Report No. 39009-MN Mongolia Sources of Growth Country Economic Memorandum July 26, 2007 Poverty Reduction and Economic Management Unit East Asia and Pacific Region Document of the World Bank ABBREVIATIONS AND ACRONYMS BHP BrokenHillProprietary MDGs MillenniumDevelopment BoM Bank ofMongolia Goals BSE Bovine Spongiform MIaT Ministryof Industry& Trade Encephylitis("mad-cow" MOF Ministryof Finance disease) MPAM Mineral & PetroleumAuthority CIVED cow0 Civic Education of Mongolia Corporacionde Foment0 MTBF Medium-termBudgeting CMEA Council of Mutual Assistance Framework CMMI Capability Maturity Model MTC MongoliaTelecom Company Integration NASA NationalAssessmentof Students' CPIA Country Policy and Achievement InstitutionalAssessment NPV Net-Present-Value DSA Debt SustainabilityAnalysis NGO Non-governamentalOrganization EITI ExtractiveIndustries NPLS Non-performingLoans Transparency Initiative NSO National Statistics Office ESMP EducationSector Master Plan OECD Operations EvaluationCountry GAP GovernanceAssistanceProject Department GDP Gross Domestic Product PICS Productivity and Investment GFMIS Government Financial Survey Management Information PIP Public Investment Program System PIT Personal Income Taxes GNI GrossNational Income PPPS Public-privatePartnerships GoM Government of Mongolia R&D ResearchandDevelopment FDI ForeignDirect Investment SCC Savings and Credit Cooperatives FONDECYT Fondo Nacionalde SEG Socio-economic Guidelines DesarrolloCientifico y SME Small and Medium Enterprises Tecnologico SPS Sanitary andPhyto-sanitary FSU Former Soviet Union STVP Skills Training Voucher Program GAC Governance & Anti Corruption TEU Twenty-foot EquivalentUnit HIES HouseholdInternational TFP Total Factor Productivity ExpenditureSurvey TIMSS Trends in International ICA Investment Climate Assessment Mathematics and Science Study ICs Investment Climate Survey TVET Technicaland Vocational ICT Information & Educationand Training Communications Technology UNCAC UnitedNations Convention INEA Institutefor Adult Education against Corruption INIA National Instituteof UNDP UnitedNations Development Agriculture Research Program IMF InternationalMonetaryFund USAID United StatesAgency of IP IntellectualProperty InternationalDevelopment I S 0 InternationalOrganizationfor UNSW University ofNew South Wales Standarization UB Ulaanbaatar KAM KnowledgeAssessment VAI Value AddedTax Methodology VTC VocationalTraining Centers LSMS Living StandardsMeasurement WHO World HealthOrganization Survey WB World Bank MCA MillenniumChallengeAccount MCC Millennium Challenge Corporation MFA Multi-fiberArrangement ACKNOWLEDGEMENTS This report has been prepared by a core team led by Mr. Sudarshan Gooptu (Lead Economist, World Bank) and comprisingof Messrshfmes.Cyrus Talati (Macroeconomic profile and impact analyses), William Mako (Private sector development and export diversification), Elena Ianchovichina (Growth Diagnostics), Graeme Hancock (Mining), Cristobal Ridao-Can0 (Education and Labor Market), Andrew Goodland (RuralLivestock sector), Giovanna Dore (Environment), Genevieve Boyreau (Regional Development and Macroeconomic Analysis), Altaa Shiilegmaa (MacroeconomicsPublic Sectorhlata Analyses), Xiaofan Liu (Macroeconomicshlata Analyses), Hiroshi Akama (Financial Sector), and Radu Tatucu (Research). Valuable comments on earlier drafts ofthe chapters, background inputs, and guidance during the preparation on this report and CEM missions, were received from Messrs. Deepak Bhattasali, Arshad Sayed, Charles Husband, Salvador Rivera, Sameer Goyal, Shubham Chaudhuri, Chorching Goh, Giovanni Ruta and Anthony Whitten. Mr. Otgonbayar Yadmaa (EACMF) provided able assistance with the administrative and logistical arrangements for the task team during missions Ms. Gloria Elmore was responsible for document preparation and formatting, a task she undertookwith usual ease andattentionto detail. This report would not have been possible without the guidance from H.E. Dr. Bayartsaikhan (Minister of Finance), H.E. Mr.Ganzorig(Deputy Minister of Finance), Governor Chuluunbat (Bank of Mongolia) and State Secretary Khurelbaatar (Ministry of Finance) during the CEM missions. The team appreciates the excellent collaboration from Mr. Enkhbayar (Adviser to the Prime Minister and former Director, MacroeconomicsDepartment, Ministry of Finance, Head of CEM counterpart team) and his colleagues for makingthe missionsproductive, and providing critical data for the CEM team to do its research and analysis in the subsequent months, the results of which are presented in this report. We are grateful for the comments received from the State Secretaries and other officials of the Ministries of: Finance (MoF); Food and Agriculture (MoFA); Fuel and Energy (MoFE); Road, Transport and Tourism (MRTT); Industry and Trade (MIT); Social Welfare and Labor (MSWL); Education, Science and Culture (MESC), Health (MoH), Construction and Urban Development (MCUD); National Statistical Office (NSO); and the Mineral Resources and Petroleum Authority of Mongolia (MRPAM) duringthe CEM working group meetings in Ulaanbaatar in June and October 2006 that were held to discuss the preliminary findings ofthe team as they became available.Additional comments on an earlier draft of this report that were receivedfrom the Government of Mongolia in May 2007 were appreciated and have been incorporatedinthis version ofthe report. Peer Reviewers for this Economic Report are Messrs. Delfin Sia Go (World Bank, AFRCE), RichardNewfarmer (World Bank, PRMTR), Prof. Enkh-Amgalan (Director of Policy ResearchCenter, Ulaanbaatar, Mongolia) and Mandar Jayawant (Deputy Country Director, Asian DevelopmentBank, Ulaanbaatar, Mongolia). Overallguidance for the reportwas providedby Mr. David Dollar, (World Bank Country Director for Mongolia), Mr.Homi Kharas (former Regional Chief Economist and PREM Sector Director, East Asia and Pacific Region, World Bank) and Deepak Bhattasali(currentlyActing Sector DirectorEASPR). i MONGOLIA SOURCESOF GROWTH Country EconomicMemorandum TABLE OF CONTENTS PageNos. EXECUTIVE SUMMARY ................................................................................................................ vii INTRODUCTION .............................................................................................................................. xix CHAPTER 1: LOOKING BACK TO GAUGE THE FUTURE.......................................................... 1 Output. Growthand Employment............................................................................................ Fiscaland MonetaryDevelopments....................................................................................... 2 12 External Sector Developments ............................................................................................... 19 CHAPTER 2: WHAT WILL IT TAKE TO KEEPMONGOLIA GROWING? ................................ 25 The BindingConstraints to FutureBroad-basedGrowth....................................................... 26 Other Obstaclesto Broad-basedGrowth ................................................................................ 41 CHAPTER3: ECONOMIC DIVERSIFICATION INA CHANGING WORLD ............................ -45 Current Issues........................................................................................................................ -45 Do MongolianFirms Innovate? Sector Perspectives................................................................................................................. ............................................................................................. -48 52 Public-PrivateInitiatives ...................................................................................................... 62 CHAPTER4: THE TYRANNY OF DISTANCEAND THE ROLE OF GEOGRAPHY ................73 MongoliaNationalGeography and EconomicGrowth.......................................................... 74 Implicationsfor EconomicGrowth The InternalGeography of EconomicGrowth in Mongolia................................................... ........................................................................................ 76 Policy Recommendations....................................................................................................... 81 90 CHAPTER5: A LABORMARKET INTRANSITION .................................................................... 95 Skills Mismatchat all Levels Supply Side Factors inthe LaborMarketNeedAttention as Well ....................................... .................................................................................................. 95 Policy Recommendations..................................................................................................... -98 104 CHAPTER 6: MANAGINGNATURAL RESOURCESFORLONG-RUN BROAD-BASED GROWTH........................................................................................................................................ 106 .. 11 Estimatingthe "True" Wealthof Mongolia................................................................................ EstimatingMongolia's "Genuine" Savings Rate........................................................................ 107 112 The Role ofthe Mining Sector inthe MongolianEconomy Mining Taxation Regime ............................................................................................................ ....................................................... 116 Reformingthe Legaland RegulatoryFrameworkfor Mining.................................................... 121 131 Key issues inManagingthe Mining Sector Impacton the NationalEconomy........................... 136 Policy Recommendationsto ImproveMiningSector InvestmentClimate ................................. 138 Wildlife andForest Resources.................................................................................................... 142 GENERATED RISKS....................................................................................................................... CHAPTER7: POLlCIES TO MANAGETHE EXTERNAL AND INTERNALLY- 147 Risksthat needto be MonitoredandManagedare many ........................................................... Fiscal Space and Use of Windfall Revenue................................................................................ 148 153 GovernanceandAnti-corruption ................................................................................................. 157 REFERENCES ................................................................................................................................. 165 ANNEXES I. 173 I1. MongoliaAt-a-Glance................................................................................................... .................................................................................... I11. Mongolia-Growth Diagnostics 176 Statistical Appendix ....................................................................................................... 192 BOXES 2.1 Stayingon the CuttingEdgethroughPartnershipsbetweenAcademic Institutionsand the Private Sector.......................................................................................................................... ........................................................ 38 3.2 Issuesfor HigherValue Meat Exports........................................................................................... 3.1 Air Cargo Exports of Perishablesfrom DevelopingRegions 55 3.3 Prerequisites for EnteringJapan SoftwareDevelopmentMarket.................................................. 56 59 3.4 World Marketsfor NaturalPersonal Care Productsand Health Foods/Supplements ....................................................................................................................... ................................................................................................... 60 3.6 How DidAustralia Come to RunChile's Mines?......................................................................... 3.5 NaturalProductsfrom Mongolia 61 70 3.8 The ChileanDevelopment Corporation......................................................................................... 3.7 R&D in Agriculture: Chile's Example ......................................................................................... 71 4.1 Urbanizationin TransitionCountries ............................................................................................ 72 4.2 How do FirmsDecideWhere to Locate?AgglomerationEconomies........................................... 82 85 4.3 Access to Basic Infrastructure, healthand EducationServices andLand 4.4 RegionalRoadNetworkonthe Way .............................................................................................87-88 Ownershipinthe Ger Areas.................................................................................................... 94 6.1 UrbanLandwas Free inMongoliauntil 2005............................................................................. 5.1 Skills andKnowledgehave many Aspects .................................................................................... 96 6.2 RuralLandManagement inMongolia......................................................................................... 116 115 7.1 Strategies for DiagnosingandFighting "Dutch Disease" ........................................................... 6.3 Australia andthe United States:Mineral Rich but with Different Outcomes ............................. 137 151 7.2 Baseline Scenarios ofJoint IMF/World Bank Debt SustainabilityAnalysis Assumes ContinuedHigh Output and ExportGrowth................................................................ 152 7.3 The World Bank's Worldwide Governance Indicators- A Way to Evaluatethe iii 7.4 Reform Measures to Improve Transparencyin Government ...................................................... Quality of Governancein and across Countries .......................................................................... 158 162 FIGURES 1.1RealGDP . andOther Transition Economies. 1990-2004 ............................................. 1.2 It took a decade for real GDP to recover......................................................................................... Mongolia 2 3 1.3 GDP Performance, 1996-2005 ......................................................................................................... 5 1.4Mining Sector Performance, 1996-2005.......................................................................................... 5 ...................................................... 1.5(b) .....which has led GDP growth 1.5(a) The Structure of Demandhas favored PrivateConsumption ................................................................................................... 6 ......................................................... 6 1.6(b) .....while labor force participation rates have declined 1.6(a) Unemploymenthas fallen faster than employmentgrowth ............................................................... 7 1.6(c) ...suggestingthat hidden unemploymentmay be on the rise 7 1.7 Unemploymentis higher amongthe youth..................................................................................... ...................................................... 7 8 1.9 Most of the idle workers are of working age................................................................................... 1.8.....but higher educationdoes not mean employability within Mongolia......................................... 8 ...................................................................................................... 8 8 1.11Rapid Increase inMigration to UBinResponseto Dzuds 1.10 ...andthose with no education ............................................................ ......................... 9 1. 2(b) ...but for ruralwages 1.12(a) Overall, householdincomefrom informal activities appears to be declining 10 12 1 3(b) 1. 3(a) Public SectorPrivatehave beenrising householdsthat is not the case, suggestinga large informal sector .................10 . ...fasterthan ..................................................................................... Sector wages ........................................................................................ 12 1. 5(b) ...and it has all been foreign financed .................................................................................... 1. 5(a) Fiscalconsolidationis evident inexpenditurecompressionand revenueeffort...................12 1. 4 Inflation has been brought under control ..................................................................................... -14 14 1.17 Currency holdings and foreign currency depositsrose as public confidence fell........................ 1. 6 Monetary policy has been geared to combatinginflation, especially in the 1990s ..................... 15 16 1.18(a) The private sector credit boomhas been accommodated by a shift away from the 1.18(b) ...andhas been fuelled by soaringdeposits in Banks as confidencehas returned..................17 Public sector................................................................................................................................. 1.19 To date, capital inflows have been sterilizedreducingthe impact of "Dutch Disease" ..............19 17 1.21 Surpluses on MineralTrade have helpedFinance Growing Deficits on Non-mineral Trade......20 1.20 Followingthe volatility of the 1990sthe nominal exchange ratehas been stable ....................... 19 ................................................. 1.22(b) ...but lackedany dominant sectors ......................................................................................... 23 1.22(a) Non-mining foreign investmentwas important inthe 1990s 23 1.22(c) Since then foreign investment for mining has soared ............................................................. 23 1.23(b) but there has been a shift towards China and new partners (2000-04) ................................... 1.23(a) FDIusedto come from a mix of former transition economiesand others (1990-99)............23 1.22(d). ..while in non-mining FDI, trade, transport & tourism are emergingas important ...............23 23 1.24(a) ForeignBorrowinghas financed the Transition., 1.24(b). ..allowing Reserves to be built andVulnerability managed................................................... ................................................................... 24 2.1 Size Distribution of Mongolia's firms shows that there are only a few large firms ...................... 24 2.2 ...While the tax burdenis large, in terms of tax rates andtax administration............................... 33 33 2.3 Effective Tax Rates Faced by Firms .............................................................................................. 3.2 Long-term Behavior of Gold Prices, 1971-2005 ........................................................................... 3.1 Copper Prices and Stockpiles, 1986-2005 ..................................................................................... 47 33 3.3 Export Pricesfor Mongolian Meat have been impactedby the Outbreakof Diseases..................47 48 3.4 Degree of economic diversification is relatively low in Mongolia 49 3.5 ...andso i the degree s of export diversification ............................................................................ ............................................... 49 3.6 Rail CargoTraffic has been on the Decline ................................................................................... 54 iv 3.7 Investment Climate Impediments: Perceptions of Mongolian Firms ............................................ 63 4.1 Most of Mongolia's Population is inUlaanbaatar ......................................................................... 75 4.2 Trade Links: Mongolia Main Trading Partners 77 4.3 FDILinks:Mongolia's Main Sources of FDI ............................................................................... ............................................................................. 4.4 Basic Infrastructure........................................................................................................................ 78 4.5 Scorecard on Information and CommunicationTechnologies. SelectedVariables ..................... 89 -92 6.2 Methodology to Estimate the "Genuine Savings" in an Economy.............................................. 6.1 Total Wealth Composition in Mongolia ...................................................................................... 109 6.3 The Optimal Effective Tax Rate.................................................................................................. 113 122 7.1 Recent and long rungold and copper price rises....................................................................... 148 148 7.3 Public Debt Sustainability Scenarios........................................................................................... 7.2 ,,.mask their inherent volatility ................................................................................................... 154 7.4 External PPG Debt Sustainability Scenarios 154 7.5 Fiscal Policy has been Largely Pro-cyclical ................................................................................ ............................................................................... 155 7.6 The Quality of Governance in Mongolia, 1996-2006 Compared................................................ 159 TABLES 1.1 Selected Indicators. Mongolia and some Comparators ................................................................... ..................................... 