’s college college graduates graduates areare from from fields fields such such asas business business There is also a mismatch between the supply of skills from education institutions and 39 39 The the The demand unemployment unemployment from rate rate of of employers. youth youth aged aged 1515to to in 2424 A in large Mongolia Mongolia number hashas sharply sharply of Mongolia’s increased increased from from9.69.6 college percent percent from from graduates 2008 2008 to to 16.516.5 are percent percent in in 2019. 2019. from fields such as business and social sciences, where employment rates are relatively 4848 39 The unemployment rate of youth aged 15 to 24 in Mongolia has sharply increased from 9.6 percent from 2008 to 16.5 percent in 2019. 52 COUNTRY ECONOMIC MEMORANDUM 2020 lower compared to the science, technology, engineering, and math (STEM) fields     (figure 4.10). Moreover, the education and training available in schools are inadequate to andprepare and   social   social graduates   sciences,   sciences,   where   wherewith the   employment   employment skills and  rates competencies   rates   are   are   relatively   relatively   that   lower lower match   compared   compared employment   to    tothe   the   needs. science,   science,     Firms complain technology, technology,  engineering,about  engineering, lack  and  and of  math adequate  math  (STEM)  (STEM) skilled  fields.  fields. workers,  Moreover,  Moreover,  the pointing  the  education  education to a  and  and potential  training  training mismatch  available  available  in  in  in the schools schoolslabor     are   are market. inadequate   inadequate “The   to   toprepare   Global prepare    Competitiveness graduates graduates   with     with   the   the Report   skills skills   and   and2019”     rated the competencies competencies     that quality that    match match  of       vocational employment employment training   needs.   needs. in  Mongolia Firms Firms   complain   complain at 3.7/7.0   about about   lack(best),   of  of   lack adequate  which adequate ranked   skilled   skilled 100th   workers,   workers,out  of   pointing 137 pointing economies,   to potential   to   potential    and the mismatch mismatch and and socialskillset   in   social   the in     sciences,  of thelabor   graduates labor   sciences,     market. market.   where   where   at  “The   employment 3.5/7.0 “The   Global   employment  Global (best),     rates Competitiveness   Competitiveness   rates   are which    are   relatively relatively ranked   Report     lower Report   lower119th     2019”2019”   compared globally.   compared  40 40   ratedrated     to   the 40 the    the to   the   quality science,   quality       science, of  of  vocational vocational technology, technology,  training  training  engineering, in Mongolia  in  Mongolia  engineering,  and   math and  at  3.7/7.0  mathat  3.7/7.0  (STEM)  (STEM) (best),  (best),  fields.  which  fields. Moreover,  which  ranked  ranked  Moreover,  the   100th the education  100th  out  education out   of and 137 of and     137  economies, training economies,  available  training  and  available  and  the in  the         in Figure 4.9 Figure 4.10 skillset skillset schools schools  of of   graduates  graduates   are inadequate are  at 3.5/7.0   inadequate at  3.5/7.0  (best),    prepare to to   prepare (best),  which   which graduates  ranked   graduates  ranked   with 119th   119th withthe   globally the  globally skills  skills   and (figure    (figure and 4.10).    competencies  4.10). competencies         that   match   that   match    Unlike Kazakhstan, employment employment Mongolia exhibited a limited Mongolia’s youth tend to choose fields where Figure Figure return  4.9 to  4.9 needs.   Unlike  Unlike education   needs.  Kazakhstan,   Firms   Firms – Kazakhstan, high tertiary   complain   complain  Mongolia  Mongolia     about   about education   lack   and   of    lack adequate   of Figure   adequate Figure 4.10   skilled  4.10 employability   skilled  Mongolia’s Mongolia’s   workers, is lower   workers,  youth   pointing  youth  to  to   pointing  tend tend to  choose potential choose  to   potential         mismatch exhibited high mismatch youth a exhibited in   limited   athein  the  unemployment  limited labor   labor  return   market. return   market.  to   “The  education to education   Global   “The   –  – high Global   Competitiveness  high     Competitiveness fields  where fields  where    Report   employability Report employability  2019”   2019”40 40  is   rated lower  rated  is lower   the    the   quality quality   of    of  vocational vocational tertiary tertiary  training  education    education  in training  and   Mongolia  in  and high  Mongolia  high  youth  youth  at     3.7/7.0 at    employment3.7/7.0  employment  (best),  (best),      which which  ranked ranked    100th     100thout  out of     137 of    137 economies,  economies,  and  and  the  the  skillset skillset  of graduates  of graduates  at 3.5/7.0  at 3.5/7.0 (best),  which  (best),  which ranked  119th  ranked  globally  119th  globally  (figure  (figure  4.10).  4.10).      40 40  Income HighHigh  Income Mongolia Mongolia Kazakhstan Kazakhstan     Average Average  of 2011  of 2011 ‐2017 ‐2017 RateRate  of employment  of employment  in 2018  in 2018     Figure Figure 35  4.9  Unlike 35 4.9 Unlike Kazakhstan,  Kazakhstan, Mongolia  Mongolia     Figure Figure  4.10 10,000 10,000  4.10  Mongolia’s  Mongolia’s  youth  youth  tend  tend  to choose  to choose   90%   90% Youth unemployment rate (%) Youth unemployment rate (%) Number of college graduates  of college graduates exhibited exhibited  a  limited  a    return limited  return   to     to   education education   –     high–     high   fields fields   where 8,000   where 8,000   employability    is employability lower  is     lower   85% 85% Rate of employment Rate of employment 30 30 tertiary tertiary  education  education high  and  and  high  youth  employment  youth  employment     6,0006,000 80% 80% 25 25 20002000 75% 75% 40 20 20 40     Average Average 4,000 4,000  of  of 2011  2011‐2017 ‐2017 Rate of  employment Rate  in 2018  of employment  in 2018     High Income High 1995 Income Mongolia 1995 Mongolia 2018 Kazakhstan 2018 Kazakhstan 70% 70% 35 35 20102010 10,00010,000 90% 90% 2,000 2,000 Youth unemployment rate (%) Youth unemployment rate (%) 15 15 Number of college graduates 20052005 graduates 65% 65% 85% 85% Number 8,000 8,000 Rate of employment Rate of employment 30 30 2000 2000 20062006 20152015 10 10 0 0 80% 60% 60% 80% 25 25 2000 2000 6,000 6,000 20102010 Number of college  5 5 75% 75% 2018 2018 4,000 4,000 20 20 2015 20152018 2018 70% 70% 0 0 1995 1995 2010 2010 2,000 2,000 15 0 15 0 20 20 40 2005 40 2005 60 60 80 80 100 100 65% 65% 2000 2000 Tertiary Tertiary  enrollment  enrollment  rate 2006 2015 (%)  rate 2006  (%) 2015 0 0 60% 60% 10 10 2010 2010 5 Source: Source: Source:  WDI5   WDI WDI   2018 2018 Source:  NSO Source: Source:      NSO NSO 2015 2015 0 0 The The   outflow   outflow 0 0   of   of 20 20 40 skilled   skilled   labor   labor 40 60   has   has   also 60 80   exacerbated   also   exacerbated 80 100 100   the   the   skills   skills   mismatch   mismatch   in   in   labor   the the   labor   market.   market.    The outflow of skilled Tertiary Tertiary  enrollment labor  enrollment  rate (%) has also exacerbated the skills mismatch in the labor  rate (%) According According   to  to“The   “The   Global   Global   Competitiveness   Competitiveness   Report   Report   2019,”   2019,”   Mongolia’s   Mongolia’s   capacity   capacity   to  to attract   attract   and   retain   and       retain market. According  WDI Source: Source:   WDI  to “The Global Competitiveness Source:  NSO  NSO Report 2019,” Mongolia’s capacity Source: talent talent is weak  is  weak  compared  compared  to to peers its  its  peers  (figure  (figure  4.11).  4.11).  Mongolia  Mongolia  needs needs  high  high ‐skilled ‐skilled  talent talent  to to  accelerate accelerate     to attract and retain talent is weak compared to its peers (figure 4.11). Mongolia needs Thegrowth, growth,The   outflow high-skilled   outflow  yet  yet   large  atalentof    a large  of skilled   skilled  share to    share labor  of highly accelerate  labor   has of highly     also has    educated  educated growth,   also   exacerbated exacerbated  Mongolians yet    Mongolians a largethe    the skills  migrates share    mismatch skills  migrates    of mismatch to to    Organisation Organisation highly in    the in educated    the labor  for    forlabor    Economic market.   Economic  Mongoliansmarket.  Co   ‐  ‐  Co According According operation operation   to  and   “The and   to  Organisation “The   Global  Development Development   Global  Competitiveness Competitiveness   (OECD)  (OECD)  countries   Report  countries   Report  and 2019,”  and   2019,”  the the   Mongolia’s  Republic   Mongolia’s  Republic   capacity   capacity  to   attract   2017, to  attract and    retain and   of of   retain     migrates to for Economic Co-operation and of Korea.  of  Korea. Development  By  By 2017,  outmigration (OECD)  outmigration countries talenttalent Mongolians Mongolians  is  is weak weak   to   compared to OECD   OECD compared  countries to its   countries  Korea.  to  its  peers peers      already (figure already   (figure   4.11). represented  4.11).  Mongolia  Mongolia represented   almost   almost  needs  needs   1.5  high 1.5 ‐skilled  high percent   percent  Mongolians ‐ skilled of  talent of the    the talent  to total   OECD  accelerate   total  to   accelerate labor labor   force   force      and the Republic of By 2017, outmigration of to countries growth, (figure (figure   growth, yet  4.12).    4.12). yet a   large        a   share   large  share   of     of highly     highlyeducated  educated   Mongolians  Mongolians     migratesmigrates  to    to   Organisation Organisation   for    Economic for  Economic  Co ‐  Co ‐ already represented almost 1.5 percent of the total labor force (figure 4.12). operation operation  and and    Development  Development  (OECD)  (OECD)  countries  countries  and   and Republic the the  of Korea.  Republic  of Korea.  By 2017,  By 2017,  outmigration  outmigration  of   of  Figure Figure  4.11 Mongolians Mongolians  4.11  The    The to    perceptions to perceptions OECD    OECD    of capacity countriesof   countriescapacity  already    to     alreadyattract     Figure to  attract represented represented  Figure  4.12 almost     4.12 almost  Gross 1.5   1.5 Gross  outflows   percent percent outflows   of     of of  the   Mongolians of the total  Mongolians     total   labor   into labor  into force        force Figure 4.11 Figure 4.12 and  retain and  talent,  retain  talent,  2019  2019     OECD OECD  countries  countries     (figure (figure  4.12).  4.12).       The perceptions of capacity to attract and Gross outflows of Mongolians into OECD Country  capacity Country  capacity  to attract  to attract talent,  talent, 1‐7 (best)  1‐7 (best) Change 100 100 Change in labor  in labor  force  force  (thousand  (thousand  people)  people) retain talent, 2019 countries Figure Figure  4.11  The  4.11 perceptions  The Country Country  perceptions  capacity  capacity  of  to retain  to  retain  of   1  capacitycapacity ‐7 (best)  talent,  talent,  to  1‐7 (best)  to attract  attract    FigureFigure 80 80  4.12   Gross 4.12  Gross Gross  outflows  Gross outmigration  outflows  to OECD  outmigration  to OECD  (thousand  of  (thousand Mongolians  of  people, Mongolians  people,  into  decrease    into  decrease  in LF)    in LF) 6 6 retain and and  talent,  retain  2019  talent,  2019     OECD  countries OECD  countries     5 5 60 60 4 4  capacity Country Country  capacity  to attract  to attract     talent, 1‐7 (best) talent, 1‐7 (best) 100 100ChangeChange  in  in labor  force  labor (thousand  people)  force (thousand  people) Gross outmigration 40 40 Gross outmigration  to OECD OECD (thousand  to  (thousand  people,  decrease  people,  in LF)  in LF)  decrease 3 3 Country Country  capacity  capacity  to retain  to talent, retain   1‐7 (best) talent, 1‐7 (best) 6 6 80 80 2 2 5 5 20 20 1 1 60 60 4 4 0 0 0 0 3 3 MNGARMARM KAZ KAZ CAN CAN CHL CHL MYSMYSUpper 40 40 MNG Upper  excl. EAP,EAP,  excl. 2000 2000 2001 2001 2002 2002 2003 2003 2004 2004 2005 2005 2006 2006 2007 2007 2008 2008 2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015 2016 2016 2017 2017 2 2 middle middle high high ‐20 20 ‐20 20 1 1 income income incomeincome ‐40 ‐40 0 0 MNG MNG ARM ARM KAZ KAZ CAN CAN CHL CHL Upper Upper MYS MYS EAP, excl.    0 EAP, excl. 0 2000 2001 2000 2002 2001 2003 2002 2004 2003 2005 2004 2006 2005 2007 2006 2008 2007 2009 2008 2010 2009 2011 2010 2012 2011 2013 2012 2014 2013 2015 2014 2016 2015 2017 2016 2017 middlemiddle high high ‐20 ‐20 incomeincome income income                                                                                                                           ‐40 ‐40 Source: 40 40 WEF  WEF WEF  2019.      2019.    Source: OECD Note: Data shown is for the latest year available. ARM = Note: LF = labor force Armenia; CAN = Canada; CHL = Chile; KAZ = Kazakhstan; 49 49                                                                                                                             MNG   40 40  WEF = Mongolia;  2019. WEF  2019.     MYS = Malaysia 49  49  40    2019. WEF EXPANDING ENDOWMENTS 53   Source: WEF  Source: OECD     Note:  Data  shown  is  for  the  latest  year  available.  ARM  =  Note: LF = labor force  The fact that CAN Armenia; the majority  = Canada; of  KAZ  CHL = Chile; emigrants are = skilled workers with a college degree  = Kazakhstan; MNG suggests Source: that Mongolia; Source:  WEF   WEF   MYS Mongolia’s  = Malaysia  existing human capital Source:  OECD OECD  Source: endowment has not been fully utilized Data Note: Note:in shown   Datathe   is  absence   shown for    is   for the   latest of    well-paying year   the   latest available. year  available.   ARM  ARM =  Note: LF = labor   =   Note: labor  force   LF =  force Armenia;The  CAN Armenia;  fact = CAN    that  Canada;= Canada;  the  CHL  =   majority Chile; CHL  = Chile; KAZ =   of  = KAZ emigrants Kazakhstan;  MNG   Kazakhstan; =are      MNG skilled Figure =    workers  with  a  college  degree  suggests  that  4.13 jobs. A significant Mongolia’s Mongolia;  MYS = Mongolia;  MYS   =   Malaysia   existing  Malaysia share     of humanMongolian   capital  emigrants endowment moving  has to not OECD  been fully countries  utilized are Migrant Mongolians are mostly highly educated in the  Figure 4.13 Migrant Mongolians are mostly highly  skilledThe The  factand that qualified,   fact absence the  that  of   majority the   well motivated   majority ‐paying     of   of  emigrantsjobs.  by   emigrants higher A   significant are are  skilled   skilled educated   workers     workers     with   with   a  college   degree   a  college   degree   suggests   suggests  that  that  wages and Mongolia’s Mongolia’s share   better   of existing existing    Mongolian job   opportunities    emigrants human human   capital abroad capital    moving     to     100 endowment endowment   has  not  has  not  of been  been  fully    fully utilized     Figure Figure  4.13 4.13Migrant Migrant  Mongolians  Mongolians  are mostly  are mostly  highly    highly   (figure 4.13). OECD As countries   2015, are   skilled 24  utilized percent and  in  the  in    the qualified, of 80 absence absence   of   well of  ‐ educated educated     Mongolians motivated in by  ‐ paying  well the higher  jobs. paying United   jobs.   wages  A   significant States    and A  significant   better had    a job    Share of migrants 60 share   of share of  Mongolian    Mongolian opportunities postgraduate degree     abroad   emigrants emigrants and   (figure  moving    4.13). another moving   to    As  35to   of  100   10040 OECD percent   countries OECD2015,   countries had  24 a   are percent   are bachelor’sskilled skilled   and  of  Mongolians     and degree.   qualified, qualified,  in  the The   United    80 80 20 motivated motivated   by     higher by    higher   wages States proportion of Mongolian migrants employed  60 60 0 had a   wages postgraduate   and    and better     degree better   job       job and   Share of migrants Share of migrants another opportunities opportunities    abroad 35  percentabroad   (figure  had    a (figure   bachelor’s 4.13).   4.13).   As   of  As     of    degree. as managers or senior officials is relatively 40 40 Male Female All 2015,  24The 2015,  24     percent proportion percent  of  Mongolians  of Mongolians of  Mongolian  in the  in  the   migrants  United United      high: States 5   employed States had percent     had a      inpostgraduate a   managers as postgraduate France,   or  4 degree percent senior   degree     and officials     and in   is 20 20 Incomplete secondary Complete secondary Hungary, another and relatively another   35      35  percent 10 high: percent percent   had  5 percent  a   a  bachelor’s had   bachelor’s in Poland.  in France,   degree.  4 The  percent degree.      0 0 Technical and Vocational College degree or higher   Male Male Female Female All All proportion proportion The  The in of professionals     Hungary, proportion    of and   of 10   Mongolian percent     Mongolian and    technicians in   Poland. migrants migrants     The Source:  Online  survey  conducted  for  this  report,  targeting      Source: Online survey conducted for this report, targeting Mongolians  abroad   is 33employed employed percent proportion   as  in   as  managers of France,  professionals managers   or  senior  or  senior4   and percent  technicians officials   is      officials inis  is  Technical Mongolians Incomplete Incomplete abroad  secondary  secondary Complete  secondary Complete  secondary  and Vocational Technical  and Vocational degree or College College  higher degree  or higher Hungary, 33    high: relatively relatively and percent  567  high:  in  percentpercent  5 France,  percent  4  in France,in percent   in Poland.   France,  in  4  4 percent Hungary,  percent     and 67 percent in Poland.      Source: Source:   Online   Online   survey   survey  conducted   conducted   for   this for this  report,    report,   targeting   targeting     in  Hungary, in  Hungary, Mongolia’s   and    and inability10    percent 10 to  percent fully   in  Poland.   in  Poland. utilize   Thehuman  The  Mongolia’s  inability   to fully  utilize its its human  capital Mongolians capital Mongolians  can  abroad can   also  abroad also   be  seen be  in seen in its female its declining declining  labor  proportion proportion  of professionals  of professionals and technicians  and  technicians  is   is  female force labor force   participation participation rates. Female labor force participation has been 33 percent 33 percent in  France,  in France,  4 percent  4 rates.  percent   Female  in  Hungary,  in Hungary,   labor and   forceand  67 participation    67 percent  percent   has  in  in Poland.   been  Poland.     persistently  low  at  around  53  persistentlyto 56 lowpercent at around  over the 53 lastto  decade56 percent  relative over to peers the  and last  has decade  been declining relative  in to peers recent  years and has    (figures been declining Mongolia’s Mongolia’s4.14 inability in and 4.15). recent inability to While  fully  to   years lower fully utilize    (figures rates  utilize its human of female   its human4.14  capital    labor and capital  can 4.15).  force can   also  participation be seen  alsoWhile be seen lower  in its are  in rates seen  its  declining  declining of  across female  female all  age  female  groups,  labor labor  labor      force force participation forcethe  gender   participation   participation  gap are  is   rates.   seen especially   Female rates. across   Female large labor  among   force   labor all age     forcethe  younger   participation participation groups,   the generations.   has  been gender has  been  For   persistently  gap those   persistently   is aged especially     low  at25–29, low   around  labor   53    53     at  around large  force among to 56to  percent the participation  56 younger  percent over     for over the generations.   