1 1.3 Sector-wise Contributorsto GDP and Employment Growth......................................................... 1.2 Employment Status of Working Age Populationby Location and Gender 8 11 1.5 Fiscal Indicators 1997-2006 .......................................................................................................... 1.4 Have Mongolian Firmsbeen Creating Jobs?................................................................................. 11 1.6 Fiscal Sustainability has been Improving...................................................................................... 13 15 1.8 Exports to China have nearly doubledand traditional destinations have changed........................ 1.7 Recent Trends in Private Sector Credit Indicators......................................................................... 18 21 2.1 Rail Transport Costs...................................................................................................................... 1.9 Import partners have not changed but China i s becomingmore dominant ................................... 21 28 2.3 Tax Reforms that became effective on January 1, 2007 are a step inthe right direction..............29 2.2 Composition o f Mongolia's Merchandise Exports ........................................................................ 31 2.4 Average Number o f Days Spent a Year Meetingwith Tax Inspectors 2.5 Mongolia's Tax Base..................................................................................................................... .......................................... 32 32 2.7 Selected Parametersofthe BusinessEnvironment-Part I1.......................................................... 2.6 List of SelectedProduct Lines Facing Tariffs above 30 Percent in Russia................................... 36 2.8 School Indicators, 2004 ................................................................................................................. 38 41 2.10 Monthly Average Wages and Salaries in 2006........................................................................... 2.9 Numbero f Academic Institutions in Mongolia............................................................................. 42 -43 3.1 Mongolia's Export Earnings, 1999-2005 ...................................................................................... 46 3.2 Indicatorsof Innovation, Mongolia ............................................................................................... 50 3.3 New Manufactured Exports Discontinued in 2004 and 2005 51 3.4 Tourism Trends, Selected Countries .............................................................................................. ........................................................ 58 3.5 Software Sector, Selected Countries .............................................................................................. 59 3.6 Current Export Sector vs.Alternatives Scenarios ......................................................................... 62 3.7 Real Interest Rates, SelectedCountries 3.8 SelectedEnterprises Groups.......................................................................................................... ......................................................................................... 64 65 3.9 Starting a Business, Selected Countries......................................................................................... 3-10Dealingwith Licenses, SelectedCountries ................................................................................. 68 67 3.12 Sovereign Wealth Funds.............................................................................................................. 3.11Quality o f Infrastructure Services, Selected Countries ................................................................ 69 4.1 Urban Population Dynamics among Asian Countries ................................................................... 72 83 V 4.2 Pollution inUlaanbaatar Needs UrgentAttention ......................................................................... 4.3 RegionalTele-density.................................................................................................................... 86 90 5.1 What is the Most Appropriate Level of Education for Your Work? 5.2 Schooling and Skill content o f Non-agricultural Wage Sectors.................................................... ............................................. 96 97 5.4 Student Achievement by School Location .................................................................................... 5.3 Returnto Educationby level ......................................................................................................... 97 6.1 Wealth Estimates for Mongolia................................................................................................... 98 6.2 Capital Output Ratios for SelectedCountries and Country Groups ............................................ 108 110 6.4 Mongolia: Actual and Counterfactual Wealth Compositions ...................................................... 6.3 Low Productivity inMongolian Agriculture ............................................................................... 111 112 6.5 Measures of Saving inMongolia ................................................................................................. 114 6.6 Mongolian Mining Sector Contribution to GDP and Exports 117 6.8 Mongolia's Mineral Taxation Regime in Transition, 2002-2006 ................................................ 6.7 Changes in Production, 1995-2005 .............................................................................................. ..................................................... 118 124 6.9 MiningRoyalty Regimes in Selected DevelopingCountries in 7.1 Alternative Shock Scenarios Highlight Risksto MaintainingDebt Sustainability ..................... Africa, Asia and Latin America............................................................................................ 126 153 7.2 Summary of Donor Activities inCombating Corruption ............................................................ 161 ANNEX I1 FIGURES 178 182 A2.3 ...asthe cost o f capital declines A2.2 Domestic investment is on the rise in Mongolia...................................................................... A2.1 Growth Diagnostics to Identify the BindingConstraints to Growth ........................................ ................................................................................................. 182 A2.4 Real cost of capital has declined primarily due to increase in the inflation rate rather than A2.5 Cost of capital is high becauseof high deposit interest rates and risk premiums..................... declines inthe risk premium.................................................................................................... 182 182 A2.6 While the cost is high, it i s not the primary reason for the small number of firms with access to credit in Mongolia .................................................................................................... 187 A2.7 Real per capita GDP has been growing over the past decade 189 A2.8 Growth Accounting: Mongolia since Transition ...................................................................... ................................................... A2.9 Value Added per Worker in Mongolia .................................................................................... 189 -191 TABLES A2.1 Cross-country Comparison o f Saving and InvestmentIndicators ............................................ 180 A2.3 Domestic Investment in Mongolia, 2001-04 ............................................................................ A2.2 Composition o f Total Investment, 2001-04 .............................................................................. 181 181 ............................................................................................ A2.5 External Finance inMongolia is not Costly ............................................................................. A2.4 Interest Rate Spreads ,1996-2005 182 183 A2.6 Gross Domestic Savings A2.7 Banks Provide Favorable LendingInterest Ratesto a Handful of its Best Customers.............186 ........................................................................................................... 184 ................................. A2.9 Sensitivity Analysis on TFP Growth in 2004 ........................................................................... A2.8 SelectedParameterson the Quality of the Business Environment, 2006 188 189 A2.11 IndustryComposition o f Total Value Added in Mongolia at Constant, Producer Prices.......190 A2.10 Industries' Contribution to Real Growth in Mongolia............................................................ 190 vi MONGOLIA SOURCES OF GROWTH Country EconomicMemorandum EXECUTIVE SUMMARY Over the past decade of economic transition, the structure of the Mongolian economy has changed.. . 1. Mongolia's transition from a planned economy to a market economy, which began in the early 199Os, has proceeded quite well relative to most other countries in similar circumstances. Fundamental economic reforms have been undertaken by the Government in the areas of price liberalization, privatization and the establishment of market institutions. Concurrently, progresshas beenmadetowards reducing the incidence of poverty. While Mongolia has suffered bouts of inaction on reforms and attendant crises in the past decade, it is noteworthy that there has been no reversal of the overall reform path towards a market-oriented economy. Unlike several Eastern European countries, Mongolia's transition was largely unhinderedby widespread social or political unrest, although the young democracy is still being perfected. 2. Today, one is seeing a country with a strong macroeconomic performance-in terms of GDP growth and low inflation-buoyant prices of its main mineral exports copper and gold, widening current account and fiscal surpluses, and has seen an appreciating nominal and real exchange rate for the Togrog vis-a-vis the U.S.dollar. The associated gains in economic well-being have occurred while at the same time Mongolia has, by and large, protected the high levels of human development that are a legacy o f its socialist period. The biggest turnaround over the past five years has been in the tertiaryhervices sector in Mongolia, especially retail and wholesale trade, transport, communications and financial services, where average value-added growth has been at around 8 percent per annum during 2001-2004 and 9.1 percent in 2005. Foreign direct investment has been rapidly growing in mining and construction activities. The average share of FDI in Mongolia's GDP of 5.2 percent for the 10-year period (1996-2005) was higher than the average for the East Asia region, and more than three times that for the low-income country group to which it belongs. Clearly, despite political uncertainties, these are good times. ...thesources of real GDP growth have become very concentrated, and heavily dependent on mining and livestock sector activities. 3. Looking deeper into these overall trends, one cannot escape from concluding, however, that some o f the very developments that have shaped recent economic conditions and history are likely to become constraints to Mongolia's continued prosperity and sustained high growth. Mongolia's heavy dependence on the exports of a few key commodities-gold, copper, cashmere-has made its economy particularly vulnerable to fluctuations in commodity prices and natural disasters. Employment vii MONGOLIA: generation has been elusive despite having a young and educated labor force. The population ofthe country i s becomingmore concentratedinand around Ulaanbaatar. 4. Formidable challenges remain in managing Mongolia's "tyrannies of distance and isolation;" delivering services equitably and cost effectively; and generating growth that is broadly shared regionally and across income groups. The country faces the challenge o f creating new opportunities for its rural population and urban unemployeddiscouraged workers. Progress in reducing maternal mortality rates, as well as in improving water and sanitation services, has been less than required to meet the Millennium Development Goals (MDGsFand i s particularly lagging in the western part of the country. The recent World Bank Poverty Assessment (2006) for Mongolia finds that of all householdswith household heads engaged in some form o f activity, the herder households had the highest incidence of poverty (41.2 percent). Analysis of household survey (HIES-LSMS)data indicates that livestock mortality shocks translate directly into lower consumption levels for herder households. It also found that the most pressing poverty challenges in Mongolia are related to widespread livestock mortality risks, attrition before upper secondary schooling, and the exorbitant heating cost burden of households. At times, these challenges may all seem daunting, but the prevailing good timesprovide apolitically difficult but fruitful opportunity to use the gains to address the vulnerabilities that Mongolia's transition to a market economy brings and make prudent policy decisions to benefit a wide spectrum of Mongolian citizens (rural and urban) over the medium-term. 5 . The Government's strategy to deal with these challenges, and instruments to implementit, are being formulated under its draft National Development Strategy (NDS). This is being linkedto its medium-term budgetfFamework (MTBF), its associated annual budgets, and its Socio-economic Guidelines (SEG) documents that are all discussed in Parliament. Thepublic investment program (PIP) remains to be formulated in a manner consistent with the MTBF with a view towards maintaining fiscal sustainability, and with consistent sector strategies covering the same time-frame. The Government has made commendable efforts to finalize its medium-term Health and Education Master Plans, while it is at an advanced stage in articulating its Infrastructure Development Strategy. Meanwhile, a mediumterm Public Debt Management Strategy needs to be articulated by the Government and communicated to market participants. Capacity building efforts are underway in the Government in collaboration with its external development partners, including the World Bank, to put in place institutional arrangements, regulations and appropriate staffto get these tasks done. 6. This Economic Report aims to inform the ongoing debate on the Government's long term development priorities in Mongolia. It discusses the key facts and potential implications the Government would need to consider when determining its public spending, public investment program, fiscal space, and borrowing strategy going forward. Inthis context, the objective is to identifyreforms where the direct beneficial effect could be the largest interms of broad-basedemployment generation and sustainable growth. ... Vlll COUNTRYECONOMICMEMORANDUM What are the "binding constraints" to broad-based and sustainablegrowth? 7. The "growth diagnostics" analysis undertaken in this study has helped narrow down the main areas where immediate policy intervention should generate "quick wins" interms of unleashing the economy's potential to maintain its high GDP growth, and at the same time, to diversify exports and its other sources of growth. It should be noted, however, that Mongolia's mining sector will remain a dominant source o f its long-term growth for some time to come. It is the fastest growing sector today, although official estimates suggest that this sector currently accounts for only 4 percent of Mongolia's labor force and uses relatively capital-intensive methods of production. For Mongolia today, these areas (or "binding constraints" as the economic literature calls them) that needimmediate policy intervention are the following: . Inzastructure bottlenecks that have led to costly transport, complex logistics, and longtransit times. For instance, the costs of rail transport, both interms of unit cost of freight forwarding per Km. or the cost of border crossings to neighboring countries, are much higher than those o f other landlocked countries inAsia and the Central Asian Republics. The loading and unloading of cargo from one wagon to another at the China-Mongolia border, due to axle width differences between Mongolian and Chinese railroad cars, can often make up for 25 percent of the overall transport cost to port. Since Mongolia's export volume on the railroad is about 10 percent of the volume for goods being imported by rail, the fee for an empty container that returns to the . border adds to the transport cost, especially for Mongolian exporters that significantly rely on imported intermediate inputs. Distortionary taxes, including lately in mining sector activities, and complex customs and trade rules that have increasedthe implicit cost of doing business inMongolia. The tax base is narrow, with the top 100 taxpayers paying over 90 percent of the government's tax revenues. In addition, the tax code may have motivated firms to operate in the informal sector. The latter issue is being addressed by the Government under the tax reforms that came into effect since January 1, 2007. Meanwhile, uncertainties remain as to the expected impact o f the mining tax regime on the incentives it generates. Tax evasion and under-reporting by firms of their labor costs are also widespread. The export tax on raw cashmere has provided incentives to processorsto offer herders the same price regardless of quality. Herders have responded by allegedly smuggling cashmere into China and selling high quality raw cashmere to Chinese buyers, thereby depriving domestic processing firms of high quality raw materials. This, inturn, has resulted in Mongolian cashmere firms operating below capacity. Need for better coordination internally and internationally: between laws and regulations; trade and logistics; sector strategies and implementation plans; as well as, resource use and environmental degradation. These coordination failures have led to the inability of exporters to comply with international quality standards and environmental degradation have occurred in the production processes. For instance, the main obstacle to expanding meat ix MONGOLIA: exports to Russia is primarily the current ban on such imports from Mongolia that was put in place after the outbreak of "foot-and-mouth" disease in 2001. Better coordination in trade and logistics with Mongolia's neighbors is imperative for growth. Prudent investments in infrastructure that have large . positive spillover effects are needed to deepen and diversify supply chains within Mongolia's mining sector. Growing corruption and inadequate contract enforcement. The former is a symptom of rising inequalities and is partly stemming from perceptions of lack of transparency and accountability in policy decision making and public sector governance. World Bank Investment Climate survey (2006) results indicate that unofficial payments, required for obtaining licenses, and the average bribe for different types of licenses, were high-estimated at around 40 percent of the official fees. Firms paying bribes to obtain access to electricity, water, communication infrastructure are respectively 26 percent, 15 percent and 23 percent of all firms surveyed. According to Transparency International and the World Bank's Governance Indicators, corruption in Mongolia has worsened substantially since 2001, and perceptions of corruption as an obstacle to growth are more widespread in Mongolia than in a number of comparator countries. Today, Mongolia ranks 9th out of 62 countries, for which firm level survey data were available, interms of its share of firms reporting corruption as a major obstacle to their growth. Survey results also found that about seventy-percent of the firms that have had disputes with clients or suppliers that had to be resolved in the Mongolian . judicial system indicated that the mechanisms for dispute resolution are a severe impedimentto doing business. The high cost of capital, although lower than inprevious years, i s primarily due to poor financial sector intermediation. Intense competition among commercial banks to attract deposits by offering high deposit rates have, in turn, put an upward pressure on their lending rates. The difficulty in assessing credit risk of borrowers, coupled with weaknesses in the bankruptcy and debt recovery framework, have forced banks to maintain higher spreads between lending and deposit interest rates and higher collateral requirements relative to comparable counties. Access to capital in Mongolia has been limited for the majority of firms. 