last men  is 87 the  decade last  percent  decade For  relative  relativethose  while  to peers   it to aged  is  just  and  peers  6225–29,  has and percent   been has been labor   declining for women. force  declining  in   participation recent  in recent  years  years for  (figures men   (figures   is 87 percent and 4.15). 4.14 4.14 and 4.15).while  While it  While  loweris only  rates  lower 62  rates percent  of female of female for  labor women.  force  labor  force  participation  participation  are seen are seen  across  across  all age  all  groups, age groups,     Figure 4.14 Mongolia’s female labor force  Figure 4.15 …it has consistently declined since  the gender the gender  gap  gap is  especially participation  is  is  large  especially  among  large  the  among   lowest among  the  in  the younger   the EAP  younger  and  generations.  2012    For those generations.  For those  aged aged  25–29,  25–29,  labor  labor  force  force     participation participation Figure other 4.14  for  men  for    peers... is 87 men  percent  is  87 percent  while  it is    while just it is  62 percent just  62 percent  Figure  for women.  for women. 4.15       Female labor force participation rate (% of female population  75 Labor force participation rate (%) Figure Figure  4.14 Mongolia’s Mongolia’s  4.14 female female  Mongolia’s labor ages force  labor  female  15+) participation  (national   labor  force estimate) force   is   …it Figure Figure  4.15 has  4.15  …it …it has  consistently consistently has consistently declined  declined  declined since  since 2012  since     among the lowest participation participation in  is among  is  the EAP  the among and  lowest  the other  lowest  in the peers...  in  EAP  the  and EAP     and2012   2012   Cambodia (2016) 76 70 other other  peers...  peers...    (2018)   Vietnam 71 Kazakhstan (2019) 63 Female Female labor  force  labor participation  force  participation  rate (% of  female rate  (% of  population female population     61 75 65 Labor Labor force  force participation  participation  rate (%)  rate (%) Timor ‐Leste  (2016) 75 ages  15+) China  (national  ages  estimate)  15+) (national (2019)  estimate) 60 Thailand (2018) 60 60 Cambodia  (2016) Cambodia  (2016) Russia  (2018) 7656 7670 70 Vietnam  (2018) Vietnam  (2018) Malaysia  (2018) 71 55 71 Kazakhstan Kazakhstan  (2019)  (2019) Indonesia  (2018) 63 53 63 55 65 65 Timor Timor‐Leste ‐Leste  (2016) Mongolia (2016) (2018) 61 5261 China (2019) China Myanmar  (2019) (2018) 60 48 60 50 PapuaThailand Thailand    (2018) New  (2018)  Guinea  (2018) 60 46 60 60 60 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Philippines Russia (2018) Russia (2018)  (2018) 56 45 56 Malaysia Malaysia  (2018)  (2018) Fiji (2016) 39 55 55 Total Male Female Indonesia  (2018) Indonesia Lao  PDR (2018) (2017) 37 53 53 55 55   Mongolia  (2018)  (2018) Mongolia 52 52   Myanmar  (2018)  (2018) Myanmar 48 48 Source:  NSO  50 Source: World Bank WDI  50 Papua Papua New  New (2018)  Guinea Guinea (2018) 46 46 20092011 2009 2010 20112013 20102012 20122014 20132015 20142016 20162018 20152017 2018 2019 20172019 Philippines Philippines  (2018)  (2018) 45 45 Fiji (2016) Fiji (2016) 39 39 Total Total Male Male Female Female 50  Lao PDRLao  PDR (2017)  (2017) 37 37           Source: Source: Source: NSO   NSO  National   statistics offices Source: World Source: Source:  Bank  WDI  World WDI Bank   WDI  50  50      54 COUNTRY ECONOMIC MEMORANDUM 2020 The absence of a diversified economy is one of the factors that could explain the lack of adequate job opportunities for female workers. Women in Mongolia, like in   most other countries, are the primary caregiver as well as the primary household member   responsible for other domestic work (World Bank 2018g). Moreover, women generally The absence work fewer hours of a diversified for paid economy jobs, earn  is one less  the factors  ofwage, and thathave  could  explain substantial to devote the lack of adequatetime on   The  absence job  opportunities  of  a   for  diversified  economy   female  workers.   is   Women  one  of  the  factors   in  Mongolia,  that   likeage  could   in  most explain  the  lack   other  countries,  of    are  the    adequate household chores, particularly, in rural areas. 41 Retirement for women is 55 compared job  opportunities primary   for  female workers.   primary   Women  in   Mongolia,   like  in  most   other   countries,   are      the to men. In  as 60 for  caregiver   well fact, as  the about 10 percent of the  female   household member   responsible labor force   is for   other 55 and   domestic older. Given   work primary  caregiver  as  well  as  the  primary  household  member  responsible  for  other  domestic  work  (World these   Bank  2018g). societal norms,   Moreover,   women  generally the authorities need to   work invest   fewer more  hours in  for   paid  jobs, creating   earn  less  wage,  a women-friendly (World  Bank  2018g).  Moreover,  women  generally  work  fewer  hours  for  paid  jobs,  earn   less  wage,  work environment, and have recognize  to devote substantial and  time  on reward  household women  chores, entrepreneurs  particularly, inand  rural leaders  areas.41 41(especially Retirement  and have to devote substantial time on household chores, particularly, in rural areas.  Retirement  given age  forthe   is in finding   women 55 Chapter compared 3 on   to   60   forpositive the   about  10between association   men.  In  fact,   percent  of women   the  female entrepreneurs   labor  force  age  for  women  is  55  compared  to  60  for  men.  In  fact,  about  10  percent  of  the  female  labor  force  are innovation) and 55 and older. and Given eliminate  these societalgender  norms, pay gap.  the  authorities need invest more in creating a women‐ are 55 and older. Given these societal norms, the authorities need invest more in creating a women‐   work  environment, friendlyWeak IV.2.2 management   recognize   and  reward of public   women in investment entrepreneurs   and  leaders infrastructure   (especially   friendly  work   environment,  recognize   and   reward  women   entrepreneurs   and leading to low leaders  (especially   given  the  finding  in  Chapter  3  on  the  positive  association  between  women  entrepreneurs  and  returns given  the  finding  in  Chapter  3  on  the  positive  association  between  women  entrepreneurs  and  innovation) and eliminate gender pay gap.   innovation) Mongolia lacks  and a  eliminate sound public  gender pay  gap.   investment management system to effectively and efficiently IV.2.2 allocate resource rents.   Weak management of public investment in infrastructure State investment in infrastructure  leading to low is  poorly returnsmanaged   IV.2.2  Weak management of public investment in infrastructure leading to low returns  leading   to low returns. Mongolia exhibits one of the lowest scores in the quality of overall   infrastructure, Mongolia   lacks suggesting   a  sound   publicsignificant   investment inefficiency   management (figure   system 4.16).   to Fragmented institutional Mongolia arrangements   lacks and  use a  sound   public of multiple   investment financing management  sources in   system Mongolia    to effectively make  effectively   and it difficult  and   efficiently   efficiently to ensure    allocate  resource allocate  rents.  resource rents.  State  investment  State  investment  in  infrastructure  in infrastructure  is  poorly  is poorly  managed  managed  leading  leading  to  low  returns.  to low returns.    cohesive Mongolia management   exhibits   one of   of  the public investment activities. Weak control of corruption also Mongolia translates into   exhibits low   one efficiency of   thelowest in  lowest   scores government   scores   in  the   in   quality   the spending   quality   of   of (figure overall   overall   infrastructure, 4.17).   infrastructure, The current   suggesting   suggesting public    significant   inefficiency significant   inefficiency   (figure   4.16).   (figure   Fragmented   4.16).   Fragmented   institutional   institutional   arrangements   arrangements   and   and  use   use  of   multiple of   Mongolia      multiple investment management index for Mongolia suggests room for improvement. financing  sources financing  sources   in  Mongolia  in Mongolia  make  make it  difficult  it developing to  ensure difficult to ensure  cohesive  cohesive  management  management  of  public  of public  investment  investment   scores below emerging market and economy averages in the selection and   activities.   Weak activities.   Weak  control     control of   corruption   also   translates   into   low   efficiency   in   government   spending    evaluation stage of public  of   corruption management. investment also  translates  into  low  efficiency  in  government  spending (figure   4.17). (figure   The   4.17). current    The   public   current   investment   public   investment   management   management   index   for   index   Mongolia   for   Mongolia  suggests   suggests  room   room   for      for improvement. improvement. Figure 4.16   Mongolia   scores   Mongolia   below   scores   emerging   below   market   emerging   and   market Figure 4.17   developing   and   developing   economy   economy   averages   averages   in   the   in   the   selection  and  evaluation  stage  of  public  investment selection and evaluation stage of public investment management.   management.   Government capital stock has been Poor government spending efficiency is plagued by inefficiency Figure 4.16 linked to  weak control of corruption  Government capital stock has been  Figure 4.16 Government capital stock has been Figure  4.17 Figure Poor  4.17  government  Poor  government  spending  spending efficiency  is    efficiency is  plagued  by inefficiency plagued      by inefficiency linked  to weak linked  control to weak  of of  control corruption      corruption 7 7 7 7 Quality of overall infrastructure, 1‐7  Quality of overall infrastructure, 1‐7  (1 = most inefficient ; 7 =most efficient ) (1 = most inefficient ; 7 =most efficient ) 6 6 6 6 Government spending efficiency Government spending efficiency 5 5 5 5 4 4 4 4 (best) Low income  developing  countries (best) Low income  developing  countries 3 3 3 3 MongoliaMongolia Emerging Emerging  markets  markets Advanced Advanced  Economies  Economies 2 2 2 2 Mongolia Mongolia Fitted value Mongolia Fitted value 1 1 Mongolia 1 1 0 20 40 0 20 40 60 60 80 80 100 100 0 0 General government capital stock per capita  ‐2 ‐1.5 ‐1 ‐0.5 0 0.5 1 1.5 2 2.5 General government capital stock per capita  ‐2 ‐1.5 ‐1 ‐0.5 0 0.5 1 1.5 2 2.5 (thousands of constant 2011 int'l US$) (thousands of constant 2011 int'l US$)     Control of corruption   Control of corruption   Sources: World Bank; WGI; WEF  Sources: World Bank; WGI; WEF  Sources: World Bank; WGI; WEF  Sources: World Bank; WGI; WEF  Sources: World Bank; WGI; WEF Sources: World Bank; WGI; WEF IV.2.3 IV.2.3   Stagnant   Stagnant  institutional  institutional  quality  quality  compounded  compounded  Mongolia’s  Mongolia’s  limited  limited  endowments  endowments  diversity  diversity    Governance seems to have deteriorated with the mining boom. Resource abundance can give rise  Governance seems to have deteriorated with the mining boom. Resource abundance can give rise  to  socially  damaging  rent‐seeking  activities  and  neglect  of  good  governance,  infrastructure,  and  to  socially  damaging  rent‐seeking  activities  and  neglect  of  good  governance,  infrastructure,  and                                                                                                                           41  Women tend to work in the low   ‐paying service sectors, typically in the trade and public sectors. According to the 2018   Women 41 Labor  tend  to  Force  work  in  Survey  the  (LFS),  low‐paying female  service  average  sectors,  wage  typically  income  was 12  in the trade percent  and  lower  public  than that sectors. According  workers.  to the 2018   for male Labor Force Survey (LFS), female average wage income was 12 percent lower than that for male workers.  51    51   Women tend to work in low-paying service sectors, typically in the trade and public sectors. According to the 2018 Labor Force 41 Survey (LFS), female average wage income was 12 percent lower than that for male workers. EXPANDING ENDOWMENTS 55 IV.2.3 Stagnant institutional quality compounded Mongolia’s limited endowments diversity Governance seems to have deteriorated with the mining boom. Resource abundance can give rise to socially damaging rent-seeking activities and neglect of good governance, infrastructure, and institutions, as well as an overvalued currency (Auty 1993; Collier 2011). In fact, state capture by businesses has translated into low perceptions of the     ability to control corruption, maintain an independent judiciary, and run an effective state’s government. Mongolia’s higher mineral rents seem to have prevented the nation from building institutions, its social institutions,   as   well   as capital,   well  as   an   as   an unlike   overvalued   overvalued many of its  (Auty   currency   currency comparators   (Auty   1993;   1993;   Collier(figures   Collier   2011).   2011). 4.18   In   In and   fact,   fact, 4.19).   state   state   capturePoor   capture   by      by governance businesses businesses  discourages has  has  translated  translated private  into  into  low  lowinvestment  perceptions  perceptions in of mining   of  the  the and leads  state’s  state’s ability  ability  to to topoor  control  controlmining corruption,  corruption, deals. maintain It also      maintain dampens anan   independent   independentprivate  judiciary, investment   judiciary,   and   and in   run   runnon-mining   an   an   effective   effective jobs and thus Mongolia’s   government.   government. accentuates  Mongolia’s   higherthe  mineral   higher underutilization   mineral   rents   rents   seem   seem    human of toto  have  have capital  prevented  prevented while  the  the contributing  nation  nation  from  from to the its  building  building weaknesses  its  social  social  capital,  capital, in public  unlike  unlike  many investment  many  of of  its  its management.  comparators  comparators  (figures  (figures    4.18 4.18 Relatedly,  and  and  4.19).  4.19). the  Poor  Poor resource  governance  governance curse has  discourages  discourages also contributed  private  private  investment  investment to complicating  in  mining  in  mining  and  and the  leads  leads creation  to  of  to poor  poor  mining  mining quality    deals. deals. jobs because also    It It also of dampens    dampens the impact private    private of an    investment investment appreciating    inin  non  and non ‐mining ‐mining highly    jobsjobs volatile    and and real    thusthus exchange    accentuates accentuates rate on    the the    underutilization underutilization   of     of   human competitiveness and investment risk perceptions.human   capital   capital     while while     contributing contributing   to   to     the the     weaknesses weaknesses     in   in public   public     investment investment     management. management.   Relatedly,   Relatedly,   the   the   “resource   “resource   curse”   curse”   has   has   also   also   contributed   contributed   to   complicating   to   complicating   the   the   creation   creation   of      of quality quality Figure 4.18   jobs   jobs   because   because   of   of   the   the   impact   impact   of  of   an   an   appreciating   appreciating Figure 4.19   and   and   highly   highly   volatile   volatile   real   real   exchange   exchange   rate   rate   on  on   competitiveness competitiveness  and  and  investment  investment  risk  risk  perceptions.  perceptions.    Poor corruption control is associated with Weak rule of law is also associated with higher mineral Figure Figure  4.18  4.18  Poor rents corruption  Poor  control  corruption  control    is is  higher Figure Figuremineral  4.19 rents  4.19  Weak  Weak  rule  rule  of  of  law  law     is associated is  with  associated      with associated associated  with  with  higher  higher  mineral  mineral  rents  rents       higher higher  mineral  mineral  rents  rents     0.60.6 0.80.8  ‐ y =y  0.0248x = ‐0.0248x  ‐ 0.0037  ‐ 0.0037 Colombia Colombia  ‐ y =y  0.0468x = ‐0.0468x  + 0.2567  + 0.2567 0.60.6 Change in Corruption Control   Control  0.40.4 Kazakhstan Kazakhstan = 0.2276 R² R² = 0.2276 Change in Rule of Law Index Change in Rule of Law Index = 0.1592 R² R²  = 0.1592 0.40.4 Canada Canada Ecuador Ecuador Kazakhstan Kazakhstan 0.20.2 Russia Russia Change in Corruption 0.20.2 Peru Peru Armenia Armenia Armenia Armenia Australia Australia Malaysia Malaysia Chile Chile Index Index 0 0 0.00.0 Australia Australia Guyana Guyana Canada Canada Chile Chile Peru Peru ‐0.2 ‐0.2 ‐0.2 ‐0.2 Colombia Colombia Russia Russia Guyana Guyana ‐0.4 ‐0.4 Ecuador Ecuador Malaysia Malaysia Mongolia Mongolia ‐0.4 ‐0.4 ‐0.6 ‐0.6 Mongolia Mongolia ‐0.6 ‐0.6 ‐0.8 ‐0.8 0 0 2 2 4 4 6 6 8 8 10 10 12 12 0 0 2 2 4 4 6 6 8 8 10 10 12 12 Change Change  rent  in mineral in mineral  rent  (%  (% of of  GDP) GDP)     Change Change in mineral  in mineral  rent  rent  (%  (% of of  GDP) GDP)     Source: Source: Source:  World  World World  Bank Bank  staff  Bank staff staff  estimates  estimates estimates     Source: Source: World Source:  World World Bank  Bank  staff Bank  staff staff estimates  estimates estimates    One One   of   of   the   the   hallmarks   hallmarks   of  of   Mongolia’s   Mongolia’s   development   development   since   since   1990   1990   has   has   been   been   the   the   ascent   ascent   of   liberal   of   liberal   One of the hallmarks of Mongolia’s development since 1990 has been the ascent democracy. democracy.   The   The   index   index   of   democracy,   of   democracy,   the   the   Polity   Polity   IV   Project’s   IV   Project’s   Polity2   Polity2   variable,   variable,   illustrates   illustrates   Mongolia’s   Mongolia’s    of liberal democracy. The index of democracy, the Polity IV Project’s Polity2 variable, strong strong  position  position  among  among  its its  peers  peers  as  as  the  the  sole  sole  unfettered  unfettered  democracy  democracy  along  along  with  with  Australia,  Australia,  Canada,  Canada,  and  and    illustrates Mongolia’s strong position among its peers as the sole unfettered democracy Chile Chile   (figure   (figure   4.20).   In   4.20). 4242   view   In   view   of   Mongolia’s   of   Mongolia’s   geographical   geographical   position,   position,   this   this  is  is   no   no   small   small   feat.   feat.   Mongolia’s   Mongolia’s    along with Australia, Canada, and Chile (figure 4.20).42 In view of Mongolia’s geographical democratic democratic position, this  is   credentials credentials no small   are   are feat.   also   also   acknowledged   acknowledged Mongolia’s democratic  by  by  Freedom   Freedom credentials   House.   House.   As are   As  the   the also   experience   experience acknowledged   of,   of,   for   for    example, example,  Australia,   by Freedom House. As the experience of, for example, Australia, Canada, Norway, and     Australia,    Canada, Canada,  Norway,  Norway,     and and  the the    United United    States States     bears bears    out, out,  a   well a  well ‐ functioning ‐ functioning    democracy democracy the facilitates United  efficient facilitates  efficient States  and and  bears  fair  fair management out,  management a well-functioning of  of  natural  natural  democracy  resources, resources,  including  including facilitates the the efficient of  avoidance  avoidance   of and excessive  excessive fair     dependence dependence management  on on of  natural natural  natural  resources  resources resources,  through  through including  judicious  judicious the  avoidance economic economic  diversification.  diversification. of excessive    dependence on natural Figure resources Figure 4.20  4.20  Mongolia’s through  Mongolia’s  strong  strong judicious  position  position economic  among  among  its its  peers diversification.  