8. Alleviating these binding constraints will yield expected outcomes (some quantifiable and others more indirect) in terms of improving returns to private sector activities, give firms the opportunity to "innovate" into new products and markets, and into higher value added products. Taken together, these would contribute towards achieving high and sustained broad-basedeconomic growth over the long-term. How to address them? 9. Diversify the real sector, including mining and livestock sector activities. Faster diversification of Mongolia's economy depends on: X COUNTRYECONOMICMEMORANDUM 0 Investment climate reforms-these include reforms to the tax system and its administration, business regulations and their enforcement, dealing with anti- competitive behavior, and access to land, among others. Improvements in public safety and quality of life in the Ulaanbaatar area, where most of Mongolia's migrating population and new economic activities are congregating, are also crucial in this regard. With an estimated effective tax rate of 62 percent and a marginal tax rate of 80 percent on mining revenues, Mongolia currently has one of the highest effective tax rates in mining in the world.' In addition, the Government is currently contemplating a state equity participation in the mining sector that will further lower mining investors' returns. Hence, it is imperative to provide a mining taxation regime that allows for efficient mining operations, encourages value-added processing, encourages exploration, research and development (R&D) and, at the same time, generate revenues for the government to spendprudently. 0 Investment in neededpublic goods-productive investment projects with large spillover effects should be encouraged with appropriate monitoring and evaluation mechanisms to be put in place to track public procurement and expected outcomes of these projects. Investments in non-sector specific investments and policies focusing on infrastructure and human capital should be preferred. The ongoing endeavor of the Government to finalize a medium-term infrastructure development strategy is an essential step in the right direction. Efforts should be made to better align pricing with costs of provision of energy, water and sanitation services, improving efficiency and governance in these sectors and better planning of infrastructure investments to reap allocative efficiency, high economic returns and greater poverty alleviation impacts (see Table 1 below).2 The challenge will then be to link this to a fiscally sustainable public investment program that conforms to its medium-termbudget framework andannualbudgets. Addressing key workforce issues-primarily, the under-utilization of human capital and skills mismatches. Idleness rates currently exceed 20 percent for the 25-29 age group. A structural shift inthe Mongolian economy is taking place that has raised the demand for foreign language skills, IT and technical skills, and behavioral (e.g., communications) skills. Government policies should accompany rather than attempt to offset the ongoing migration and economic concentration in Mongolia and take advantage of the agglomeration effects it generates. 10. Inorder to ensure that the Mongolianeconomy continues to grow by diversifying its non-mineral exports, enter new markets (at home and abroad) and create jobs, it i s essential to extract higher value-added from its livestock herd and to motivate firms to provide additional productshervices to improve quality and efficiency. Small and medium enterprises (SMEs) could provide much useful support, for example, in water well development/maintenance, fodder production, product quality control, product development, animal breeding and health, insurance, and other financial services. * Furtherdetails are ' World Bank staff estimates. provided inthe recent World Bank Reportentitled "Foundations for Sustainable Development:Rethinkingthe Delivery of InfrastructureServices in Mongolia", June 2007. xi MONGOLIA: Development of new sources of export earnings will need to work around transport constraints. Rail transport will likely remain useful for bulk cargo, while the gestation lags involved with infrastructure development imply that truck transport will be problematic in the next few years for anything except low-value products. Hence, the focus should be on high-value niche products suitable for air cargo, tourism, and "knowledge" products such as software development. To facilitate these possibilities, Mongolia's investment climate should feature ease of business entry, exit and ongoing regulation; a fair, transparent, and pro-growth tax system; good access to finance; enhanced educatiodskills; and better infrastructure. 11. Exploit more systematically Mongolia's position of a transit corridorfor trade between its neighbors. Appropriate investments in infrastructure and associated policy measures to promote its efficient development and use may go a long way in facilitating trade-routes, cross-country commerce and foreign direct investment. It would help strengthen supply chains and thus improve the investment climate. Given Mongolia's vast territory, small population and harsh weather conditions, this is no easy task. The geography and natural resource bias in the Mongolian economy make it susceptible to exogenous shocks that can have significant adverse effects on growth. Negative terms-of- trade shocks directly reduce real income and resources that are available for investment and consumption. 12. The role of Informationand Communications Technology (ICT) infacilitatingthe acquisition, dissemination and use of knowledge across a country is critical in today's rapidly growing Mongolian economy, more so given the vast geographical territory that needs to be covered by information. This will influence the way in which manufacturers, service providers and the government (central, provincial and local) are organized and how they perform their functions. This should not only be translated into the need for computer hardware and software, but for institutional reforms in key areas such as ensuring timely access of the public to information on government operations, strategies and action plans. 13. Address skills mismatches in the labor market, especiallyfor Mongolia's youth and those migrating to urban centers. According to the LSMS 2002-03, about 57 percent of workers are family labor or self-employed (79 percent in rural areas). The importance of agriculture is declining but it continues to be the main sector of employment (40 percent), and it is low skill-intensive (small scale and low technology). And the sectors that have increased the most in terms of employment (mining, construction and retail & wholesale trade) are not high skill-intensive. To improve the skills of young people for work and life, education opportunities must be made more relevant to the needs of the market. This involves improving educational preparation for adolescence by providing quality basic education for all. It also involves meeting the growing demand for post-basic skills, by providing diverse and flexible learning options in upper secondary and tertiary education; by implementing a relevant curriculum that teaches practical subjects, thinking skills, and behavioral skills; by blending the academic andvocational curricula, andby connecting school and work. xii COUNTRYECONOMICMEMORANDUM 14. Second-chance education opportunities must also be provided for young people who failed to acquire basic skills the first time around, suchas equivalence education and skills training programs. To facilitate transition to work life, the connection between school and work needs to be improved. This goes beyond just providing vocational education and involves strengthening the partnership between industry and schools. Universities are subject to an accreditation system since 1998, but this system i s voluntary and weak in terms of the assessment done. The private sector (including foreign institutions) is well established in the higher education sector in Mongolia (73 percent of institutions and 32 percent of students), but less so in the vocational and technical education sector (14 percent of institutions). Here, public-private partnerships (PPPs) can improve learning outcomes and efficiency overall by increasing choices and injecting competition. 15. Prudent management of windfall revenues and an internationally competitive investment climate inthe mining sector is imperative. In2005, the mining sector directly accounted for 18 percent of GDP, 65.5 percent of industrial output, almost 76 percent of export earnings and 20 percent of Government revenue. The economy grew at about 10.7 percent in 2004 (supported by the investment in and the initial gold production from Boroo Gold), 6.2 percent in2005 and 8.4 percent inreal terms in 2006. Mongolia's GDP per capita reached US$1,037 in 2006. The mining sector output has the potential to increase substantially over the next decade. It is projected to double or even triple from 2003 levels by 2010 provided large projects get development approvals and are successfully commissioned. Currently, the formal mining industry sector employs over 14,500 people and the informal (artisanal) mining sector may involve more than twice this number. The government is now in the process of drafting a legal framework for artisanal mining-a commendable step that is inthe right direction. The next challenge in this regardwill beto implementthat newlaw. 16. The adoption of a stable, competitive and transparent legal, regulatory and fiscal regime for the mining sector will be essential for its continued growth and development. To this end, it is imperative to provide a mining taxation regime that allows for efficient mining operations, encourages value-added processing, exploration, research and development (R&D) and, at the same time, generates revenues for the government for it to spend prudently. International experience suggests that almost all Governments of mineral resource-rich countries choose to have some specific provisions for Mining, and some Governments have entirely separate but transparent mining fiscal codes. In analyzing mining tax systems, it is essential to look at the complete system of &l taxes and fees rather than at individual rates in isolation. The total effective tax rate (ETR) should be usedas a first step incomparing mining tax packages. Common incentives that other countries have given to mining operators include: accelerated depreciation, loss carry forward, no-ring-fencing rules (Le. level of consolidation of tax base. Ring-fencing favors existing operators and is complex to implement.), carry forward and amortization of exploration, feasibility and development costs, deductible environmental and closure costs, and deductible community and public infrastructure costs. Although less common, another important incentive is fiscal stabilization. Tax holidays or initially reducedrates, depletion allowances and loss carry back are uncommon and not recommended. Xlll 9 . . MONGOLIA: Meanwhile, it is imperative to build capacity o f tax agency, especially to collect the mineral taxes owed to Government under the existing tax laws. 17. Investment agreements in the mining sector need to be structured to primarily define the basic rights and obligations of both the government and investors and to stabilize the fiscal provisions upon which investment decisions are based. It is important to ensure that such agreements remain subordinateto existing legislation and apply to the sector as a whole, rather than provisions which result in discriminatory treatment of individual firms. The recent changes to the fiscal and policy regime in Mongolia undermine its competitiveness and could impact negatively on the investor confidence that has been built over the period 2001-2005. In this regard, the authorities must reconsiderhe-evaluate the prevailing mining royalty rates, the windfall profits tax, and the share of equity participation bythe State inminingprojects. 18. It is not only the efficiency of the mining exploration and extraction activities that matter in the conversion of its natural capital, but the way in which these are undertaken that could lead to significant environmental damage, production losses, and a reduction in national wealth. The Government is working to address these challenges by enacting and updating a series of environmental laws, preparing regional economic development plans, strengthening its monitoring and compliance systems as well as the technical skills of its personnel in the relevant government agencies. It is also making efforts at strengthening its ability to back up the Government's plans by better and systematic analysis and projection of environmental impacts. Even then there are risks that will have to be contendedwith 19. These risks emerge from both external factors that are beyond the government's control and internally generated ones that may emerge as a result of perverse incentives that may be fueled by government's own policies. Exogenous risks relate to the dependence of the country on natural resources, specifically negative terms-of-trade shocks resulting from commodity price cyclicity, and environmental shocks primarily affecting the livestock sector. Risks also emerge from the threats of an unsustainable fiscal policy and populist spending programs; the weakening o f domestic industries inan economy that discovers and exploits an abundant natural resource, such as gold and copper (the so-called "Dutch Disease" phenomenon); domestic policies that may influence the investment climate and the country's attractiveness to foreign direct investment; and the perceptions of corruption and weak governance that tend to raise the costs of doing business. This calls for: Good management of windfalls with the goal o f maintaining macroeconomic stability, and with due consideration to fiscal and debt sustainability. 0 Prudent investment of the windfalls to support productive investments and broad- based growth; Institutionalizing counter-cyclical fiscal policy (i.e. minimizing boom-bust cycles through expenditure and investment smoothing) through the budget rather than off-budget vehicles, and xiv COUNTRYECONOMICMEMORANDUM Develop transparent mechanisms to enhance public oversight o f mining revenue expenditures and ensure accountability. To this end, the ongoing efforts of the Government to implement the new anti-corruption law and the Extractive Industries Transparency Initiative (EITI) in mining are commendable and must take precedence. This requires the Government to maintain an ongoing financial commitment to collect, compile and publish its mineral revenue statistics over time. Strengthening the institutional structure for pastureland management at national and local levels and supporting stronger livestock support services. Issuing and enforcing regulations for the insurance industry to facilitate the emergence o f a stronger insurance market that is able to cover some environmental risks. In the mining sector, due consideration should be given to mine closure, environmental rehabilitation and clean-up costs when designing the investmentagreements and fiscal regimefor this sector. xv $ 0 . 0 0 0 . 0 . 0 0 . . e e e e e e e e e e e e e e e e m m COUNTRYECONOMICMEMORANDUM INTRODUCTION The previous World Bank Country Economic Memorandum (CEM) for Mongolia was completed in 1997. At that juncture, the country was facing a period of declining GDP growth, sharp decline incopper prices (which cut the 1996 real GDP growth to less than half the 6.3 percent achieved in 1995), and continuing inflation since 1994. The fiscal support for weak state enterprises and a banking crisis had fueled inflationary pressures and unleashed administrative price reforms in 1996. Today, Mongolia is in the midst of good economic times, although political uncertainties remain. The associated gains ineconomic well-being have occurred while at the same time Mongolia has, by and large, protected the high levels of human development that are a legacy of its socialist period. This overall positive assessment is not meant to suggest that Mongoliadoes not face formidable challenges in completing its transition to a market economy, managing the "tyrannies o f distance and isolation," delivering services equitably and cost effectively, and generating growth that is broadly shared regionally and across income groups. Progress in reducing maternal mortality rates, as well as in improving water and sanitation services, i s less than requiredto meet the Millennium Development Goals (MDGs)-with progress particularly lagging in the western part of the country. The recent World Bank Poverty Assessment has found that, despite the decline in overall poverty from 43 percent to 36 percent between 1998 and 2002 on the basis of comparable consumption baskets and consistent coverage and poverty lines, the most pressingpoverty challenges inMongolia are related to widespread livestock mortality risks, attrition before upper secondary schooling, and the exorbitant heating cost burdenof households. Since the beginning of 2005, the manufacturing sector has been very seriously affected by the expiration of the quota-system under the WTO Multi-Fiber Agreement. This has led to closures of textile and garment firms and relocation of many of their activities to China. Meanwhile, the processing industry remains stagnant. As a result, the overall, textile industry value added decreased by 41 percent in2005. In the short to medium term, Mongolia will continue to rely on the traditional agricultural and mining sectors for growth, while putting in place policies to encourage export diversification and encourage private sector development. Mongolia's heavy dependence on the exports of a few key commodities-Gold, Copper, Cashmere-has made its economy particularlyvulnerable to fluctuations incommodity prices and natural disasters. To address this vulnerability continued fiscal discipline and deepening of the structural reform agenda would enable the government to better manage commodity booms and shocks in the future. Increaseddiversification of the economy will also serve to soften the economic impact of large fluctuations in commodity prices. Overall, with the consolidation of gains from good performance inthe last four years, Mongolia should xix MONGOLIA: be well placed to accelerate growth and poverty reduction in the period ahead with sustained support from the external donor community and inthe absence o f large external shocks. On March 23, 2006, the new Government issued its priority areas with the goal "to liberate vulnerable groups o f the society from their current attitude to their own lives as just receivers who rely on others support; and support employment and increase income o f the groups." These priorities will be implemented through the annual budgets, interms o f financing, and will be reflected inthe Government's medium term budgeting framework (MTBF) and through its Socio-economic Guideline (in terms o f specific policy actions to fulfill these priorities and the associated institutional arrangements). Recently, the Cabinet has also issued a resolution to include the MDGs explicitly inthe Socio-economic Guidelines, the MTBF, and other sector strategies and i s taking measures to provide consistency among them. This Economic Report aims to inform the ongoing debate on the Government's long term development priorities in Mongolia. It discusses the key facts and potential implications the Government would need to consider when determining its public spending, public investment program, fiscal space, and borrowing strategy going forward. In this context, the objective is to identify reforms where the direct beneficial effect is largest in terms o f broad-based employment generation and sustainable growth. To this end, the report will provide suggestions and recommendations that could be considered by the Government when preparing the next Government Action Plan (GAP) and Socio- Economic Guidelines (SEG)-two key Medium term strategic documents that are discussed inthe Parliament. The Government is also inthe process o f finalizing a MDG- based National Development Plan. This report will provide inputs to that exercise as well. The report begins by reviewing the Mongolian growth experience over the 1990s as a pre-requisite to understand the present endowments, and the circumstances under which one needs to think about the future. Chapter 2 applies the "growth diagnostics" approach to identify those factors that are "binding" constraints to growth and are areas in need o f immediate policy interventions by the government. By focusing only on a few key constraints the approach maximizes the chances that the total effect of economic policy interventions (including hard to measure indirect effects) to remove these obstacles will be favorable and large.3 The next two chapters o f this report are concerned with the policies that are needed to relax the "binding" constraints to growth identified in Chapter 2. This required using sector specific and cross-country knowledge to deduce the specific distortions that lie behind these constraints and finding ways o f alleviating them in view o f Mongolia's unique characteristics-distance, low population density, natural resource abundance, among others. Chapter 3 discusses the issues that will need to be addressed in order to develop non-mining sector activities with the aim o f economic and export diversification and suggests policies to encourage firm %novation'' and private sector growth. Specific policy measures are proposed that would have a significant impact towards fostering 3This approachwas postulatedby Ricardo Hausmann,Dani Rodrik and Andres Velasco (2005). xx COUNTRYECONOMICMEMORANDUM sustained and broad-based growth (especially in the non-mineral-based sectors o f the economy). Chapter 4 discusses policies to relax infrastructure bottlenecks in the context o f regional development and Mongolia's unique geography. The next two chapters discuss policies that should ensure sustainable, high long- term growth. Specifically, Chapter 5 presents a menu o f policies tailored to address the mismatch o f skills workers bringto the market and those demanded by the market. Given that the mining and livestock sectors will remain central to the Mongolian economy for the foreseeable future, Chapter 6 discusses issues related to appropriate management and development o f its mineral wealth, as well as those arising from present practices in the livestock sector and others related to rapid urbanization in Ulaanbaatar. The chapter also examines the environmental consequences o f present practices in the livestock and mining sectors. Finally, in Chapter 7, the possibilities of governance failure, policy and other risks are analyzed to demonstrate their inhibiting effects on the achievement o f much higher long-term growth rates inthis natural resource dependant economy during a commodity price boom. One concludes that good macroeconomic management will be essential for maintaining high, sustainable growth which is essential to reduce poverty and achieve the Millennium Development Goals, as targeted inMongolia's draft National Development Strategy (NDS). This will require makingrealistic assumptions on prices o f minerals, avoiding unsustainable and untargeted social transfers and unproductive investments, prioritizing infrastructure investments given resource constraints, continued reforms that reduce vulnerability to external shocks, and improving transparency and governance o f public administration. xxi COUNTRYECONOMIC MEMORANDUM 1. LOOKINGBACKTO GAUGETHE FUTURE Mongolia has managed the transition JEom a planned economy to a market economy quite well relative to most other countries in similar circumstances. In a space of 15 short years it has made much progress in undertaking fundamental economic reforms centered on price liberalization, privatization and the establishment of market institutions. These efforts are reflected in the growth performance of the Mongolian economy over the period and the accompanying structural changes in the economy. Concurrently, progress has been made towards reducing the incidence of poverty. But some of the very developments that have shapedrecent economic conditions and history are likely to become constraints to Mongolia's continuedprosperity and maintenance of high growth rates. 