peers  as  as  the  the  sole  sole  unfettered  unfettered  democracy  democracy 42 Polity IV Project’s Polity2 variable reflects several characteristics of democratic compared to autocratic authority in governance (Polity IV Project 2019). 56                                                                                                                             COUNTRY ECONOMIC MEMORANDUM 2020   Polity 42 42   IV   Polity   IV   Project’s   Project’s   Polity2   Polity2   variable   variable   reflects   several   reflects   characteristics   several   characteristics   of   democratic   of   compared   democratic   compared   to   to   autocratic   authority   autocratic   authority   in   in     governance governance  (Polity  (Polity  IV  IV  Project  Project  2019).  2019).     52 52         Figure 4.20   Mongolia’s strong position among its peers as the sole unfettered democracy Structural peers Aspirational peers 10 10 6 6 2 2 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 ‐2 ‐2 ‐6 ‐6 ‐10 ‐10 Mongolia Armenia Colombia Mongolia Australia Canada Ecuador Guyana Kazakhstan Peru Russia Chile Malaysia Qatar   Source: Polity IV Project  Source: Note:Polity Project IV    Vertical axes shows the Polity2 index of democracy (from ‐10 to +10). Data for EAP are not available.  Note: Vertical axes shows the Polity2 index of democracy (from -10 to +10). Data for EAP are not available Mongolia  can  build  on  its  solid  reputation  as  a  liberal  democratic  state  in  a  challenging  Mongolia can build on its solid reputation as a liberal democratic state in a neighborhood to promote asset and product diversity. Mongolia’s democracy is an asset in that it  challenging neighborhood to promote asset and product diversity. Mongolia’s creates greater democracy is an  accountability asset in that  it and  thus may creates  reduce greater  the risk of grand accountability and corruption thus may  and  state capture. reduce the   riskHowever, of grand  this  is  not guaranteed, corruption and state  as  the elites capture.  may buy this However, off  voters is not through guaranteed,   electoral as giveaways the elites that  may generate buy off   short voters   term   improvements through electoral   at   the  cost  ofthat giveaways   exacerbating generate   volatility short term   and  reducing  long  term  improvements cost of  It prospects. at the   seems  Mongolia exacerbating   has  not volatility and   avoided reducing  this   risk.term long   But  through prospects.  improved It seems   transparency Mongolia  and  has not   based on  the  strong avoided But  mandate   popular this risk. of  the  existing through   improved   government transparency   which and based  afteron  2016the  resisted strong   the  temptation popular mandate   for  electoral   giveaways of the existing   (not  counting government   COVID which after‐19),   Mongolia 2016 resisted   now the  has   a  chance  to temptation   break  for electoral giveaways (not counting COVID-19), Mongolia out of this cycle. This is what the following recommendations aim to convey.  now has a chance to break out of this cycle. This is what the following recommendations aim to convey. IV.3  Policy recommendations – Escaping the natural capital overreliance trap  IV.3 Policy priorities – Escaping the natural capital overreliance trap Mongolia’s Mongolia’s  failureto failure  better utilize  tobetter utilize  its  human its human  capital capital  and and  its institutional buildbuild  capital is its institutional  explained capital is  by  several factors explained by several including  the skills/education factors including the  and  labor market mismatch, skills/education and labor  and  outmigration market mismatch,  of skills.  These  are   compounded  by  weak  control  of  corruption and outmigration of skills. These are compounded by weak control of corruption and rule  and  rule  of  law.  Accordingly,  the   main  thrust  of  the of law.   policy  recommendations Accordingly, the main thrust   on  these   issues of the   is  articulated policy   around  (i)  improving recommendations on these   the   quality issues is   and  utilization   of  human  capital  and  leveraging  an  effective   articulated around (i) improving the quality and utilization of human capital and leveragingmigration  policy  to  attract and  retain  talents;   an and   (ii)  strengthening effective migration policy   the to quality attract   of   institutions and   through retain talents;   improved and   transparency (ii) strengthening the quality and  public  investment efficiency. of institutions    through improved transparency and public investment efficiency. IV.3.1  Invest and better utilize human capital  IV.3.1 Invest and better utilize human capital Design Design a humanresources a  human  resources development development  plan  focusing plan  on education focusing  quality on education  and STEM quality and areas STEM    areas A human resource development plan can be a powerful policy tool to improve coordination of the  A human resource private  and   includingplan development   public  sectors, can be   universities, a  powerful   and policy to  ensure  that   the  tool to improve education   and  training  programs  match  market  demands.  Under  the  plan,  the  government can  estimate  theensure coordination of the private and public sectors, including universities, and to   demands  of  that the education and training programs match market demands. Under educational facilities by type of education and by region and diagnose the supply capacity.plan, the  Based on  government thethe can estimate the demands of educational facilities by type of education  demand analysis  of  occupations, skill levels,  and sectoral and regional distribution  of the labor  and by region and diagnose the supply capacity. Based on the demand analysis of occupations, skill levels, and sectoral and regional distribution of the labor force from 53    EXPANDING ENDOWMENTS 57 the private sector, the government can prepare specific goals and targets in education, training, labor, and employment policies. Throughout this planning process, the supply- demand gap by industry and occupation can be identified, which can help authorities redirect resources in a more efficient way and guide the reform direction of education and training programs. Establish a strict quality control system to enhance the quality of education and training Mongolia should establish a strict quality control system to improve the quality of education and training programs. The institutions that fail to meet the minimum requirements would be closed or turned into another educational institution at a lower level. For example, at the tertiary level, independent authorities comprised of domestic and global experts can review whether certain individual universities or departments can provide students with proper curriculums and training. If any college program does not pass the review, it would be given time to improve prior to the next review, and absent of sufficient progress, it would be restructured or closed.43 For vocational and technical training institutes, a group of independent experts can review their curriculums, management, and outcomes of the training programs. The decision-making process could be based on a standardized checklist or scoring system, with participation of foreign experts to minimize the risk of nepotism. Mongolia can also learn from Kazakhstan’s experience for promoting youth employment (see above).44 Leverage the private sector for better skills matching (public and private dialogue with universities and foreign investors) A university and industry linkage program can be established to help educational institutions develop more market-friendly curriculums and improve the job readiness of graduates. Encouraging collaboration and communication between academia and industry would be mutually beneficial. The government could promote appropriate financial incentive mechanisms. Entrepreneurial leaders of universities could invite their partners from business and industry to improve curriculum design. Businesses and universities could mutually benefit from this program through collaboration on research and development and through contract- based training programs for potential and current employees. Redesign school curriculums to match future needs It is urgent that policy makers and teachers quickly adapt to dynamically changing socio-economic demands. The OECD recently revised its core competencies for better education. Education and Skills 2030 has replaced the Definition and Selection of Competencies: Theoretical and Conceptual Foundations project, which was developed between 1997 and 2003 with the aim of identifying the competencies needed for a successful life and a well-functioning society. Within the new project, the OECD has categorized the main themes as competencies, knowledge, skills, and attitudes under the title “Learning Compass 2030,” which is expected to be embedded in the curriculum. The World Economic Forum also recently listed the skills or competencies expected to be in high demand in the fourth industrial revolution (box 4.2). 43 Note that the government is already doing such a review, but such a commission should be independent and comprise domestic and global experts. 44 In the aftermath of the global financial crisis, the authorities of Kazakhstan adopted a Regional Employment and Retraining Strategy supported by the International Labor Organization. The strategy aimed (i) to contain the rise in unemployment with the provision of short-term employment and job creation in public works and other social programs; and (ii) to rehabilitate social infrastructure and facilities as a necessary condition for sustainable development. The program also provided vocational training, retraining, and youth internships (IMF 2014). 