1.1 Mongolia commenced the transition from a planned economy to a market-based economy in 1990. Today, it is facing a number o f challenges borne by its geography and its history. It is a large landlocked country with a land area of some 1.5 million sq. km with a relatively small population. Consequently it has the distinction of being the least densely populated country in the world, with 1.7 persons per sq. km, compared to 137 and 8.5 for neighboring China and Russia, respectively. Climatic conditions are severe with mean average temperatures ranging from -4OC to +4OoC during the short summer season. Other Table 1.1: Selected Indicators,Mongoliaand some Comparators,2005 (million (us$) in growth rate- % in largest millions YO city (%) km2) Azerbaijan 1,240 8.4 1.o 43.7 98.8 0.1 Cambodia 380 14.1 2.0 73.6 0.2 Ghana 450 22.1 2.0 19.2 57.9 0.2 Kazakhstan 2,930 15.1 0.9 13.0 99.5 2.7 KyrgyzRepublic 440 5.2 1.2 47.6 98.7 0.2 Mongolia 690 2.6 1.6 37.6 97.8 1.6 Uruguay 4,360 3.5 0.7 42.0 96.5 0.2 Uzbekistan 510 26.6 1.5 22.3 98.7 0.4 Vietnam 620 83.0 1.o 22.7 90.3 0.3 Memo: East Asia andPacific 1,627 1,885.3 0.8 7.4 90.7 15.9 Low Income 580 2,353.0 1.8 17.1 61.5 28.2 Note: a/ latest available year, in most cases 2004. Source: World Development Indicators database, WorldBank and Bank staffestimates. LOOKING BACKTOGAUGETHEFUTURE - I - kfONGOLIA: facets of the country's endowments have been positive-namely a well educated populace as reflected in a 98 percent literacy rate, a strong sense of cohesion and well developed social capital due to a near absence of ethno-linguistic variation, a vibrant political democracy and a wealth of largely untapped mineral deposits. These factors have shaped its economic development, particularly since the early 1990s. 1.2 Gross National Income (GNI) per person in 2005 was at US$690 having roughly doubled since 1995 when it was US$330. This places Mongolia in the group of countries classified as low income. Other countries of similar income level include Vietnam, and Uzbekistan (Table 1.1). With more than half its population estimated to be living in Ulaanbataar, the capital city, Mongoliais also one of East Asia's most urbanized countries. OUTPUT, GROWTH AND EMPLOYMENT 1.3 Among transition economies, Mongolia hasperformed well. Following the withdrawal of transfers from the Former Soviet Union (FSU), Mongolia like most planned economies suffereda "transformational recession" during 1990-93 that ledto a cumulative decline inreal output of some 20 percent. Since then, despite a number of crises Figure 1.1: Real GDP--Mongolia and Other Transition Economies, and setbacks, when viewed against 1990-2004 (1990*100) the performance of other transition 150 7 I 140 - economies in terms of real GDP 130 . (with 1990 as the base year), 120 . Mongolia has outperformed most 110 . East I Cen. Europe (Figure 1.l).' Specifically, when compared to individual transition 'f economies, Mongolia has 70 outperformed all such countries BO except for Poland during the 1990- 50 2004 period, including Albania, the lob: Based on wnstanl2ooous.1994 1990 1992 1988 1998 20w 2002 2004 Czech Republic, Hungary, the ioum: WDIDatabase, World Bank.dollars. Slovak Republicand Slovakia. 1.4 The transformational recess-ion in Mongolia was also shorter than in most other transitional economies. This has been attributed to a number o f factors. First and foremost among transitional economies, Mongolia was relatively less industrialized than its peers, with a majority of its population engaged in traditional activities (mainly animal husbandry and agriculture). To some extent this may have also provided a certain degree of natural social protection, thereby lowering the call on fiscal resources associated with state-sector restructurings that were seen elsewhere. Other factors which mitigated the size and duration of the transformational recession are believed to be the early adoption of structural reforms and market-based institutions. For example, Mongolia moved swiftly to establish an open trade policy and a freely floating exchange rate regime. While Mongolia has also suffered The country groupingsutilizedinFigure 1.1, comprised: (a) Baltic States-Estonia, Latvia,andLithuania; (b) Commonwealthof IndependentStates-Armenia, Azerbaijan, Belarus, Georgia,Kazakhstan,Kyrgyzstan, Moldova, Russia, Tajikistan, Ukraine andUzbekistan;(c) EastandCentralEurope-Bulgaria, CzechRepublic, Poland, SlovakRepublic, and; (d) Resource Rich-Azerbaijan, Kazakhstan,RussianFederationandUkraine. - 2 - CHAPTER I: COUNTRYECONOMICMEMORANDUM bouts of inaction on reforms and attendant crises, it is Figure 1.2: Ittook a decade for real GDP to recover noteworthy that there has been _ _ ~ . _ _ _ _ . _ _ _ __.I_____ ~ _ . . relatively little reform reversal. 1000000 - Finally, in Mongolia the transition to a market economy 800000 . was not hindered by widespread social and political unrest as was seen in so many EasternEuropean countries. By 2001, Mongolia's real GDP had recovered to the level enjoyed at the onset of its transition process (Figure 1.2) 1990 1991 1992 1893 1994 1995 1896 1997 1988 1998 2000 ZOO1 but due to the population Sourm:National Sfatislioal Omoe OfMongolia. increase during this period, the end result wasa 15 percent lower real GDP per capita. 1.5 The GDP growth that occurred in the first decade since 1993 was driven by the primary sector but severe weather thereafter blocked the growth path. Between the years 1994-99, livestock husbandry and agriculture output was expanding at an average rate of 4.4 percent annually. This was due in large part to the "efficiency dividend" associated with liberalization of state farms and collectives, and the emergence of private ownership in this sector. Fortuitously, farm sector reforms that were introduced prior to 1990 were also beginning to bear fruit around this time and they complemented the market reforms that were being undertakeninthe primary sectors2These early reforms included increased autonomy in farm management, improved education, and provision of incentives. But, the years 2000 and 2001 saw devastating winter dzuds and withering summer droughts which, in turn, led to a staggering collapse in this sector's output by nearly one-third. The brunt o f this was borne by the livestock sub-sector as some 7.5 million animals perished leaving the national livestock herd severely depleted. Another similar, but less severe, dzud occurred in 2002 as well leading to further contraction of the primary sector of the economy. 1.6 The performance of the secondary (or industrial) sector-which includes mining, manufacturing, and construction and utilities-was more mixed during the early years of the transition as it bore the brunt of adjustment. The sector experienced annual losses in real output averaging 10percent during 1990-93, Since then, there has been a gradual recovery but the improvements have not been consistent. Enterprise restructuring in the manufacturing sector led to real declines averaging 14 percent in each of the years 1996 and 1997. Later, in 1999-2000, manufacturing output declined again, primarily as a result of the end of garment import quotas associatedwith the U.S. MultiFiber Arrangement which saw Mongolia quickly lose this sub-sector almost in its entirety. Meanwhile, mining activities were taking off. Despite being a small minerals producer sensitive to global commodity market demand * Detailed farm level analysis of Mongolian agriculture shows Total Factor Productivity (TFP) growth turning positive and significant inthe second halfof the 1980s and attributes this to the new policies and reforms. See Bayarsaihan(2003) for details. LOOKINGBACKTOGAUGETHEFUTURE - 3 - MONGOLIA: conditions and prices, after an initial output collapse in 1991,the copper-dominated mining sector inMongolia grew at a healthy rate of 5.6 percent during 1996-2001.3 The construction and utilities sub-sector has mirrored the overall trends in the rest of the economy during this period. 1.7 Mongolia's tertiary sector output has moved in line with trends in government spending. Real output of the tertiary or services sector collapsed during 1990-93, suffering a cumulative decline of nearly one-quarter over the period. In large part this was the result of the severe contraction ingovernment spendingthat was necessitateddue to the withdrawal of transfers from the FSU. Another major contraction inthe sector occurred in 1996 arising from the fiscal adjustmenteffort necessitatedthat year to free uppublicresourcesto recapitalize the banking sector. Thereafter, the tertiary sector continued to expand (in excess of 6 percent per annum, on average) until2001. This improvement was fueled inpartby increasedgovernment spending on education and health as well as the fiscal stimulus arising from the banking crisis of 1997. 1.8 The twenty Jirst century has seen economic performance improve significantly4. Sectoral developments have been much more favorable for Mongolia during the second decade of its transition to a market based economy and much progress has been made. Agricultural performance improved sharply, underpinned by a sustained recovery in the livestock sector-following the devastating dzud of 2002-which saw the national herd increase to over 30 million head in 2005, approaching the levels existing before the crisis. Agricultural sector output has expanded at an average rate of nearly 10 percent a year during 2002-05. 1.9 Overall, the secondary sector has also performed relatively well during the recent period, averaging real increases of 7.7 percent a year during 2001-04 before contracting by 0.9 percent in 2005. Much of this overall positive performance has been due to the rapidly expanding mining sector which posted increases of 34.3 percent and 11.3 percent, respectively, during 2001-04 and 2005. The increase in mining value added is a result both of newactivities andprojects coming on stream as well as the recent runup inglobal commodity prices. The manufacturing sub sector expanded at an annual rate averaging 8 percent during 2001-04 this growth coming from a number of areas including food and non-food production. In 2005, however, the sector contracted by 1 percent, mostly due to a collapse in the production of textiles and garments. This was due to closure of a numbero f garment facilities, mostly foreign owned, that was prompted by the removal of quotas on Chinese exports of textiles and apparel to the U S and EU. 1.10 The big story in the turnaround in Mongolia concerns the tertiary or services sector. This is the largest sector of the economy and has beenthe most consistentperformer over the past five years, averaging 8 percent annual growth during 2001-04 and 9.1 percent in 2005. 3 The national accounts data preclude isolation o fmining sector value-added before 1995,although industrial production data is available for earlier periods. 4 Measurement issues in the estimation o f sectoral value-added have understated the value o f GDP historically. The National Statistical Office o fMongolia commenced work in2006 to rectify the situation. As a consequence o f this exercise historical estimates o f GDP are expected to be revised upwards. - 4 - CHAPTER I: COUNTRYECONOMIC MEMORANDUM This good performance has been driven in the recent past by growth across the spectrum, but especially inretail and wholesale trade, transport, communications and financial services. 1.11 Mining sector value added as a share of GDP has only recently started to grow and future prospects are bright. The recent boom inglobal prices for copper and gold, Mongolia's two main mineral exports, has fueled considerable public debate about the role o f the mining sector as the engine o f the country's future growth. This aspect will be discussed in more detail in Chapter 5. However, looking at the available historical data, two factors need to be kept in mind. First, that mining has tended to develop as an enclave activity nearly everywhere inthe world and it has been quite challenging to build backward linkages to other sectors in the relevant economies in order to promote economic development and employment. Aside from obvious multiplier effects o f mining related spending in the economy and some spin-off activities from mining, the present effect o f the sector on the economy i s quite minimal simply because it has, until now, been a very small part o f the economy. In 2005, mining accounted for 25 percent of GDP, 71 percent of Mongolia's exports and 13 percent o f government revenue. The situation will, o f course, change further in the near future as the newly discovered deposits come on stream. Figures 1.3 and 1.4 suggest that despite the apparent near doubling o f the share of mining activity in GDP between 2001 and 2005, when one examines the same ratio at constant prices, the effect i s much less pronounced-mining has only increased its share in GDP by two percentage points over the decade. This serves to underscore that the recent expansion o f the sector has primarily emanated from the price effect. Figure 1.3: GDP Performance, 1996-05 Figure 1.4: Mining Sector Performance, 1996-05 1,400 25% __ - - - - 180 1 `e 1,200 8n /t 160 1,000 20% -- 140 3 0 E -- 120 E 8 $ 800 0 m Non-mineralGDP / 15% -- 100 Q c 3 600 -- 60 Em u) I 400 s 10% -- 60 I 0 5% -- 40 .E 200 -.-- -- 20 m 0 0% T o 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 19961997 1998 19992000 2001 2002 2003 2004 2005 source National Statistical Omceof Mongolia iource:National Statistical Ofr7ceof Mongolia. 1.12 Developments in aggregate demand havefavored consumption. Following a reduction inoverall demand duringthe period of 1990-94, the structure of demand shows an increasing trend punctuated by rising private consumption and very modest increases in investment, while public consumption has been quite constant following some compression in 1995-96 (Figure lS(a)). Thereafter, increasing levels o f real private consumption have been the key drivers o f GDP growth (Figure lS(b)). It appears that increasing private consumption has LOOKING BACKTOGAUGETHEFUTURE - 5 - MONGOLIA: been the key ingredient to maintaining growth and income levels since the start of the transition. Measured against the unfavorable alternative of poorly selected investments which could have reduced longer term growth, this can be considereda fortuitous outcome. Figure 1.5(a): The structureofdemandhas ....which has IedGDP growth favoredprivateconsumption .... Figure lS(b): 140 I -1,000, , 15% 120 10% 100 80 5% (3 g 60 c) 0% % s t 40 -5% f 20 on -10% 0 -I5% -20 1991 1993 1995 1997 1999 2001 20032005' Source: National Statistical OBce of Mongolia and Bank staffestirnales. Source: National Statistical Office of Mongolia and Bank staff estimates. 1.13 Employment collapsed in the aftermath of the withdrawal of direct financial support from the FSU in 1990 and the unemployment rate spiked at a reported 9 percent in 1993, thereafter remaining around 7 percent until after the banking crisis in 1997. This reflected the depressed labor market conditions well. Given that unemployment benefits are minimal and only last for a few months, there is little incentive to register as "unemployed". Thus, it is well accepted that, at least until 1997, official figures grossly understatedthe unemployment rate. In 1997, it was believed to be some three times higher than the figures contained in official statistic^.^ Some evidence of this existence of the discouraged labor (disguised unemployment) can be deduced using the official data. Although, unemployment is recorded to be falling quite rapidly, especially after 1997, employment numbers are on the rise but not commensurately. That is largely explained by labor force participation rates which have fallen steadily through out the period (Figure 1.6(a)-(c)). 1.14 Consistent with such a view, that "hidden" unemployment i s on the rise, the employment and labor force data also show an increase inthe number of persons of working age who are neither employed nor registered as unemployed. This figure nearly doubled between 1992 and 2005 (when it stood at 566,000 persons). Undoubtedly, the public sector restructurings and privatization programs, that saw some 47 large enterprises and over 400 small enterprises and assets privatized between 1999 and 2004, contributed to the pressure on labor markets. 1.15 Underemployment is also significant, particularly in rural areas and for workers "employed" in the livestock sector. The livestock sector officially accounts for 40 percent of Mongolia's total workforce (although), and the official unemployment rate in rural areas is only 4.2 percent. These figures, however, may mask the true extent of rural under- employment. The agricultural sector only accounts for 22 percent of GDP and at $888 per 'WorldBank,1997. - 6- CHAPTER 1: COUNTRY ECONOMICMEMORANDUM year (World Bank 2006i) the value added per agricultural worker i s low by international comparisons and suggests that many officially listed as agricultural workers may in fact be only working part-time in the sector. To some extent, this may be explained by the rise of informal employment opportunities in rural areas, such as "ninja" mining, though even with this, it is likely that underemployment is asignificant rural phenomenon. 1.16 The significant increase in hidden unemployment noted above, has given rise to a large and growing informal sector: those who are discouraged from finding formal employment inexchange for a wage or salary, have increasingly turned to household or other activities to earn cash. At the national level following a surge in 1991,household income from informal sources and a concurrent rise in the share from household or other activities, suggesting a fundamental structural change in that sector of the economy as a result of the transition to a market led economy (Figure 1.6(a) and 1.6(b)). Figure 1.6(a):Unemployment hasfallen faster than Figure 1.6(b): while labor force participationrates ... employment growth ... have declined 10% , I1,000 78% I / ,I 9% 900 76% - -E 8% 800 74% - 7% 700 f 72% - 15% 6% 600 eE 70% - 500 E 4% 400 68% - a 3% 300 f 66%- 2% 200 64% - 1% 100 62% - 0% 0 1992 1994 1996 1998 2000 2002 2004 1992 1994 1996 1998 2000 2002 2004 ource: National Sah`stical Omce Of Mongoliaand Bank staffestimates. Source: National Satistical Omce of Mongolia and Bank staff estimates. Figure 1.6 (c): ...suggesting that hidden unemployment may be on the rise 1.17 Mongolia's existing human capital i s being underutilized. Using international definitions of employment, data from the LSMS 2002-03 shows that while unemployment remains a problem 1000 (particularly among youth), the main group OI Reg sterea * n ,nempoyec of working-age people without jobs are z0 800 8 those who are not looking for ajob and not 600 E in school (Le., idle), suggest that it is the 400 Employea working age individuals who are idle and 200 are not looking for a job. Interestingly, those who are working are indeed working 0 1092 P 9 4 a 9 6 P 9 8 2000 2002 2004 long hours (48 hrs per week on average). ource NatmalSlati?lioal Officeof Mongollaendt3ank daff sdimales LOOKING BACK TOGAUGE THEFUTURE - 7- MONGOLIA. Table 1.2: Employment Status of Working Age Population by Location and Gender (%), 2002 Urban Rural National Male Female Total Male Female Total Male Female Total Labor force 56.5 54.6 55.5 76.9 70.6 73.8 65.4 61.3 63.3 Of which unemployed 9.5 8.8 9.2 3.9 4.8 4.3 6.6 6.9 6.7 Ofwhich employed 51.2 49.8 50.5 74.0 67.4 70.7 61.2 57.1 59.1 Ofwhich employee 69.8 72.5 71.2 19.6 21.9 20.7 43.1 47.7 45.4 Ofwhich selfemployed 30.2 27.5 28.8 80.4 78.1 79.3 56.9 52.3 54.7 Idle 25.3 26.3 25.8 12.9 15.5 14.2 19.8 21.9 20.8 Notes; Working age population is by Mongolian definition: 16-59for men, 16-54for women SeEfemployment includes unpaidfamily labor. Source: LSMS 2002, based on the employment status in the 7 daysprior to the survey interview. 