58 COUNTRY ECONOMIC MEMORANDUM 2020 Box 4.2 OECD and World Economic Forum directives to improve learning and competencies The Organisation for Economic Co-operation and Development Learning Compass 2030 programa covers the following categories: • Transformative competencies: creating new value, reconciling tensions and dilemmas, and taking responsibility • Knowledge: disciplinary, interdisciplinary, epistemic, and procedural • Skills: cognitive and metacognitive, social and emotional, and practical and physical • Attitudes and values: personal values, social values, societal values, human values. The World Economic Forum list of skills or competencies expected to be in high demand in 2022b are: • Analytical thinking and innovation • Active learning and learning strategies • Creativity, originality, and initiative • Technology design and programming • Critical thinking and analysis • Complex problem-solving • Leadership and social influence • Emotional intelligence • Reasoning, problem-solving, and ideation • Systems analysis and evaluation. Sources: a. OECD 2019; b. WEF 2018 Promoting female labor participation Promoting female employment requires an integrated set of policies. These include: (i) improving the provision of high-quality affordable childcare for young children (Martınez and Perticara 2017);45 (ii) promoting better access to information technology to facilitate job search and increase opportunities for flexible work arrangements; (iii) improving the education system to provide equal opportunities to succeed in the labor market for both the males and females; (iv) allowing the retirement age to increase as was envisaged by the 2018 reform, which was then reversed; and (iv) implementing gender budgeting (box 4.3). These should coincide with efforts to tackle the slack in the labor market and promote job creation. 45 Martınez and Perticara (2017) found, in Chile, that offering after school care for children aged 6–13 increases employment by 5 percent and labor force participation by 7 percent. EXPANDING ENDOWMENTS 59 Box 4.3 Gender Responsive Budgeting and female labor participation Tackling gender gaps requires governments to commit resources to implementing targeted measures on a continuous basis and beyond interventions at a single line ministry. Gender Responsive Budgeting (GRB) is a tool supported and recognized by leading multilateral organizations including UN Women (the United Nations Entity for Gender Equality and the Empowerment of Women), the World Bank, and the International Monetary Fund (IMF)a and is important in several aspects. For example, GRB helps identify gender gaps in sectors and assess current policies, programs, and measures financed from the budget to determine their effectiveness and whether they contribute to addressing gender gaps. The Government of Mongolia (GoM) has committed to introducing GRB in its public financial management (PFM).b The lead role in the process is taken by the Ministry of Finance (MoF) and the National Committee on Gender Equality, in close cooperation with the National Statistical Office. The GoM has been implementing a PFM Strategy and Action Plan (2018–22), which includes a GRB framework to be integrated in the budgeting process. This approach is in line with international best practices (for example, Austria, the Republic of Korea, and Serbia). The GoM is starting pilot implementation of GRB through the MoF and two lines ministries (the Ministry of Education and the Ministry of Labor and Social Protection), but its further rollout through the national budget is expected by the end of 2021. The GRB can contribute to a more efficient, effective, and equitable use of public funds and thereby address some of the issues endemic to Mongolia’s declining labor force participation. These issues include a skills gap, employment discrimination toward young women, the predominance of women in caregiving for children and the elderly, lack of access to affordable nurseries and kindergartens, lack of care services for the elderly, lack of jobs, lack of capital to start a business, lack of family support, a gender pay gap and low wages, and gender norms in the society. Source: Compiled by World Bank staff Note: a. GRB has been getting more attention in the last 10 years in light of public finance reforms and is gaining recognition by multilateral organizations such as UN Women (https://gender-financing.unwomen.org/ en), the World Bank (http://boost.worldbank.org/tools-resources/topics/general-techniquestopics/gender- budgeting), and the IMF. The February 2019 publication, “IMF and Gender Equality – Operationalizing Change,” noted that gender is to be even more integrated into public finance reforms, including macroeconomic policies (https://www.brettonwoodsproject.org/2019/02/the-imf-and-gender-equality-operationalising-change/. In its brief published in February IMF). b. The Ministry of Finance has developed a gender strategy in which GRB is recognized as a priority A migration policy to retain and attract talent Migration can create a positive impetus for human capital accumulation and significant economic gains when skilled migrants return from abroad. For instance, the Returning Experts Program introduced by the Talent Corporation Malaysia Berhad (TalentCorp) in 2011, was highlighted by the World Bank as an effective measure to attract people with the skills the country needed. It had strategic importance in Malaysia’s plan to become a high-income economy. After assessing the talent needs of Malaysia, the TalentCorp designed a program that offered four benefits to emigrants upon their return and start of employment: (i) a flat income tax for first five years, instead of the standard progressive tax schedule; (ii) tax exemption on the purchase of vehicles; (iii) automatic permanent residency status for foreign spouses and children; and (iv) tax exemption for all personal effects brought back to Malaysia. The Returning Experts Program increased 60 COUNTRY ECONOMIC MEMORANDUM 2020 the probability of return by over 40 percent and offered positive monetary value rather than a cost to Malaysia, with net fiscal benefits estimated at RM 27,000 per returned applicant (box 4.4). Mongolia also may benefit from the experience, outward-looking attitudes, and know-how of skilled emigrants (a brain gain). To do so, Mongolia needs to do a delicate pivot whereby it attracts key talent and resources from among the diaspora. However, it is unrealistic to expect that some quick policy measures would encourage a mass return of skilled emigrants. Rather, there needs to be a concerted effort to engage with the diaspora and make them partners in Mongolia’s development. Such steps should be sustainable and backed up with concrete actions. Potential first policy steps include: (i) Appoint a nodal agency to deal with emigrants and diaspora matters. One quick action of such agency would be to organize a diaspora summit in an easily accessible location. (ii) Systematically map migrants in major host countries to gauge numbers, income, human capital, and financial endowments. (iii) Accelerate transfers of technology and skills from the Mongolian diaspora by promoting return of foreign-educated students, establishing networks of knowledge exchange (Pack and Page 1994), and developing a form of mentor-sponsor model in key sectors (for example, telecoms, manufacturing). (iv) Encourage the Mongolian diaspora’s involvement in the development of the country’s financial and capital markets, investment, and bilateral trade. Once Mongolian emigrants are comfortable doing business with their country of origin, return and reintegration are logical next steps. To further support the process of brain gain, returning emigrants could be incentivized through several measures similar to those used by Malaysia. These incentives include tax, housing, access to quality education for children, smoother transfer of assets, permits for foreign spouses or foreign- born non-citizen children, and dual citizenship. Box 4.4 Mongolia can learn from the Malaysian experience of attracting talent To attract high-skilled immigrants and fill some of Malaysia’s skills gaps, the government introduced the Residence Pass-Talent (RP-T) in April 2011. The program confers six key benefits: (1) ability to live and work in Malaysia for up to 10 years; (2) flexibility to change employers without having to renew the pass; (3) spouse and children under 18 years old are eligible for the RP-T dependent pass; (4) dependents over 18 years old, parents, and parents-in-law are eligible for a renewable one-year Social Visit Pass for up to five years; (5) spouse can also seek employment without the need to apply for an Employment Pass; and (6) spouse and children under 18 years old are eligible to study in Malaysia. The World Bank found that RP-T expatriates earn 4.3 times and Returning Expert Programme returnees earn 2.3 times the wages of comparable Malaysian professionals, suggesting the programs target highly skilled talent and that employers value international experience. Sources: World Bank 2015b; Del Carpio et al. 2016 EXPANDING ENDOWMENTS 61 IV.3.2 Investing in institutions Enhance transparency and accountability Mongolia needs to continue strengthening its governing institutions and accountability systems to facilitate the transition from mines to minds. As a resource-rich country, Mongolia needs to build institutions to effectively use revenues from extractive industries for long-term growth, following the example of well-managed resource-rich countries. Advance the Extractive Industries Transparency Initiative (EITI). EITI has laid the foundation for solid gains in transparency since 2006, but it must push further into some of the most contentious and difficult areas within the extractives value chain where company opacity, in particular, is a concern (beneficial ownership, licensing, commodity trades). Some of these actions should include: (i) Introduce amendments to existing laws and regulations in the mineral resource sector and approve a new EITI and mineral law. (ii) Improve the dissemination of the kind of regularly provided information promoted by EITI (and by some other forms of fiscal transparency initiatives), as they can play a valuable role in providing background information on the context in which corruption takes place, shedding light on the processes behind transactions, and highlighting risks. (iii) Promote multistakeholder rules of engagement and strengthen coordination to reinforce the tripartite character of EITI itself, as these three parties (government, company, and civil society) have different interests and are pulling the implementation of the initiative in different directions. Fostering the leadership and monitoring capabilities of civil society organizations to keep in check the interest of government and the private sector should be considered. Improve transparency in the management of natural resources through building a nationwide transparency and accountability coalition. This agenda will include government reform champions, accountability agencies, civil society organizations, the private sector, and international development agencies working across sectors. Transparency and accountability are potential areas of strength for Mongolia given its vibrant democracy. It should leverage this asset more. Reform the public investment management framework The new public investment management framework aims to build a unified, quality-based, single entry point for all forms of public investment, regardless of funding source or means of implementation. Some specific actions include: Adopt an integrated, whole-of-government approach for digital investments and transformation of the public sector. A whole-of-government approach for digital government provides the commonly used information technology (IT) tools and services for shared use across all agencies on a “built once, reuse always basis.” This reduces the need for each agency to invest in their own IT resources, cuts IT operational and overhead costs, improves interoperability and coordination, and enables agencies to focus on core digital services delivery to citizens and businesses instead of technologies. It also enhances data and information sharing and collaborative decision making at the political and operational levels, and provides agencies integrated cybersecurity protection of their mission-critical systems. 62 COUNTRY ECONOMIC MEMORANDUM 2020 Improve the management and governance of public investment projects through: (i) Developing a medium-term strategic plan with a priority list of projects that is realistic, based on a rigorous economic and financial assessment of investment needs. Instead of projects being proposed by line ministries on an ad- hoc basis, the medium-term and subsequently annual plans should be informed by the national master plan and linked to the Public Investment Plan process. (ii) Adopting sector-based investment planning, starting with the utility sector. Five- and 10-15-year investment plans for each utility should be drawn up based on projected need for increased supply and transmission or the replacement of existing supply and transmission. These investment plans should be subjected to independent audit. (iii) Ensuring that large-scale projects are subject to parliamentary approval. This includes, for example, projects supported by Development Bank of Mongolia or Erdenes Mongol LLC, which would draw on public funds or guarantees. (iv) Developing a policy that defines the selection of guarantees to be used in public-private partnerships for critical infrastructure development and a set of strict criteria by which they can be deployed. Leverage Mongolia’s comparative advantage Provide incentives for developing manufacturing industries (including meat and cashmere) consistent with Mongolia’s comparative advantage to facilitate diversification, upgrading, and preparedness for a low carbon transition. Mongolia’s small economy makes it easier to focus government efforts on specific value chains. Experience with industrial policies around the world suggests that governments can play an important role in overcoming information or coordination failures (box 4.5). By focusing on key value chains, such as meat production for instance (box 4.6), Mongolia can target public resources to help create better quality jobs. This includes targeting public infrastructure to maximize economic benefits through coordination with other policies and synergies across sectors and users. More specifically: (i) Develop infrastructure selectively to unlock specific value chains most likely to support economic diversification and improve competitive advantage in the region (including infrastructure for the meat, leather, and milk value chain; tourism, services; and renewable energy). (ii) Strengthen the infrastructure for Mineral Value Chains. Ultimately, the whole economy benefits as the tax base grows by lifting the infrastructure constraint which until now has limited mineral value chains to those projects that do not rely heavily on infrastructure or are able to absorb the high costs of self-supplied power and dedicated transportation. • Power plant - Prioritize power sector investments that unlock unmet demand from mines and mineral processing for continuous grid-supplied electricity. • Transport - Prioritize transport sector investments that help to enhance the competitiveness of traded goods generally by selectively piggybacking on rail investments needed for bulk minerals, while relying on upgrading the road network as far as possible. EXPANDING ENDOWMENTS 63 Upgrade the current Trans-Mongolian Railway to improve the benefits for developing mineral value chains. The competitiveness of minerals already reliant on that rail line would be enhanced, since existing exporters would benefit from lost time reduction, which contributes to costs as much as tariffs. Leverage existing and potential trade agreements and cooperation (including regional infrastructure) to facilitate Mongolia’s access to international market (for example, Japan, the United States, China, and Russia). More specifically, (i) Strengthen the infrastructure for regional connectivity with China and Russia. This should also include a clear priority to upgrade the signaling system and other technical systems on the railway infrastructure for the central economic corridor connecting China and Russia. Moreover, the plans to construct a Russia-China gas pipeline going through Mongolia opens important opportunities for coal substitution in heat and power generation as well as use as a feedstock in industrial processes. (ii) Establish preferential trade agreements or gain access to certain markets via trade negotiations in specific areas including meat exports. For example, the Economic Partnership Agreement with Japan can be used for the export of pet food produced from meat byproducts. The government also needs to accelerate progress on trade negotiations and commit to reaching a more liberalized and convenient trade arrangement under the World Trade Organization framework. This trade arrangement should enable progress on issues like market access, inspection and quarantine, export subsidies, domestic support, bilateral exchange rates, and product standards that are consistent with trade liberalization and investment facilitation. Box 4.5 Industrial policy – Pros and cons The literature is divided on the effectiveness and therefore justification of industrial policy. For instance, potential advantages of picking winners to promote certain industries were widely considered to be outweighed by substantial drawbacks in terms of gross inefficiency, especially in Latin America. However, as in the case of Malaysia, Chile, and China, if carefully designed and implemented, industrial policy can be envisaged as part of a successful national economic diversification strategy. Therefore, as Stiglitz et al. (2013) put it, “the question is not whether any government should engage in industrial policy but how to do it right.” To tailor such policy according to a country’s characteristics and become one of the success stories, one must be familiar with its pros and cons, and conditions for successful implementation. Industrial policies are advocated to correct two key market failures that deter the entrepreneurial drive to restructure and diversify (a process of self-discovery) in low-income economies. As Rodrik (2004) summarized, these market failures are related to the informational spillovers (cost of discovering new products) and the coordination of investment activities with scale economies. For instance, subsidizing investments in new, nontraditional industries with high social returns is considered a policy response to the information externalities. While doing so, Hausmann and Rodrik (2003) argue that a carrot-and-stick strategy should be adopted. Providing rents to initial investors as compensation for the cost of new discovery would be considered the carrot, while these rents must in turn be subject to performance requirements or close monitoring, which is the stick, so that mistakes and bad projects are not perpetuated. Chinese experience in this sense can be a good example, where it showed that industrial policy in the form of cheap loans, public ownership, local-content requirements, export subsidies, and technology-transfer requirements can boost macroeconomic performance and growth. In case of the coordination failure, industrial policy does not necessarily involve government 64 COUNTRY ECONOMIC MEMORANDUM 2020 subsidies; rather, the government can create an environment so that simultaneous investments are made and new industries are formed in a cluster. For instance, the Taiwanese government’s upstream investment in a genetics laboratory, quarantine site, shipping and packing areas, new roads, water and electrical hookups for privately owned greenhouses, and an exposition hall, has supported individual farmers to form a cluster of an orchid industry. In its modern guise, industrial policy should be about advancement of the economy as a whole and should emphasize external competitiveness and integration into global value chains, including foreign direct investment (Inter-American Development Bank 2014). The instruments include market-friendly policies that aim to promote innovation, human capital investments, entrepreneurship, the formation of clusters, globalization, and