1.18 Unemployment mainly affects young people. One also finds that those young people with secondary education who are currently unemployed are mainly living in urban areas. Overall, about 7 percent of the labor force is unemployed, which is not high by international standards (Figure 1.7 and 1.8). The unemployment rate among the 16- to 24-year-olds is 13 percent, accounting for 40 percent of the unemployed, and the ratio of youth to adult unemployment is 2.6. Unemployment rates, however, do fall quite dramatically at later ages. Unemployment is significantly higher in urban areas (9 percent) than in rural areas (4.2 percent). Unemployment affects mainly those workers with secondary education (9.3 percent of upper secondary graduateshbut vocational graduates don't do well either (6 percent). Figure 1.7: Unemployment is higher among the youth.. . Figure 1.8: ...but higher education does not mean employability within Mongolia Unemployment rates (%) Unemployment ratesby education level 30 .................................................................. 25 ............................................................. 10 20 ......................................................... 4 86 2 0 I 16-24 25-34 3544 45-54 55-59 ItotalImaleIfemales0urban0rural Source: LSMS2002. Figure 1.9: Most of the idle workers are of working age.. . Figure 1.10: and those with no education ... I Idleness rates (Yd Idleness rate by level of educatlon, 2002 30 25 20 15 10 5 0 none primary lower Upper sec. sec. vocational diplomab acheIor 16-24 25-34 3544 45-54 55-59 I I Itotal Imale Ifemales urban B rural 1 I Source: LSMS2002. Source:LSMS, 2002. - 8 - CHAPTER I: COUNTRY ECONOMICMEMOM NDUM 1.19 The distinctive feature o f the Mongolian labor market, from the humanresource side, i s the high idleness rate, which mainly reflects "discouraged workers". About 21 percent o f the working age population is not working, not looking for a job and not in school (Figure 1.9). This mainly reflects discouraged employment rather than engagement in domestic duties, as males and females have similar idleness rates (20 percent and 22 percent, respectively). In fact, Figure 1.10 shows that idle-workers are not a rural phenomenon (idleness rates are even higher in urban areas, 26 percent, versus 14 percent in rural areas). Nor i s it a temporary problem o f youth since idleness rates remain high throughout working life and peak just before retirement age. Idleness rates are particularly high among workers with no education (28 percent) and vocational educationgraduates (26 percent). 1.20 Another distinctivefeature, even in the Government, is the extensive use of temporary employment contracts in the labor market. These contracts are used in response to the high social security taxes employers have to pay for permanent workers. Hence, underreporting o f labor costs is also widespread to avoid the burden o f high social security taxes. In addition, temporary contracts are not regulated by the Labor Law and so temporary workers do not enjoy the protection and benefits, including social security benefits that permanent workers do. There are no reliable figures on contract workers, but according to administrative data only 20 percent o f workers have permanent contracts (the other 80 percent includes self- employed, contract workers, subcontracted workers and workers without contract). facilitated by the influx o f rural Influx of migrantsto UB migrants into Ulaanbaatar (Figure 1.11), as they usually take the least 45000 protected and lowest benefit jobs. 40000 35000 Thus, migrant workers are a 30000 25000 particularly vulnerable segment o f the 2woo urban labor market. O f course, 15000 temporary contracts should be part o f 1woo 5000 the system, but their use should be 0 more regulated to ensure that these 90 91 92 93 94 95 98 97 98 99 00 01 02 03 04 05 temporary workers are granted more Source` Mongolia Statistical Yearbook Various issues. protections and be integrated in the country's social security system. Social security taxes need to be rationalized to reduce the incentive o f firms to evade these taxes by resorting to issuing temporary employment contracts. 1.22 Inspite o fthe difficult labor marketconditions the economy has generated on average about 20,000 newjobs a year since 1994, mostly inthe private sector. As a result, by 2005 the private sector accounted for three-quarters o f total employment in the country. While this performance falls far short o f the increase in the labor force, which added approximately 10-12,000 persons each year the challenge for the future will be ever more difficult as the LOOKING BACKTO GAUGE THEFUTURE - 9 - MONGOLIA: labor force is expected to increase by 250,000 new entrants over the next decade. The majority of the newjobs created since 1994, numbering over 126,000 have beeninservices in the Tertiary sector while nearly 50,000 newjobs were created inAgriculture with the balance in the Secondary sector. Within the latter, it is worth noting that of late, the manufacturing sub-sector has suffered a net decline of nearly 18,000 jobs over the period, reflecting the results of enterprise restructuring, as well as, the impact of the expiry of the US MFA in the textile and garment industry. 1.23 The demandfor skilled and educatedworkers is rising inMongolia. The skills that are in increasing demand include jobs that require critical and creative thinking, good communication skills, leadership, teamwork, practical and technical knowledge (e.g., in Information Technology) and English language skills. This rising demand, however, is unmet by available supply of potential workers, including the younger workers, in part due to the current education and training systems inthe country. Figure 1.12(a):Overall, h o u s e h o l d i n c o m e f r o m Figure l , l Z ( b ) : ..but f o r r u r a l households t h a t ii i n f o r m a l activities appears to be declining ... n o t the c a s e , s u g g e s t i n g a large i n f o r m a l s e c t o r imo mo . $ w, v -E G) 7 0 0 . mo- C z2 2 400. 8 a 3 0 0 . I220. Householdhother Housnhold6 other , , activ;ties, , , , , , , , , , , 100. 1.24 The recent Investment Climate Assessment (ICA) (World Bank, 2006) finds that although the Mongolian economy has grown significantly since 2002 (with an unprecedented GDP growth rate of 10.6 percent in2004, the highest inthe East Asia at the time), this has not generated commensurate increases in employment in the Mongolian private sector. The sectors that have grown the most in terms of GDP share, particularly mining, have been relatively capital-intensive, as indicated by changes in sectoral employment shares (Table 1.3). Also the growth injob opportunities has been confined to urban areas, mainly UB, and has been fueled by large migration flows from rural areas. In fact, less than half of the firms surveyed in the ICs who were operating by 2001 had added any jobs over the period 2001- 2004 (Table 1.4). Micro-enterprises tended to create jobs at the time of start-up. Small and medium enterprises (SMEs) appear to be the locus of job creation-nearly 60 percent o f SMEs addedjobs. Entrepreneursonly accountedfor 1.6percentofthe labor force. - 10- CHAPTER 1: COUNTRYECONOMIC MEMORANDUM Table 1.3: Sector-wiseContributionsto GDP and EmploymentGrowth Share of Employment ( O h ) Share of GDP (YO) Change Change 2001 2004 2001-04 2001 2004 2001-04 Agriculture, livestock,forestry and fishing 48.3 40.2 -8.2 24.9 21.3 -3.5 Industry Miningand quarrying 2.4 3.5 1.1 9.0 17.3 8.3 Construction 2.5 4.1 1.7 2.0 2.6 0.6 Manufacturing 6.7 6.0 -0.7 8.1 5.3 -2.7 Services Wholesale andretail trade 10.8 14.1 3.2 26.7 24.6 -2.1 Hospitality 2.0 3.0 1.o 1.3 1.o -0.3 Transport 4.2 4.4 0.2 13.0 12.7 -0.3 Financial,real estate and business 1.7 2.9 1.2 4.2 5.3 1.1 Others (utilities, social, public) 21.4 21.8 0.4 10.9 9.8 -1.1 Source: National Statistical Oflce of Mongolia (ZOOS)? Monaolia Statistical Yearbook. Table 1.4: Have MongolianFirmsBeen CreatingJobs? Fraction (YO)of firms which: No Added Created jobs Share of all Shed jobs change jobs through entry firms (YO) All firms 17.8 27.1 40.4 14.7 100.0 By industry cluster Construction 12.3 31.7 42.8 13.2 25.7 Apparelandtextiles 25.9 26.4 43.5 4.2 15.5 Foodand beverageproducts 22.6 18.2 38.5 20.7 21.6 Woodproducts 8.8 19.2 43.1 28.9 6.9 Hides and leather products 24.6 34.9 40.5 0.0 5.6 Business services 19.9 31.2 36.4 12.5 18.6 Tourism 16.1 20.0 36.7 27.2 6.1 By initial firm size (# of permanent workers) Microenterprises (< 10) 7.4 32.9 25.6 34.1 43.O Small andmedium (10-99) 21.4 21.7 57.0 0.0 41.4 Large (>= 100) 37.3 25.5 37.2 0.0 15.6 By ownership status Domestic private 16.4 28.5 39.1 16.0 84.1 Foreign 11.0 18.6 59.1 11.3 10.1 Public-sector 49.9 21.8 27.0 1.3 5.8 Source: Mongolia Productivity and Investment Climate Survey, 2004 1.25 Public sector wages now exceedprivate sector wages in Mongolia. Wage growth in recent years has been robust. Available data indicate that real wages in the public sector have risen at an average annual rate o f nearly 9 percent in the five years to 2005, while wage growth across all sectors averaged just under 5 percent over the same period. This i s an indication o f both slower wage growth in the private sector and o f the relatively tight labor market conditions (Figure 1.13(a) and 1,13(b)). As a result average wages inthe public sector exceeded average wages across the entire economy for the first time in 2005. The 30 percent wage increase granted the public sector in2006 i s estimated to have widened the gap between LOOKING BACKTOGAUGETHEFUTURE -11- MONGOLIA: public and private wages further. This will be exacerbated even further by the planned 20 percent increase for 2007 that is contained inthe approved 2007 budget. Figure 1.13 (a): Public sector wages have been rising.. .. Figure 1.13 (b): ...faster than Private Sector wages 2 180.0 ~~~ 5 5 10% , 160.0 MNT) 5 5% ................... 140.0---(in,thou.s&lr Private average 0% E 120.0 $ 4 % 100.0 59x-10% &80.0 ;-15% -20% B 60.0 d 2000 2001 2004 2005 40.0 I 2002 2003 2006 2007 2000 2001 2002 2003 2004 2005 2006 2007 Plm plan Source: MOF and Bank staff estimates 1 Source: MOF and Bank staffestimates 1.26 International sound practices in civil service reforms suggest that, in general, public sector wage growth should be restrained and based on productivity increases or guided by comparable private sector wages, which are generally more competitively determined. The recent increases in civil service, wages without a civil service census or commensurate civil service reforms, runthe risk of undermining labor competitiveness inMongolia. This, in turn, may be to the detriment o f the private sector and its growth prospects. Furthermore, the recent wage increases raise the unwelcome prospect o f triggering higher inflation. While the real wage index for the economy showed a cumulative increase o f 20 percent over the period 2001-05, some sectors were clearly more dispersed. For example, financial intermediation services experienced the largest increase, amounting to 114 percent over the period while the hotel and restaurant sub-sector experienced a 27 percent real increase. Meanwhile, real wages in agriculture were down 19 percent, probably reflecting the residual effects of the severe weather of 2000-02, while those employed in real estate and rental industries on average earned 10 percent less duringthe period 2001-05. Fiscal and Monetary Developments 1.27 Inflution pressures remain persistent. The collapse in output during 1990-92 was accompanied by a large increase in inflation which spiked at over 300 percent Flgure 1.14: Inflation has been broughf under control in 1992. This first bout o f inflation was 350 I- fueled by the price deregulation reforms o f early 1991. Subsequently, thanks to monetary restraint during 1993-94 inflation was on a declining trend but remained persistently around 50 percent during 1994-96, partly because o f ongoing adjustments in relative prices, such as the 1991 1993 1995 1997 1999 2001 2003 2005 energy price adjustments o f late 1996 Source NLlond s1dIsfIcY Officeof Monpolla nd Bsnk st#f ulmdu - 12- CHAPTER I: COUNTRYECONOMICMEMORANDUM (Figure 1.14).6Increasingly the causes of inflationbecame more complex, as did the measures required to contain it. Fiscal pressures emanating from the need to support ailing public enterprises were aggravated in 1996 by the banking crisis: first, because resolution of the crisis required a greater call on budgetary resources; and second the loss of public confidence in the banking system resulted in a large movement out of deposits and into domestic and foreign currency, blunting the effectiveness of monetary policy to control inflation, and placing downward pressure on the togrog which depreciated sharply in late 1996, adding further to inflationary pressure. 1.28 Stabilization was achieved through implementation of a new round of comprehensive reforms commencing in late 1996 and centered on restructuring of the banking system, higher domestic interest rates, tight fiscal policy and included other measures as well. Together these measures succeeded in reducing inflation progressively and for the first time to single digit levels in 1998. Thereafter, inflation was on a declining trend until 2002 when the Consumer Price Index increased by only 1.6 percent. Inflationary pressures re-emerged in mid-2004 as food and fuel prices rose rapidly, and increased again in2005 due to an expansion indomestic credit growth. These have subsided in 2006 with inflation registering an increase of 3.4 percent betweenJanuary and June. 1.29 Fiscal consolidation has relied heavily on foreign grants and loans. The fiscal situation deteriorated rapidly in 1991-92 with the budget deficit approaching 25 percent of GDP in 1992, under the weight of subsidies, mainly to state owned enterprises. Thereafter, the effects of a concerted adjustment effort were beginning to bear fruit by 1995 when the deficit once again burgeoned in 1996 due to the collapse of copper prices and election related spending pressures. The deterioration continued through 1998 with the fiscal deficit skyrocketing to 13 percent of GDP. 1.30 A recovery incopper prices in 1999 marked a new phase in Table 1.5: Fiscal Indicators, 1997-2006 fiscal consolidation efforts which (percent of GDP) have been maintained to date. 1997- 2001 2002 2003 2004 2005 2006 2000 Est. While NKXessive budget deficits Current Balance 1.6 5.7 4.4 7.6 8.8 9.3 12.3 have been smaller, these have been Overall balance -13.9 -4.5 -5.9 -4.2 -2.1 2.9 5.1 the result of strong savings efforts Primary balance -12.1 -3.1 -4.3 -3.0 -0.9 3.8 5.7 as increasing surpluses have been generated on the current side Source: Ministry of Finance and Bank staffestimates. (Table 1.5). At the same time commensurate improvements have occurred in the primary balance, which for the first time registered a surplus in 2005 and again in 2006. The fiscal consolidation effort has focused on bothreducing expenditures and a strong revenue effort but a key ingredient which has facilitated it has been the considerable foreign assistance which has gone towards financing the Government's budget. (Figures 1.15 (a) and (b)). The recent Estimatedto have added 18 percentage pointsto inflationin 1996. LOOKING BACKTOGAUGETHEFUTURE -13- MONGOLIA: global commodity price boom has also contributed in this regard7. The fiscal consolidation efforts can rightly be thought o f as the cornerstone o f Mongolia's macroeconomic stability. I I Rgure 1.15 (a): Rscal Consolidation is evident in Figure I.lS(b): ...andit has all been foreign expenditure compression and revenue effort... financed -5.0% - II/JLlv 4 U Delioil Domeatlc j I -10.0% J I 1996 1997 W 9 8 1999 2000 20012002 2003 2004 2005 2001 2002 2003 2004 2005 2006 ioume.Minisfryof finance,Mongolia. S o w ~ ~ M i n i s t r yFo fi m . ,Mongolia 1.31 Underscoring these trends, budgetary performance in 2005 was exemplary relative to the planned budget at both the aggregate level as well as with respect to key components. Specifically, an overall surplus equivalent to 3 percent o f GDP was achieved (compared to a planned deficit o f 3.2 percent o f GDP) largely on the back o f a revenue windfall accruing from higher than expected global copper prices. As a result, corporate income tax receipts were about Tg33.3 billion (or 38 percent) higher than programmed, equivalent to 1.5 percent o f GDP. But revenue performance was better than budgeted across the board with nearly all categories o f tax revenue exceeding the budget plan-overall tax revenues in 2005 were 4.1 percentage points o f GDP higher. On the expenditure side, overall spending came in at about 2 percentage points o f GDP lower than the budget plan. Notable about this performance is that the all important category o f current expenditure was on target, with spending for wages and salaries being held slightly below the plan and that for goods and services exceeding the plan slightly. 1.32 The track record of meeting, if not exceeding its overall fiscal targets, be it through expenditure compression at the expense of spending on capital operations and maintenance expenditures, suggest that the need to maintain aggregate fiscal discipline through expenditure control appears to be entrenched in the minds o f the Government. There is, nonetheless, a need to now turn to improving the quality and efficiency o f public spending. This will require in-depth analysis o f government spending and should provide an opportunity for benchmarking in various areas, both as a baseline for Mongolia to measure its progress against, as well as, relative to other countries.' 7 Figure 1.15 (b) excludes the settlement of Ruble denominated pre-1990 debt, which was settled in 2003 as that was not relevant to budget financing. The settlement involved a 97.5 percent reduction in the principal amount which was valued at US$]1.4 billion. The balance was paid as a residual cash payment which was financed rartly from domestic sources and partly from foreign sources. The forthcoming World Bank Public Expenditure and Financial Management Review will aim to address this issue to some extent. - 14- CHAPTER I COUNTRYECONOMIC MEMORANDUM 1.33 As expected the combination of a growing economy and relatively stable macroeconomic conditions has led to an improving picture with respect to fiscal sustainability. This is reflected inthe trends of all relevant indicators (Table 1.6). After rising sharply through the Table 1.6: FiscalSustainabilityHasBeenImproving ... decade of the 1990s, both the ratio o f public (%) 1999- 2000 2001 2002 2003 2004 2005 2006/g debt to GDP and the Public Debt/ GDP 102 89 92 113 93 68 55 Net Present Value NPV Public Debt/ GDP 71 63 63 80 60 45 35 (NPV) of public debt Public Debt/ Revenue 328 226 239 301 251 203 150 to GDP have declined NPV Public Debmevenue 228 159 163 212 162 133 94 Debt Service/ Revenue .. 6.4 6.4 58.8 7.0 5.3 3.5 since 2000.9 At the same time the ratio of Source: Ministry of Finance, IMF and Bank staff estimates. debt service to revenue has remained stable, reflecting the increasingly concessional nature of new borrowings and strong revenue performance. 1.34 Monetary policy was effective in the 199Os, but was followed by a protracted and costly banking crisis. The conduct of monetary policy has been dominated by a number of crises especially during the early I I Figure 1.16: Monetary policy has been geared to 1990s. Initially the major priority combating inflation, especially in the 1990s was to contain the inflationary I pressures which had been triggered 90% by the successive rounds of price I I 1600% 80% Central Bank Bill Rate 140 0% 70% 120 0% liberalization that marked the early 60% 1000% stages of transition from a planned 50% 80 0% to a market economy (Figure 1.16). 40% 60 0% At the same time-and within these 30% 40 0% parameters-there were pressing 20% 20 0% demands for credit, mainly from 10% 0 0% the large government sector which 0% -20 0% <& 0-3,000,000,000 30 percent 3,000,000,001> 25 percent PIT 0-2,400,000 10 percent 2,400,001-4,800,000 Tg 240,000 plus20% of income exceeding 2,400,000 togrog 10 percent 4,800,001 and above 720,000 togrog plus 30% of income exceeding 2,400,000 togrog Mining Royalty Domestic 2.5% Domestic 2.5% Export 5 Yo Export 5yo 2.20 It is not only the tax rate that will influence the incentives for firms and individuals to undertake activities that will foster Mongolia' sources of growth but how they are collected (tax administration) and from whom (tax incidence). Calls for lower tax rates that one hears from the private sectors in most countries should thus be considered carefully with this in mind. WHAT WILLIT TAKE TOKEEP MONGOLIA GROWING? - 31- MONGOLIA: Table 2.4: Average Number of Days Spent a Year Meetingwith Tax Inspectors Mongolia 9.0 Europe & Central Asia 2.8 East Asia & Pacific 5.4 Azerbaijan 1.3 Cambodia 7.2 Kazakhstan 3.2 China 12.0 Kyrgyz Republic 3.2 Malaysia 3.8 RussianFederation 2.5 Source: WorldBank (2006b). 2.21 The tax code has resulted in a narrow tax base and possibly increased informality. Although in 2005 the total tax payable by a Mongolian firm was on average 32.2 percent of the gross profit for the year-a share lower than that of firms inother comparable countries in East Asia and elsewhere in the developing world, the tax code tends to harm the growth of Mongolia's private sector by creating incentives towards tax avoidance; aying less taxes by staying small; and creating unnecessary disincentives to start-upbu~iness!~As a result the tax base in Mongolia is very narrow. The top 100 taxpayers provided over 90 percent of the revenues (Table 2.5), and nearly half of the firms reported zero or negative profit in2004.16It may have also motivated firms to operate inthe informal sector. Fortunately, a major overhaul o f the tax code took effect on January 1, 2007 which tries to address a number of major shortcomings of the tax code, including the perverse incentives it causes for firms to avoid payingtaxes by staying small. Table 2.5: Mongolia's Tax Base 2002 2003 2004 No. of distinct tax statements filed 19,835 21,733 25,169 Compliance rate: % paying positive tax 58.1 54.4 54.4 % reporting negativeor zero net income 43.O 41.6 43.6 Share of EEOIT* paidby top 100 firms (%) 87.9 89.7 92.2 Source: World Bank (20066). *EEOIT standsfor "Economic Entity and Organization Income Tax Law ". 2.22 Problems related to tax administration (Figure 2.2) are also just started to get addre~sed'~. Uncertainties remain as to the expected impact of the new mining taxation regime on the incentives it generates for existing and new entrants in this crucial sector in Mongolia. The mining sector generated an estimated 40 percent of tax revenues in 2006, up from 16 percent the previous year.". The mining tax regime does not only entail the windfall profits tax but consists of a package of : corporate value added tax (VAT that has been lowered from 15 to 10 percent); personal income taxes (PIT) on its workers (unified for foreign and domestic workers at a 10 percent rate); windfall tax, royalties (that have been doubled from 2.5 to 5 percent); mining license fees (increased and its duration shortened in order to discourage speculation in mining rights and their underutilization); investment contracts (whose maximum duration has been doubled to 30 years), among others. In 15Double taxation agreementshowever have facilitated FDIand encouragedreinvestment. l6 The Productivity and Investment Climate Survey does not provide information on the amount of profits or lossesby firm. The ongoing World Bank GovernanceAssistance Project (GAP) has a sub-componentthat aims at providing relevant technical assistance to GDNT to improve tax administration. The ADB i s also supporting efforts in the MongolianCustomsAdministration to improve its operations. Source:IMF(2006). -32- CHAPTER 2: COUNTRYECONOMICMEMORANDUM evaluating the attractiveness of a taxation environment in a country, potential firms will typically look at this entire fiscal packagewhen deciding to open or expand operationsthere. Figure 2.1: Size Distribution of Mongolia's firms Figure 2.2: ...While the tax burden is large, in shows that there are only a few large firms... terms of tax rates and tax administration. 0 XGl5net ncom(000W4T) repfledfor lax purposes 0 W 100000 lMo00 QO x10 iD0 a0 4lO SnO a 0 700 Source: WorldBank (20066) based on datafrom General Wfnmdthgtar&aaamjcrusewc4t$& Departmentfor National Taxation (GDNT). Figure 2.3: EffectiveTax Rates Faced by Firms Otol 10to 50 to 100to 500 to Net income25 75 250 1000 reported on 2004 taxstatements (million MNT) Source: WorldBank (20066). 2.23 Tax evasion is also wide-spread as is the under-reporting by firms of labor costs.'' Over a third of the firms appear to be under-reporting their sales. The World Bank Productivity and Investment Climate Survey (2004) found that, on average, firms report just over a quarter of their true labor costs in an effort to reduce the burden of labor taxes. These taxes average 29 percent of a firm's gross wages, which are unusually high for an economy at Mongolia's level of development. A negative by-product of this under-reporting is that firms that distort their balance sheets inan effort to avoid taxes are a lot less likely to have access to financing at levels that allow them to grow and improve the quality and variety of goods they produce. 2.24 When it comes to trade-related taxes, Mongolia uses duty exemptions on exports in order to stimulate processing and assembly. Since Mongolia can be considered a price taker both for inputs and outputs o f most products, duty drawbacks are likely to do more harmthan l9Source:2004 Productivityand Investment Climate Survey. WHAT WILLIT TAKE TOKEEPMONGOLIA GROWING? - 33- MONGOLIA: benefit to Mongolia's small open economy.20This is because trade tariffs are already low and uniform (at 5 percent) in Mongolia while tax administration i s weak. Exemptions are granted not only to imported inputs but to all sorts o f product lines2' Such duty drawbacks also disadvantage domestic SMEs more since these small companies lack the expertise, incentives and political connections to go through the bureaucratic processes o f obtaining a duty exemption.22 Finally, an export tax on unprocessed cashmere, intended to encourage production and export o f processed cashmere products, has resulted instead in an increase o f smuggled cashmere into China, and has not led to the intended boost in processed cashmere output,23 2.25 The tax regime i s a binding constraint for Mongolia's future growth. The urgent need to structure an appropriate tax environment and administrative burden for economic entities to operate and help the country continue to grow i s well demonstrated by the sudden drop intax revenues from gold production in2006, when domestic producers reportedly sold to the Bank o f Mongolia 6 tons o f gold less between August 2005 and August 2006. This was further complicated by the filing o f suits against the Government by some firms who alleged that the windfall tax on gold was unconstitutional since the index price on the basis o f which this tax was to be computed did not exist. Need for better coordination internally and internationally 2.26 Firms need services, which require simultaneous, large scale investments, in order to Irinnovate", make profits and to market their products suc~essfully.~~developed countries In these services are taken for granted by entrepreneurs. In developing countries, however, lack o f such services i s a serious obstacle to output expansion o f existing products, improving the quality o f existing goods, and new product development ("self-discovery"). Examples o f such services include access to electricity, water, telecommunications, logistics transport networks, marketing, research and product quality information, health and quarantine measures to protect and improve the quality o f agricultural output. In a global economy entrepreneurs need also access to information on international industry standards, and international trade agreements in order to compete in world markets and understand the implications o f these agreements for their operations. 2.27 Coordination failures which create inefficiencies and stunt growth exist in Mongolia. These coordination failures stem from several areas, for instance: i. intradeandlogisticswithMongolia'sneighbors; ...ii. inthe laws andregulations that Parliamentpasses; 111. inthe sector strategies and corresponding implementationplansthat the Government designs; and 2oSource:UNCTAD/WTO 2006. 21While 3 1.5 percent of imports were duty exempt, only 10percent of imports were duty-exempt imports used for the production of exports in 2004 (World Bank 2006b). 22Studies have shown that duty exemptions are more likely to have a positive welfare effect if the economy is small with high input tariffs, low administrative costs, and uncormpt tax authorities (Ianchovichina, 2005). 23The government has plansto abolishthis export tax. 24See (Rodrik, 2004; Chandra2006). -34- CHAPTER2: COUNTRY ECONOMICMEMORANDUM iv. policies for natural resource management andminimizingenvironmental degradation, among others. This, supplemented by carefully selected prudent public investments in infrastructure, could have large beneficial impacts to deepen and diversify supply chains within Mongolia and generate growth, including in its mining and livestock sectors-the two sectors that will continue to be an integral part o f Mongolia's future growth story. For instance, in the cashmere industry there are a few processors o f cashmere who have buying power over a large number o f herders who are supplying raw cashmere. These herders operate in remote areas, lack information, and are often forced to sell their cashmere either to traders at the farm gate or at informal provincial markets at 10 to 45 percent discounts from the prices in the main market in Ulan Bator. Herders realize that poor quality raw cashmere is a problem and are reluctant to allow buyers to separate their raw cashmere into different grades. They fear that they may not be able to sell the rejected cashmere, and therefore prefer to sell it in one lot. Buyers have responded by buying unsorted raw cashmere at lower prices in order to hedge the risk o f poor quality. 2.28 Even if one wanted to invest in improving the quality o f the cashmere that they sell to the firms, herders have lacked access to finance, information and infrastructure. Processors could have helped herders to improve the quality o f raw cashmere but have been reluctant to enter into direct marketing or vertical relationships with them because o f lack o f transparent and enforceable contracting rules, and the difficulty to police such arrangements due to the small size o f herds per household and the long term nature o f the investment. 2.29 The problem has been compounded by lack o f market information that is available to herders, and the fact that processors have had no incentive to form strategic links with downstream agents and to improve their productivity as government policies generally favor them.*' The export tax on raw cashmere has provided incentives to processors to offer the same price regardless o f quality. Herders have responded by smuggling cashmere into China and selling quality raw cashmere to Chinese buyers, thereby depriving domestic processing firms o f high quality raw materials. This, in turn, results in Mongolian cashmere firms operating below capacity. High labor costs, unreliable energy supply, lack o f technical skills, non-tax administrative barriers, and high transport costs have added to the problems o f Mongolian cashmere processing firms.26 2.30 Another example o f coordination failure i s the government's inability to regulate the use o f critical inputs such as land and water which have led to overgrazing, near saturation o f land-use capacity, and soil erosion inMongolia. Lack o f regulation o f water well use and poor public sector maintenance have decreased agricultural productivity and have left herders searching long distances for water facilities. The combination o f these failures and the lack o f risk management have worsened the impact o f bad weather on the farm sector. Since sustainability considerations preclude further growth in the size o f Mongolia's herds, it i s essential to improve quality and efficiency by providing additional services to farmers. 25 Laborproductivity in Mongolia's cashmere processingcompanies is much lower than that in other countries (USAID, 2006) 26 A study by USAID (2006) foundthat overallthe manufacturingquality of cashmere apparelmakers is good. WHAT WILLIT TAKE TOKEEP MONGOLIA GROWING? - 35- MONGOLIA: 2.3 1 The remains the needto better coordinate the development o f an international railhoad network to facilitate transit, international, and domestic trade, and air transport to facilitate tourism and international trade. Mongolia's poor transport network i s a severe constraint to most activities in Mongolia, including mining. Given that infrastructure development takes resources and time, the government needs a transport strategy that addresses such logistics issues as soon as possible. Customs facilitation and transit procedures also need to be improved. Fortunately work on the latter has already begun. Table 2.6: List of SelectedProductLinesFacingTariffs above30 PercentinRussia Code Product Description MFNTariff 6 digits Rate 2003 020120 Meat of bovineanimals: other cuts, fresh or chilled, with bone in 30 020210 Meat of bovineanimals: carcasses and half-carcasses,frozen 30 220860 Vodka 30 020220 Meat of bovineanimals: other cuts, frozen, with bone in 31 650692 Other :--Of fur skin 31 020230 Meat of bovineanimals: boneless, frozen 32 020726 Meat and edible cuts and offal of turkeys, fresh or chilled 32 611710 Shawls, scarves, mufflers, mantillas, veils andthe like 32 020130 Meatofbovine animals: boneless, fresh or chilled 33 160250 Other preparedor preservedmeat, meal offal or blood of bovineanimals 33 640320 Footwear with outer soles of leather, and uppers which consist of leather 34 straps 630190 Other blanketsandtravelingrugs 37 640420 Footwear with outer soles of leather or compositionleather 37 160100 Sausagesandsimilar productsof meat, meat offal or blood 37 020110 Meat ofbovineanimals: carcasses andhalf-carcasses,fresh or chilled 38 420310 Articles of apparel, of leather or of compositionof leather 38 640510 With uppersof leather or compositionleather 41 620510 Ensembles:Ofwool or fine animalhair 50 020621 Ofbovineanimals, frozen Tongues - 50 420321 Gloves, mittensand mitts, especially designed for use in sports 82 640590 Footwear with outer soles of rubber, plastics, leather or compositionleather 82 621131 Other men'sor boys' garmentsof wool or fine animalhair 105 2005 640320 Footwearwith outer soles of leather, and uppers which consist of leather 30 straps 160220 Other preparedor preservedmeat, meat offal or blood: of liver of any animal 30 611110 Babies' garments and clothingaccessories, knittedor crocheted-of wool or 33 fine animal hair 020230 Boneless cuts 36 160100 Sausagesand similar products ofmeat, meat offal or blood 37 160249 Other preparedor preservedmeat, meat offal or blood 38 020220 Other cuts with bone in 38 420329 Gloves, mittensandmitts Other - 56 020321 Frozen-Carcasses and half-carcasses 58 020621 Ofbovine animals, frozen Tongues - 70 Source: Tarr, Shepotylo, and Koudoyarov (2005). See Tarr et al. (2005)for a complete list ofproducts facing &a@ above 30percent. -36- CHAPTER 2: COUNTRYECONOMICMEMORANDUM 2.32 Better coordination intrade and logistics with Mongolia's neighbors is imperative for growth as well. High protection in China and Russia on a number of key Mongolian exports has been cited as an obstacle to export growth. Indeed, in2003 a number of leather, wool and meat products faced tariffs above 30 percent in Russia (Table 2.6). Since then protection has declined in Russia, and remains high mostly on meat and meat related products (Table 2.6). At this time, however, the main obstacle to expanding meat exports is not the tariff, but the current ban on imports from Mongolia that was put in place after the outbreak of Hoof and Mouth disease inMongoliain2001. 2.33 The inability of Mongolianlivestock-based products to meet international sanitary and phyto-sanitary (SPS) requirements in foreign markets is a binding constraint to Mongolia's future growth that needs immediate attention domestically. To this end, facilitation by the Government and others (like self-governing private sector firm associations) to make widely available marketing, export promotion and product quality information is critical to the success of companies.27Many medium and small companies and companies operating in the informal sector do not have funds to license new technologies or to send their employees to foreign markets for training. Lack of marketing skills and information is one reason why Mongolian firms miss opportunities to expand inforeign markets. For example, they have not beenable to take advantage of the duty free access to the EUfor 7200 products. 2.34 Diversification and deepening of supply chains within Mongolia's mining sector i s also extremely important given the country's vast mineral wealth and high transport costs. The government of Mongolia however still does not have a comprehensive strategy for the development of the mining sector, and so far has not been effective intransforming its natural capital into intangible capital. 2.35 Finally, network of organizations-or knowledge clusters-is considered the main strategic and competitive asset of many developed resource-rich countries, which face increased competition from low-cost producers elsewhere (from Brazil, Chile and Eastern Europe).28 For instance, in Sweden, the network of institutions permeating the forestry industryhave beenessential for maintaining and developing international competitiveness and the dissemination of skills and research from universities and research organization to the industry (see Box 2.1 which expands on the roles of the different members of the network). The network was especially critical to collaborative research projects involving several industries' institutions such as the multi-disciplinary research program entitled Paper-Color- Print. The program had the goal of developing Swedish expertise in paper processing, paper coating and printingtechnology and was conductedjointly by the Royal Technical University, the Swedish Pulp and Paper Research Institute, the Institute of Surface Chemistry, the Graphical Research Laboratory, and the Swedish Newsprint Mills' ResearchLaboratory, with financing from these institutions, independentresearchfoundation and the government. *'According to Otsuka (2006) informationabout and access to markets, and access to specialized skills needed to improve product quality are critical to multi-faceted innovation, while access to credit matters only after multi-faceted innovation has taken place. His findings are based on research in a number of countries including China, Taiwan, VietnamandAfrica. 28This sectionis basedon de Ferrantiet al. (2002) and Blomstriim and Kakko (2001). WHAT WILLIT TAKE TOKEEP MONGOLIA GROWING? - 37- MONGOLIA: Box 2.1: Staying on the Cutting Edge through Partnerships between Academic Institutions and the Private Sector Three technicaluniversities in Sweden-the RoyalTechnical University,the Chalmers Technical University and the University of Karlstad-train engineers specializing in pulp and paper processing, biotechnology, and related fields. The industry's leadingresearchinstitution-the SwedishPulp and Paper ResearchInstitute-finances student researchprojects, arranges guest lectures, and provides lecture rooms and equipment. The institute also undertakesa major shareofthe researchanddevelopmentactivitiesofthe cluster. The SwedishPulpand PaperResearchInstituteandthe threetechnicaluniversities managejointly a major share ofpostgraduateeducation. Source: Blomstrom and Kokko (2001). Lower privatereturnsto capitaldue to perceptionsof increasedcorruptionand inadequatecontractenforcement Table 2.7: Selected Parameters of the Business Environment -PartII Cost of Cost of Total Procedures Cost of Time for starting a closing a tax for enforcing enforcing business business payable enforcing contracts contracts contracts (Yo of (YOof (YOof number YOof debt Days GNI per estate) gross capita) profit) Mongolia 5.1 8.0 32.2 29 17.6 3 14 Cambodia 236.4 No practice 22.3 31 121 401 Vietnam 44.5 14.5 41.6 37 31.0 295 Azerbaijan 9.5 8.0 44.9 27 19.8 267 Kazakhstan 7.0 18.0 45.0 37 11.5 183 Kyrgyzrepublic 9.8 14.5 67.4 44 12.0 140 Uzbekistan 14.1 10.0 122.3 35 13.5 195 Ghana 49.6 22.0 32.3 29 13.0 552 Uruguay 44.2 7.0 27.6 39 15.9 655 EastAsia & Pacific 42.8 23.2 42.2 31.5 52.7 477 Europe& CentralAsia 14.1 14.3 56.0 31.5 15.0 409 L.America & Caribbean 48.1 13.6 49.1 39.3 23.4 642 Middle East & N.Africa 74.5 12.1 40.8 41.6 17.7 606 OECD 5.3 7.1 47.8 22.2 11.2 351 SouthAsia 46.6 6.3 45.1 38.7 26.4 969 Sub-SaharanAfrica 162.8 16.0 71.2 38.1 42.2 581 Source: Doing Business Data, World Bank (2006a). 2.36 According to more than half o f the firms that participated in the most recent World Bank Productivity and Investment Climate survey (2004), corruption pervades every sphere o f business activity. Firms paying bribes to obtain access to electricity, water, communication infrastructure are respectively 26 percent, 15 percent and 23 percent o f all firms surveyed. A quarter o f these firms pay bribes for customs clearances o f traded goods as the number o f - 38- CHAPTER 2: COUNTRYECONOMICMEMORANDUM documents and steps requiredfor trading across borders as well as the time spent on clearance procedures is much higher in Mongolia than in other countries in the world (Table 2.7). Unofficial payments, requiredfor obtaining licenses, and the average bribe for different types of licenses were high-around 40 percent of the official fees according to World Bank (2006b). 