public and private partnerships. An important objective is the promotion of actual and potential comparative advantages through strategic export transformation rather than seeking to protect domestic producers against foreign competition. Nevertheless, industrial policy is commonly criticized for two potential pitfalls, informational objection and political capture. Often referred to as “governments cannot pick winners,” some argue that governments cannot accurately identify market imperfections. Even if it could, some doubt that governments could withstand lobbying from powerful firms and therefore would use industrial policy to transfer rents for the incumbents (Rodrik 2019). In both cases, however, a well-designed public-private collaboration could ensure that governments are close enough with the private sector to understand market failure, but not so close that they are in bed together. In other words, striking a balance between full autonomy and full embeddedness can ameliorate both of these potential pitfalls. For instance, the Inter- American Development Bank (2014) argues that industrial policies should aim at strategic collaboration between private enterprise and the government to uncover the most significant obstacles to restructuring and to identify the interventions most likely to remove them. Considering the above-mentioned potential benefits and pitfalls to look out for, policy experiments based on general principles and international experience and, at the same time, tailored to local circumstances, are proposed for effective implementation of industrial policy (Inter-American Development Bank 2014). Source: Compiled by World Bank staff EXPANDING ENDOWMENTS 65 Box 4.6 Meat exports offer significant potential Mongolia has a comparative advantage in meat exports due to its vast grasslands and proximity to large markets in Asia. However, several factors limit its competitiveness including low quality of meat and meat products, prevalence of diseases, complex non- ecofriendly supply chains with limited traceability, and lack of quality assurance mechanisms and institutions. To become a key player in this field, Mongolia must make careful strategic choices that address these factors and leverage its comparative advantage. Mongolia has failed to develop a cohesive, food safety-oriented, self-reliant meat industry that operates independently of, but in partnership with, the government, as in successful meat-exporting countries. Value addition for export involves sectioning and packing the carcass into individual cuts to suit markets, as well as heat-treated products. This requires a solid value chain beginning with animal production and health and ending with delivery of the finished product to the consumer. Unfortunately, some parts of the country are prone to several endemic animal diseases that threaten human health and thus limit Mongolia’s access to international markets due to the health standards and export certification. While the government has attempted to initiate insurance schemes for selected diseases, most herders remain reluctant to enroll due to poor understanding of potential risks and mitigation options. Meat processors also suffer from insufficient working capital to cover operational costs and face high interest on loans. Industry in general lacks the capacity to smooth its production, brand their products, and maintain viable market share. The bureaucracy of state organizations has also proven to be a serious problem. To export, companies are required to get clearances from multiple agencies, which can take up to three weeks. Vast grasslands and free-range production practices can provide a competitive edge, but Mongolia needs to make strategic choices to leverage them. To its advantage, Mongolia hosts one of the world’s largest remaining grassland ecosystems of global environmental importance. However, degradation of this ecosystem due to growing market pressures and lack of a coherent resource management policy, have become a central challenge in sustainable animal production. It is argued that “the control of livestock numbers is a fundamental precondition for effective rangeland management.” In other words, the production must focus more on improving productivity and quality, and less on the number of livestock. To tackle these constraints, action must be taken on several fronts: (i) Improve the enforcement of domestic livestock product hygiene standards and ensure the safety of Mongolian meat and meat products. These include enhancing inspection work on meat factories and tightening legislation on food safety and production safety. (ii) Attract investment in infrastructure, storage facilities, scientific labs, transportation, and cold chains. (iii) Enforce more seamless institutional coordination - especially among the General Agency for Specialized Inspections, General Agency for Veterinary Services, and the private sector - to increase food safety standards and meet importers’ requirements. (iv) Support breeding services, review permits and border clearance processes for importing high-quality semen and investing in capacity for genetic improvement of animals. 66 COUNTRY ECONOMIC MEMORANDUM 2020 (v) Invest in sector-specific public-private dialogue platforms including business associations. Such platforms can be useful to lead marketing, branding, and setting industry standards, and their implementation. (vi) Strengthen cooperation with trading partner countries to improve the domestic logistics infrastructure (efficiency of logistics clearance and logistics cost). (vii) Increase cross-border law enforcement cooperation on food safety. For cross- border trade, it is more difficult to trace back once product quality and safety issues occur. To further its competitive advantage, Mongolia could leverage digital technologies and e-commerce. These tools can further facilitate growth of exports by identifying target markets, reducing transactions costs, and bringing more transparency through the value chains. For instance, Mongolian SMEs could integrate operations with e-commerce platforms such as Alibaba and JD.com. The new marketing strategy may broaden the channels to enter new markets and reduce the high cost of the traditional trade model, which is currently employed in Mongolia. In the long term, the government should support private sector linkages with regional or global value chains to attract FDI focused on exports (efficiency seeking FDI). The case of the cashmere sector is a good example of successful integration of Mongolian export products into the global chain. Leveraging investments from the United States, Japan, Italy, and China and the new technologies and know-how that followed, the cashmere industry is successfully integrated into the global chain and has become an integral part of worldwide brands such as Burberry, Loro Piana, Huckets, and Uniqlo. Source: Compiled by World Bank staff EXPANDING ENDOWMENTS 67 ANNEX 1. THE CONCEPTUAL FRAMEWORK The basic goal of the Mines and Minds report is to identify policy and institutional reforms that can propel Mongolia to both expand its production possibility frontier (PPF) and operate at its most efficient point in the PPF. This transition is captured through a stylized theoretical framework as illustrated in the below figure. We assume that Mongolia’s economy is currently operating below its current PPF, where the y-axis measures the endowment related to natural capital and public sector spending (the latter is closely linked to price of natural capital) and x-axis measures other endowments, namely human and institutional capital. We further assume that Mongolia operates at point A during boom years and at point B during bust years. The goal is to move from points A and B to point E in the long-term, where the latter represents the most efficient long-term production structure for Mongolia’s economy. 68 COUNTRY ECONOMIC MEMORANDUM 2020 The three transitions As the figure shows, moving from point A/B to point E involves three transitions: Seeking Stability (moving from point A or B to C): While retaining the current production structure, Mongolia can improve national welfare by smoothing aggregate consumption and thus behaving as if the economy is operating at C and not at A or B. This smoothing of consumption can be achieved by adjusting public sector spending, i.e., government saves excess commodity revenue in a stabilization fund during periods of high commodity prices (point A) and withdraws from that fund and spends more during periods of low commodity prices (point B) and de facto operates at point C year after year. This is the first transition that involves achieving macro stability, implementing counter-cyclical fiscal and monetary policies and effectively operating the Stabilization Fund. Boosting Productivity (moving from point C to D): Point C, while an improvement, is below the PPF. And that’s because of inefficient use of its current endowments, both mines and minds. So the next set of economic gains can be achieved by moving from under the PPF (point C) to the frontier of the PPF (point D). This move would require better utilization of the endowments through improved business environment, foreign investments and technology, better trade and infrastructure outcomes-in short, by boosting productivity. Expanding Endowments (moving from point D to E): Moving Mongolia to the frontier of its current PPF is important, but not enough in the long run. Given the challenges of climate change and China’s green growth ambitions, Mongolia cannot continue to rely on natural resources to achieve high-income status. It must diversify and produce goods that are more intensive in human capital. This is illustrated by an outward shift in the PPF and for Mongolia to move from point D to E. 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International Renewable Energy Agency, Mongolia. 72 COUNTRY ECONOMIC MEMORANDUM 2020 73 Floor 5, MCS Plaza, 4 Seoul Street, 14250 Ulaanbaatar, Mongolia Tel: +(976)70078200 Web: www.worldbank.org/mongolia 74 COUNTRY ECONOMIC MEMORANDUM 2020 Facebook: World Bank Mongolia