2.37 According to Transparency International and the World Bank's Governance Indicators, corruption in Mongolia has worsened substantially since 2001,and perceptions of corruption as an obstacle to growth are more widespread in Mongolia than in a number of comparator countries.29Mongolia ranks gthout of 62 countries, for which firm level survey data were available, in terms of its share of firms reporting corruption as a major obstacle to their growth.30Mongolia's Country Policy and Institutional Assessment (CPIA) score on transparency, accountability and corruption of the public sector i s much lower than that of most countries in East Asia.3' But Mongolia's rank on the Transparency International Corruption Perception Index i s 3, slightly better than the `B' median of 2.9 (Fitch). 2.38 Corruption appears to be a major impediment to large, successful firms in Mongolia, especially those based inthe capital The processof obtaining permits is nontransparent and many companies have to employ expensive mediators whose job is to negotiate the process of obtaining a permit. Inspectors, most commonly from the Tax Offices of the Government and the State Professional Inspection Agency, visited firms frequently. According to calculations in World Bank (2006b) the total cost of fines, fees and unofficial payments made up over half of the direct financial costs incurred by firms. 2.39 Government procurement is perceived to be corruption-ridden and non-transparent as well. More thanhalf of the firms surveyedinthe World Bank Investment Climate Assessment (PICS 2004) reported that they were expected to make an unofficial payment to government officials, whose value on average was over 4 percent of the value of the government contract inquestion. This average payment is higher thaninmost of the countries for which such data exist.33An even larger share of firms surveyed (64 percent) are concerned with the openness and fairness of the bidding process. There is little understanding of conflict of interest issues, and although the Law on Civil Service asks for income and asset declaration by public officials, the law has not beenenforced. 2.40 The perception of nearly half of the firms surveyed is that individuals with political ties have a major or decisive influence on the formulation of laws and regulations governing the business climate.34Havingpoliticalties is consideredmore important inMongoliathan in Cambodia and inother countries inEast Asia. 2.41 The processof acquiring land lease certificates has become a locus for corruption as it i s extremely bureaucratic and costly. Disputes and lawsuits involving leases are increasing, 29 See also Chapter 7 for further details inthis regard. 30 Source: World Bank (2006b). 3 1Only Tonga and Lao, PDRhave scored lower than Mongolia on this dimensionof the CPIA ratings. 32 Source:World Bank (2006b). 33 Source: World Bank (2006b). 34 Source: World Bank (2006b). WHAT WILLIT TAKE TOKEEP MONGOLIA GROWING? - 39- MONGOLIA: while disputes over the use of state pastures, especially in the more densely populated areas, are common. Since access to credit depends mainly on collateral in the form of immovable assets (land or buildings), problems with land registration and leases are a constraint to growth inurban and rural areas. 2.42 Connected to the above is the weak contract enforcement (and perceptions thereof by potential investors) that have become an important obstacle to growth. The degree of confidence entrepreneurs have in the mechanisms for contract enforcement and dispute resolution tends to be strongly and positively associatedwith investment levels and economic growth.35Mongolia's institutions for contract enforcement though weak are improving and are not a binding constraint to growth (Table 2.7). 2.43 More thanhalf of the firms surveyedexpressedconfidence inthe ability of the judicial system to enforce their contractual and property rights inbusiness disputes. However, only 10 percent of all firms have had disputes with clients or suppliers that had to be resolved in the judicial system, and of these firms 70 percent indicate that the mechanisms for dispute resolution are a severe impediment to doing business.36Although crime has been on the rise of late, especially in Ulaanbaatar, it does not appear to be a major obstacle to growth in Mongolia at this time. Less than 1percent of firms considered it to be one of the three biggest obstacles to growth. Nevertheless, given, on average, in2004 firms' losses due to crime added up to 1.6 percent of sales, higher thanthe average for East Asia (1 percent); crime needs to be kept from risingso as not to becomeabindingconstraint to investment andgrowthinfuture. 2.44 Mongolia has taken recently a number of steps to combat corruption among which the following measuresstand out: (i)Ratification of the UN Convention Against Corruption in October 2005. The convention requires parties to simplify rules and regulations, enact right to information and conflict of interest legislation and take other measures to prevent corruption. Parties must also ensure the penalties for bribery and other corrupt acts are a sufficient deterrent and procedures are inplace to permit the authorities to seize the proceeds of corrupt acts. The Government i s now implementing the ambitious convention and to this end needs to bring Mongolia's laws into compliance with the convention. A working group has been established under a Vice Minister to review Mongolian law and draft the requiredamendments; (ii)Adoption of an anticorruption law in July 2006 by the Grand Hural establishing an anticorruption agency and vesting it with the responsibility to administer an income and asset declaration disclosure program. The Agency was officially created in January 2007. On February 1 the Grand Hural passed an ordinance specifying the form the income and asset declaration must take and setting June 15, 2007, as the date for filing the initial report; (iii) revision of an improved draft code of Ethics for Mongolia public servants Last discussed by public service representatives in April 2007. The draft i s expected to be ~ 35Source: Knack and Keefer (1995). 36Source: 2004 Productivity and Investment Climate Survey. - 40- CHAPTER 2: COUNTRY ECONOMICMEMORANDUM final, after an extensive consultation process. Two important revisions are the introduction of the notion of conflict of interest and the integrity principle. It i s expectedthat the Code will be submitted to Cabinet under civil service regulations for approval in2008. OTHER OBSTACLESTO BROAD-BASED GROWTH 2.45 Clearly, Mongolia faces many other challenges in bringing about sustained broad based growth. But the "binding constraints" that have been identified above are distinguished from those that are not "binding" by the degree to which small policy actions to deal with them will have the largest direct impact on the proximate determinants of broad-based market-oriented growth-namely, accelerating factor accumulation, improving productivity through self-discovery and appropriability (a la Hausmann, Rodrik, Velasco, 2005) creating economic activities that lead to growth. O f course, the non-binding constraints will needto be addressed, but at a measured pace which will yield results in the long-term. The following paragraphs discuss those constraints that the "growth-diagnostics" analysis showed was non- binding inMongolia for now. 2.46 The skills mismatch poses a constraint to future growth. Sustained growth in the future requires more and better education. Mongolia has a relatively large supply of workers with secondary education or higher. However, there is a mismatch between the skills demanded by the market and the skills that workers bring to the workplace. If unaddressed, the skills mismatch will become a serious constraint to growth as the demand for higher order skills grows. Table 2.8: School Indicators, 2004 Secondary school enrollment Tertiary school enrollment rates (gross) (YO) rates (gross) (YO) Mongolia 89.5 38.9 Cambodia 29.4 2.9 Vietnam 73.5 10.2 Azerbaijan 83.1 14.8 Kazakhstan 98.1 48.0 Kyrgyz republic 88.0 39.7 Uzbekistan 94.6 15.3 Ghana 41.8 3.1 Uruguay 108.0 39.3 East Asia & Pacific 70.9 19.4 Low income 45.1 9.1 Low & middleincome 61.4 18.6 Middle income 75.3 26.5 High income 99.5 68.8 Source: World Bank, SIMA. 2.47 Higher secondary and tertiary enrollment rates combined with low dropout rates suggest the existence of a steady supply of educated labor in Mongolia. The country's secondary school enrollment rate o f 90 percent in 2004 was similar to that in the Central Asian republics of the Former Soviet Union, and muchhigher than the enrollment rates inthe group of low and middle income countries (Table 2.8). In fact, the tertiary school enrollment WHAT WILLIT TAKE TO KEEP MONGOLIA GROWING? - 4I- MONGOLIA.' rate inMongoliawas twice the rate inthe East Asia region, and more than four times the rates in low income countries. The dropout rates in Mongolia have been relatively low, but they have been much higher for children in rural areas. About 78 percent of the children between ages 8 and 19 who start school ended up completing upper secondary school in 2005.37The rate is much lower in rural areas where only 65 percent of children managed to complete upper secondaryschool. 2.48 The demand for education has increased but job creation for skilled workers in the private sector has been limitedS3* The number of public colleges, technical and vocational schools rose to accommodate an increasing number of students seeking tertiary education (Table 2.9),39 but in 2004 the percent of unemployed with secondary and tertiary education was 64 percentY4'and except among large firms, a shortage of educated labor does not seem to be a significant concern inM~ngolia.~' Table 2.9: Number of Academic Institutionsin Mongolia 2001-02 2002-03 2003-04 2004-05 Universities,colleges, technicaland vocational schools 210 216 215 219 Public 71 72 78 76 Universities 8 8 8 8 Colleges 33 34 39 35 Technical and vocationalschools 30 34 39 35 Private 132 137 130 137 Universities 3 3 3 3 Colleges 127 133 126 132 Technical and vocationalschools 2 1 1 2 Branchesof foreign universities 7 7 7 6 Source: Mongolian Statistical Yearbook (2004)). 2.49 A particular challenge, therefore, is the mismatch betweenthe skills demandedby the market and the skills workers bring to the market. While a high percentage of high skilled workers are employed injobs well below their qualifications, over half of the large firms cite a shortage of skilled workers as a reasonfor not operating at full capacity. A third of the firms report vacancies for professionals, and nearly two-fifths report vacancies for educated workers. Employers-especially large firms-complain about shortage of certain types o f skills such as practical knowledge (e.g., English), technical knowledge (e.g., computers), and managerial, marketing and behavioral skills (work ethics and ability to work in teams).42It appears that Mongolia's education system continues to emphasize traditional academic subjects and memorization rather than the skills increasingly demandedby the market. 37 Source:CPIA ratings and discussionon building humanresources in Mongolia. 38 Source: World Bank (2006b). 39 Accordingto the World Bank's CPIA ratingreporton human capitaldemandfor existingschools is so high that many schools operatemultiple shifts. 40 Source: World Bank, SIMA. 442'Source: World Bank (2006b). Accordingto representatives from the ForeignInvestment and ForeignTrade Agency marketingknowledge and skills are critical to export growth. -42- CHAPTER 2: COUNTRYECONOMICMEMORANDUM 2.50 The data on wages of different types of labor support these findings (Table 2.10). In 2006 skilled agricultural and fisheries workers earned less per month than unskilledworkers employed inurban and rural areas. Clerks, service and sales workers earned approximately as muchas unskilledlaborers. Large premiums on skills were earned only by legislators, senior officials and managers. Premiums earned by professionals, and plant and machine operators and assemblers, presumably working in mining and construction, were larger than those of other skilled workers but significantly smaller thanthose for legislators and managers. Table 2.10: Monthly Average Wages and Salaries in 2006 (thousandtug) Legislators, senior officials and managers 195.8 Professionals 152.2 Technicians and associate professionals 132.2 Clerks 93.4 Service workers and shop and market sales workers 103.2 Skilledagricultural and fishery workers 74.7 Craft and relatedtrades workers 130.8 Plant and machine operators and assemblers 147.7 Elementary occupations 91.3 Average 128.5 Source: Mongolia National Statistical Ofice. 2.5 1 Poor quality jobs for skilled workers and underutilization of the skilled labor force are also problems in Mongolia. Although the labor market is relatively flexible,43 high social security taxes and the fact that these are applicable only to permanentworkers, tends to result in poor-quality job opportunities by increasing the share of contract and informaljobs. Also, according to the most recent LSMS, a high percentage of working age people betweenthe age of 25 and 29 neither look for jobs nor are in school. These idle people, considered discouraged workers, have mostly upper secondary or tertiary education and live in urban areas. 2.52 Environmental degradation and natural resource use. The country and many o f its people are dependent on natural resources such as grasslands, soils, forests, air and water, yet the quality of these is eroding even as their contributions to the public and shadow economies are increasing. This is a threat both in the short and long term for the country's economic growth as the costs of environmental degradation in terms of labor and land productivity, biodiversity, tourism and government revenues as well as public health related expenditures continue to raise. Existing empirical and anecdotal evidence clearly indicates that illegal logging and wildlife trade, the mining sector, particularly artisanal mining, water and air pollution are responsible for the increasing economic costs of environmental degradation. A further discussion of this and its long term implications and policy recommendations is provided inChapter 4 of this Economic Report. 43According to the DoingBusinessDatabase, and the Growth CompetitivenessIndex for 2005 minimumwages and firing costs are low, andtemporary contractsare permitted inMongolia. WHAT WILLIT TAKE TOKEEP MONGOLIA GROWING? - 43- MONGOLIA: 2.53 Finally, the macroeconomic environment has been stable and as long as it remains so will not be a binding constraint to growth. Monetary and fiscal policies have insured macroeconomic stability in recent years and have not been a constraint to growth. In 2005 inflationary pressures accelerateddue to a rise infuel and meat prices and administrative price adjustments in utilities. Core inflation rose sharply, and Mongolia's inflation rate jumped from 8 percent in2004 to 13 percent in2005. Inflationary pressures are expectedto ease up in 2006, but monetary liquidity has remained loose. Although the Bank of Mongolia (BoM) stepped up the issuance of central bank bills to mop up excess liquidity, it purchased gold from mining companies and monetized US$195m worth of gold by printing local currency in 2005.44The key challenge will be to maintain macro-stability over the long-term and reduce the economy's vulnerability to international commodity price fluctuations. Chapter 5 will discuss these issues and provide policy recommendations for maintaining macroeconomic stability through appropriate fiscal policies, especially those affecting the composition of public spending programs, public borrowing and debt management policies, and improve accountability inthe use of public funds (governance considerations). 44Since 1994BoM started buyinggold to support the development of the nationalgold sector. -44- CHAPTER 2: COUNTRYECONOMIChfEMORANDUM 3. ECONOMICDIVERSIFICATIONINA CHANGING WORLD In order to ensure that the Mongolian economy continues to grow by diversifiing its non- mineral exports, enter new markets (at home and abroad) and createjobs, it is essential to extract higher value-addedfrom its livestock herd and to motivatefirms toprovide additional products/services to improve quality and efpciency. Small and medium enterprises (SMEs) could provide much useful support, for example, in water well development/maintenance, fodder production, product quality control,product development, animal breeding and health, insurance, and other financial services. Development of new sources of export earnings will need to work around transport constraints. Rail transport will likely remain useful for bulk cargo, while the gestation lags involved with infiastructure development imply that truck transport will be problematic in the nextfew years for anything except low-value products. Hence, thefocus should be on high-value niche products suitable for air cargo, tourism, and "knowledge" products such as software development. To facilitate these possibilities, Mongolias investment climate should feature ease of business entry, exit and ongoing regulation; afair, transparent, andpro-growth tax system; good access tofinance; enhanced education/skills; and better infiastructure. 3.1 The discussion in the previous two chapters suggested that Mongolia's future economic development will depend on sustaining and enhancing traditional sectors, particularly mining and livestock, while nurturing new sources of growth and export earnings. While the growth diagnostics exercise helpedus identify the "binding constraints" to broad- basedgrowth inMongolia today, it i s now imperative to look at how these constraints needto be alleviated. This chapter looks deeper into the issue of economic diversification and provides policy recommendations on how the share of the non-mining sector can be increased inthe coming years. Indoing so, it also will show how some measureswill have a beneficial effect towards improving private sector development across the board, including in mining sector activities. This chapter also highlights that potential vulnerabilities and will recommend policy measures to help sustain (and ho efully augment) the currently observed high export earnings growth trajectories inMongolia. E: CURRENT ISSUES 3.2 Mongolia's export sector remains overly dependent on mining. Mining has accounted for 50-70 percent of Mongolia's annual earning from commodity exports since 1999 (Table 3.1). The tripling of mining revenues since 1999 mainly reflects a 130 percent rise incopper prices, a doubling of gold production, and a 60 percent rise ingold prices. 1Chapter 5 of this report will look at the issuesrelatedto the Mongolianminingsector and naturalresource management issues in more detail. 'During 1999-2005,annual average growthrates for Mongolia's export earningshave exceeded 25 percent. ECONOMICDIVERSIFICATION INA CHANGING WORLD - 45 - MONGOLIA: Table 3.1: Mongolia's Export Earnings, 1999-2005 (USDmillions) 1999 2000 2001 2002 2003 2004 2005 Mining: Copper concentrate 119.2 160.3 147.9 140.2 163.7 284.3 326.2 Molybdenum concentrate 9.0 6.2 5.1 10.1 15.0 20.0 46.7 Fluorite concentrate 16.8 19.3 19.8 17.0 15.0 11.4 24.7 Gold - - - 117.6 95.9 69.7 74.7 157.3 239.9 331.4 240.9 255.5 247.5 284.9 35 1.O 555.6 729.0 Sawed wood 4.9 0.3 0.1 0.0 0.0 0.0 0.1 Cashmere: Cashmere tops 2.2 0.6 0.3 0.9 1.8 1.1 1.1 Cashmere, de-haired 45.9 54.5 55.0 30.5 25.7 44.1 52.8 Cashmere garments 7.8 13.0 11.6 12.8 15.6 33.1 17.5 Cashmere, greasylraw 14.4 - - - - - - 21.9 0.9 0.9 1.1 0.6 0.3 70.3 90.0 67.8 45.1 44.2 78.9 71.7 Other goods: Textiles 18.4 73.2 44.2 18.8 37.4 96.5 42.3 Camel wool, raw 1.7 1.7 2.2 0.7 0.7 0.7 1.9 Skinandhides 23.9 34.9 16.2 11.3 6.1 5.9 3.0 Leather goods 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Sheepskin coats 0.1 0.2 0.3 0.1 0.2 0.2 0.5 Carpets 0.9 1.4 0.9 0.9 0.0 0.0 0.0 Meat 13.2 15.8 18.5 20.5 15.7 13.2 10.1 Scrap metal 5.6 5.2 4.0 3.5 3.7 8.7 8.3 Other 74.2 57.5 121.6 137.9 141.1 93.8 197.9 Goods sub-total 454.1 535.7 523.3 523.7 600.1 853.5 1,064.8 Tourism 5.8 32.8 39.3 138.0 143.O 185.1 176.8 Total export earnings 459.9 568.5 562.6 661.7 743.1 1,038.6 1,241.6 Source: Mongol Bank; SIMA. 3.3 Export earnings are vulnerable to minerals price shocks. Copper prices, for instance, have followed 4-7 year cycles since the mid-l980s, with prices typically falling more than 50 percent from peak to trough (Figure 3.1). Ifrecent copper prices represent a new high, a new downturn could lead to a 15 percent drop (assuming no change in output) in overall revenues from export goods. Gold prices can drop 30 percent from peak to trough (Figure 3.2), as happened in 1996-2000. A similar downturn could (again assuming no change in output) reduce Mongolia's export earnings by IOpercent. 3.4 Rural livelihoods remain overly dependent on low-value livestock products. Livestock-related products (e.g., cashmere, skin and hides, meat) accountedfor only 8 percent of Mongolia's export product revenuesin2005. However, the livestock-dominated agriculture - 46- CHAPTER 3: COUNTRY ECONOMICMEMORANDUM sector still accounts for 40 percent o f employment. For rural households, livestock are an important source o f income, jobs and food security, and wealth accumulation. Figure 3.1: CopperPricesand Stockpiles, 1986-2005 .I,200 -600 k.-a 4 3 -400 8 B -200 Ian Jan @I Jm ]xi? Jzn pn jao Bin Jar ]an Jm JMI jan Jan I.zn Jan 86 87 08 JSJO Jon B9 W 91 91 93 94 95 96 97 98 99 W OI 02 03 M Source : www.equinoxminerals.codwhvcouper.asp Figure3.2: Long-term Behavior of GoldPrices 1971-2005 Gold Price, $ per ounce (London pm fix) Jan.71 Jan.71 Jan.?? Jan.80 Jm.83 Jan-86 Jm.89 Jam92 Jan-95 Jdn.98 Jan.01 Jan44 Source: \nvw.poIdprice.orp/3O-vear-eold-~rice-historv.ht1nl 3.5 Thelivestock sectorfaces multiple vulnerabilities. These include climate and disease. For instance, dzud killed 10 million livestock inthe period 1999-2002. Dzud-related livestock losses were partly responsible for the 50-t percent reduction in export sales o f de-haired cashmere between 2001 and 2003. An outbreak o f hoof and mouth disease, which resulted in restrictions on meat exports, contributed to an 82 percent drop in export prices for meat in 2003 (Figure 3.3). These problems reflect the lack o f an adequate support structure for Mongolia's livestock sector (e.g., fodder production, well maintenance, veterinary health surveillance and extension services). O f course, sector vulnerabilities will not automatically result in additional shocks. Analysis o f developing countries over the past three decades ECONOMICDIVERSIFICATION INA CHANGING WORLD - 47- MONGOLIA: indicates that "commodity pessimism" is not alwaysju~tified.~ Figure 3.3: Export Prices for Mongolian Meat Have Been Impacted by the Outbreak of Diseases I Export Pricesfor Meat, 1999-2005 1 1600 1 I 1400 e 1200 1000 800 $ 600 a 400 200 I L I 0 J 1999 2000 2001 2002 2003 2004 2005 Year Source: Mongol Bank 3.6 Persistent export concentration may akFo result in slower growth. Mongolia's export sector is less diversified than such other land-locked countries as Kazakhstan and the Kyrgyz Republic, and far less diversified than China. Among 100 developing countries, Mongolia is the 37`h least diversified. A World Bank study of LatinAmerican economies-including such minerals powerhouses as Chile, Brazil, Peru, Bolivia, and Venezuela-concluded that "the evidence is clear: concentration reduces subsequent economic growth." "A 1 percent increase inthe concentration of exports is associated with a 0.5 percent decline in the growth rate of real-GDP per capita." Only a fraction of this is explained by the correlation betweenexport concentration and macroeconomic volatility. 3.7 The main factor seems to be that highexport concentration is typically correlated with low incidence o f intra-industry trade (Le., the share of total trade consisting of imports and exports in the same product class). Driven by productivity gains, product development, and product differentiation, intra-industry trade i s correlated with the pace of economic development. Additional analysis shows that intra-industry trade is positively correlated with higher levels of education, higher trade/GDP ratios, and lower transport/logistics/customs costs.4 DoMONGOLIAN INNOVATE? FIRMS 3.8 Diversification of the productive structure requires "discovery" of an economy's cost ~tructure.~Firms must experiment with new product lines, adapt new technologies from abroad to local conditions, and "discover" which products they can produce at low enough cost to be profitable and competitive. Given Mongolia's abundant land and mineral resources ~ ~~ Federico Bonaglia and Kiichiro Fukasaku, "Export Diversification in Low-Income Countries: An International ChallengeAfter Doha," OECD DevelopmentCenter working paper #209, June 2003, p.18. World Bank, From Natural Resources to the Knowledge Economy: Trade and Job Equality, Latin American 'andHausmannand Caribbean Studies, 2002, pp. 38-44. Rodrik (2004). - 48 - CHAPTER 3: COUNTRYECONOMICMEMORANDUM relative to its population size and land area, the country has a natural comparative advantage inindustries that use intensivelylandand natural resources. Mongolia's current export base is consistent with its comparative advantage. Since 2000 the share o f ores and minerals intotal exports has stayed above 40 percent, the share o f primary goods excluding ores and minerals has been around 15 percent, and approximately 50 percent o f manufactures have been metals.6 However, as a result o f its specialization in mining and primary products, Mongolia has a low-degree o f export diversification. Mongolia i s less diversified than its comparators, which include other land-locked, resource-rich countries, except Cambodia (Figure 3.4) Figure3.4: Degree of export diversificationis Figure3.5: ...and hasbeen decliningfurther. relativelylow in Mongolia.,, Source: WorldBank Database on export diversification Source: Staffestimates based on export diversification data (PRMED). 2004 data. (World Bank, PRMED). 2004 data. Note: The higher the Herfindahl and Hirshman indices, the lower the degree of diversification. 3.9 Since 1990 Mongolia's dependence on primary good has grown and the top five exports interms o f value have claimed an ever increasing share o f exports, which in2004 was 90 percent (Figure 3.5). The manufacturing base i s narrow as well. In 2005, it comprised o f three product groups-metals, which accounted for 61 percent o f manufactured exports; textiles (18 percent); and apparel (13 percent). All remaining products-including metal products-add uptojust 8 percent o f export^.^ 3.10 A narrow manufacturing base does not imply that Mongolianfirms do not attempt to export new products. Infact, they do. One way to assess the level o f entrepreneurial effort or "self discovery" inMongolia i s to look at the number o f new exported goods. When measured at the 4 digit level o f the Harmonized System the number o f exported products has grown from 351 in 2002 to 462 in 2005 - an increase o f 32 percent. The increase could have been much higher had Mongolian firms managed to lower the number o f discontinued exports and had they not failed to continue exporting the majority o f their new export lines. According to UN COMTRADE database every year during the period 2002-06 Mongolia exported on average 135 new product lines, but discontinued 98 products, o f which 62 percent were new exports (Table 3.2). 3.11 While manufactured goods represented a large share o f new exports, they also represented a large share o f new exports discontinued the following year. In 2003 and 2004 'See Source: Database on export diversification (PWED). also WID0 (2002) -a report on Mongolia's manufacturing sector. ECONOMICDIVERSIFICATIONIN A CHANGING WORLD - 49 - MONGOLIA: this share was 83 percent and 72 percent, respectively. This suggests that while some Mongolian firms attempt to "innovate", they fail to market these products abroad. Table 3.2 displays the lists o f discontinued new manufactured products in 2004 and 2005. The process o f "self-discovery" has beenhampered by a variety o f negative coordination externalities. Table 3.2: Indicators of Innovation, Mongolia (number of firms) 2002 2003 2004 2005 Exported goods 35 1 393 436 462 New exports 120 145 139 New manufacturedexports 99 104 Discontinued exports 78 102 113 New exports discontinued next year 63 71 New manufacturedexports discontinued next year 51 51 Source: Staffestimates based on UN COMRADE data, HS 4 digits. 3.12 Although economic diversification o f a resource based economy poses many challenges, successes ina number o f countries show that it is possible to use natural resources to diversify within the natural resource sector as well as move into new sectors. In Finland this happened with the move ofNokia, which was establish in 1865 andby the early twentieth century was the country's largest pulp and paper mill, to one o f the largest telecommunications companies inthe world.' The existence o f a secure market inthe former Soviet Union provided a strong incentive to increase capacity and diversify Nokia's product lines. In 1962, Finish Cable Works-a subdivision o f Nokia4eveloped a prototype radiotelephone at the request o f the army and in competition with Finland's leading electrical engineering firms, Salora and Televa, and the Swedish producer, Sonab. In 1966 Nokia, Salora and Televa were formally merged and divided into four divisions: paper, cable, rubber and electronics. The electronics division was the smallest and non-profitable for years, but Nokia's executives ensured that it had access to the latest technology. By the early 1970s the electronics division expanded with the public radiotelephone system and the marketing o f foreign computer equipment inthe domestic market. By the late 197Os, Nokia had learned to develop its own computer terminals, cash registers and a portable computer that competed well with Apple in the Nordic markets, and the new CEO o f the company had decided to transform Nokia into a leading hightech company. The leadership o f the company was aware that Nokia lacks necessary skills and experience to compete with established American, European and Japanese incumbents in the global electronics market. Its ambition and commitment to eventually compete inall markets provided an incentive to form alliances with American and European companies. These alliances were essential to Nokia's transformation from a raw material-based to a knowledge-base high-tech company. Another important factor was an aggressive human-resource development program that encouraged work abroad in foreign affiliates. The company's leadership worked with the government to modernize the public education system and to support broad international student-exchange programs, continuous lifelong learning, and close collaboration between industry and academia. * Source: de Ferranti, Perry, Ledermanand Maloney (2002). -50- CHAPTER3: COUNTRY ECONOMICMEMORANDUM Table 3.3: New Manufactured Exports Discontinuedin 2004 and 2005 H S No. 2004 H S No. 2005 3208 Paintsandvarnishes 3214 Glaziers'putty, graftingputty 3306 Preparationsfor oral or dentalhygiene 3302 Mixtures of odoriferoussubstances 3402 Organic surface-activeagents 3305 Preparationsfor use onthe hair 3405 Polishes and creams, for footwear 3502 Albumins 3603 Safety fuses; detonatingfuses 3916 Monofilament 3813 Preparationsand charges for fire-e 3919 Self-adhesiveplates, sheets, film 4008 Plates,sheets, strip, rods andpro 3921 Other plates, sheets, film, foil 4410 Particleboardandsimilar board 4005 Compoundedrubber 4411 Fiberboardofwood or other 4404 Hoopwood;split poles; piles 4503 Articles of naturalcork. 4601 Plaits andsimilar products 4602 Basketwork,wickerwork and other 4904 Music, printedor in manuscript 4818 Toilet paper and similar paper 4909 Printedor illustratedpostcards 5110 Yam ofcoarse animalhair 4910 Calendarsof any kind, printed 5804 Tulles and other net fabrics 5113 Woven fabrics ofcoarse animalhair 5911 Textileproductsand articles 5509 Yam (other than sewingthread) 6005 Warp knit fabrics 5601 Wadding oftextilematerials 6006 Other knittedor crochetedfabrics. 5801 Wovenpile fabrics andchenille fabrics 6303 Curtains (includingdrapes) 5805 Hand-woventapestries ofthe type 6401 Waterproof footwear with outer sole 5808 Braids inthe piece 6804 Millstones, grindstones,grindingw 5905 Textilewall coverings 6805 Natural or artificial abrasivepowder 6112 Track suits, ski suits andswimwear 6813 Frictionmaterialand articles 6213 Handkerchiefs 6901 Bricks, blocks, tiles and other 6402 Other footwear with outer soles 6910 Ceramic sinks, wash basins 6507 Head-bands, linings, covers, hats 7004 Drawnglass andblownglass 6601 Umbrellasand sun umbrellas 7315 Chainandpartsthereof, of iron 7001 Culletand other waste and scrap 7317 Nails, tacks, drawingpins, 7010 Carboys, bottles, flasks,jars, pot 7325 Other cast articles of ironor steel 7116 Articlesof naturalor culturedpearls 7405 Master alloys o f copper. 7213 Bars androds, hot-rolled 7503 Nickelwaste andscrap. 7314 Cloth(includingendless bands) 8112 Beryllium,chromium, germanium, van 7508 Other articles ofnickel. 8207 Interchangeabletools for handtool 8305 Fittingsfor loose-leafbinders 8208 Knivesandcuttingblades, for machines 8417 Industrialor laboratory furnaces 8434 Milkingmachinesanddairy machinery 8437 Machines for cleaning, sorting 8442 Machinery, apparatus andequipment 8438 Machinery 8445 Machinesfor preparingtextilefibers 8461 Machine-tools for planning, shaping 8459 Machine-tools 8503 Partssuitable for use solely or pr 8504 Electricaltransformers, static con 8510 Shavers, hair clippers 8532 Electricalcapacitors, fixed, variable 8518 Microphonesand stands 8537 Boards, panels, consoles, desks, ca 8523 Preparedunrecordedmediafor sound 8540 Thermionic, coldcathode or photo-cathode 8527 Receptionapparatus for radio- telephone 8705 Specialpurposemotor vehicles 8535 Electricalapparatus for switching 8801 Balloons and dirigibles;gliders 8543 Electricalmachinesand apparatus 8901 Cruise ships, excursionboats 9023 Instruments,apparatus andmodels 9001 Optical fibers andoptical fiber 9029 Revolutioncounters 9006 Photographic 9104 Instrumentpanelclocks andclocks 9208 Musicalboxes, fairground organs 9110 Completewatch or clock movements 9307 Swords, cutlasses, bayonets,lances 9205 Other wind musical instruments 9601 Worked ivory, bone, tortoise-shell, 9303 Other firearms andsimilar devices 9609 Pencils 9611 Date, sealingor numberingstamps 9618 Tailors' dummiesand other lay figures 9614 Smokingpipes Source: UN COMTRADEdata. ECONOMICDIVERSIFICATION INA CHANGING WORLD - 51 - MONGOLIA: 3.13 It is also possible not only to use mineral wealth to diversify withinand out of mining, but to start exporting mineral know-how. Australia's Broken Hill Proprietary Company (BHP) offers an example of how a firm can achieve this. BHP was floated in 1985 after a rider on a sheep station in New South Wales discovered lead and silver and formed a syndicate with other local workers, and leasedthe mine. Over the years BHP diversified into manufactured steel products, coal and iron ore, petroleum, and shipping and shipbuilding. It became a modern conglomerate with vertical control from mining to blast furnaces to wire rope factories to shipping lines. Critical to its success has been the emphasis on building mining expertise. Australia began recruiting engineers and metallurgists in 1886. The Sydney Mechanics Institutewas established in 1843, followed by Sydney University in 1850, School of Mines in Ballarat and Bendigo in 1870 and 1873, respectively, the Sydney Technical College in 1878, and the University of New South Wales in 1949. These institutions rested on a commitment to universal education beginning with the Victoria Education Act of 1872. Australia now leads the world in mineral detection technology embodied intheir "transparent earth" initiative, in mine-closing techniques, and mining-related environment knowledge. Cutting-edge know-how enabled BHP to discover and undertake the development of Chile's largest producer of copper. SECTOR PERSPECTIVES 3.14 The Government has considered giving priority to various sectors: mining, meat, carpets and wool, cashmere, skins and hides, textiles, tourism, forestry and wood, petroleum, metallurgy, and informationtechnology.' 3.15 Priority for some sectors is questionable. For instance, as the Government's own analyses indicate, the textile sector suffers from low labor productivity, lack of direct customer access, and other issues that leave it at a major disadvantage vis-&-vis China. The wood sector's potential is said to be constrained by insufficient forest reserves." At first glance, efforts to build downstream linkages and add value close to the mines might seem to make sense. According to a comprehensive study of mining clusters in Latin America, however, "some minor examples may be found of where this has worked well, but as a proposal of strategy it does not seem wise."' 3.16 Cashmere's prospects should be viewed dispassionately. The government should reassess its efforts to raise cashmere output, encourage domestic processing of raw cashmere, and support production of cashmere garments in light of recent experience and market realities. 0 Little or no taxes or user fees (e.g., for grazing or water) have encouraged herders to increaseherdsizes beyond sustainable levels. 0 Various measures have been attempted to raise the quality of raw cashmere. But herders still favor greater volume o f raw cashmere, at the expense of quality. Low-quality, coarse 9 Ministry of Industry and Trade, "Mongolia Industrial Sector Development Strategy: Priority Sector Policy," undated; and supporting exhibits (processed). IoIbid. I'Rudolf M.Buitelaar, "Mining Clusters and LocalEconomic Development inLatin America," htt~://www.carleton.ca/economics/seminar0/o2Opa~ers/Buitelaar-Nov 1-2001.Ddf, p. 17. - 52 - CHAPTER3: COUNTRYECONOMICMEMORANDUM cashmere is becoming the norm for Mongolia. Hence, access to more lucrative markets is limited. Improving the quality of the national herd would take time and be very challenging as the country does not have a strong animal breeding industry in place. A more promising route would involve the strengtheningof linkages betweenprocessors and large scale herders (which are increasing in number) and well-performing herder cooperatives and NGOs. Improving quality will require introduction of improved breeds, improved nutrition and introduction of more rigorous grading systems. l2 Other observers are skeptical about the prospects for quality improvements, however, suggesting that revenue-maximizing herderswill continue to favor quantity over quality.l3 Despite taxes on the export of raw cashmere and consolidation and downsizing of cashmere processors since 1997, domestic processors still operate below 50 percent of capacity while about half of Mongolia's raw cashmere i s smuggled to China for processing. Changes in the world garment industry have made it even more difficult for Mongolia's garment producers to compete. Costs and prices have been driven down, while the fashion cycle has accelerated from four seasons to 8-12 style changes for some brand names and retailers. Bargaining power in the value chain has shifted from producers and retailers to brand name holders, who have withdrawn from production by outsourcing to contract producers. Despite decades of subsidies, even Chinese cashmere garment producers have so far beenunable to integrate forward into international distribution channels-much less to develop an internationally recognized brand name. This USAID analysis concludes that it is too late for Mongolianproducersto integrate into international distribution or develop a brand (and hence should receive no special incentives), but that Mongolia's cashmere industry could forge alliance with world-class players seeking to counterbalance Chinese producers. Modest reforms that do not specifically target the industry are held out as offeringthe best hope for Mongolia's cashmere sector.l4 3.17 Overland transport is suitable only for bulk and "commoditized" products. In today's world economy, competition is often not just between products but between global supply chains. Timeliness of delivery, predictability, and in-transit visibility may determine product competitiveness. Manufactured goods with tenuous links to global supply chains may become commodities that can compete only on the basis of price. 3.18 Use of trucks to access seaports i s a non-~tarter.'~Except for bulk or commodity products, rail transport is not viable for reasons of cost and service quality. The cost of shipping a 20-foot container by rail from Ulaanbaatar to Tianjin (about $1,037) is double the World Bank,From Goats to Coats: Institutional Reform in Mongolia's Cashmere Sector, report 26240-MOG, 19 December2003; and subsequent reporting. l3USAID Economic Policy Reform and CompetitivenessProject, "A Value Chain Analysis of the Mongolian Cashmere Industry," May 2005. l4 These measures include a reduction in tax rates to 15 percent, accelerated depreciation, and tax loss carry- forwards; lower interest rates; privatization and withdrawal of State support for Gobi Cashmere. USAID Economic Policy Reform and Competitiveness Project, "A Value Chain Analysis of the Mongolian Cashmere Industry," May 2005. 15 The nearest seaports at Tianjin (1700 kilometers) and Votoschney (4500 km) are beyond the maximum efficient range for trucking. In any case, the road from Ulaanbaatar to China will not be h l l y paved for several more years and Mongolian trucks are still denied access to China. The road to Russia i s paved, but Mongolian truckers face delays and uncertaintiesentering and operating inRussia. ECONOMICDIVERSIFICATION INA CHANGING WORLD - 53 - MONGOLIA: cost of trucking a container from Hohot, Inner Mongolia to Tianjin.16The bulk of China's low-cost manufacturing base is located even closer to seaports and thus enjoys even greater transportation cost advantages. Many rail service reliability issues are well-known. A rail gauge change at the China border necessitates a time-consuming axle adjustment or transfer of containers, while customs and quarantine inspections add further delays and uncertainty. *' After crossing into China, additional issues will likely arise. While notingthat rail is a lifeline within China for moving coal and other bulk goods, a McKinsey study concludes that China Rail "is unsuitedfor movingmost finished goods because of extensive delays, little flexibility in routes, and a lack of genuine service orientation." In addition, ports in China "often lack modern and efficient rail sidings, making it impossible to load goods directly into wagons and from wagons to ships"." Examples of China Rail's lack of service orientation include a lack of real-time tracking and tracing of cargoes, estimates of arrival time, or reports of en-route service failures,'. 3.19 A dramatic fall in rail-borne container traffic between Ulaanbaatar and Tianjin highlights these supply chain issues. In May 2002, twice-weekly container-express train service began between the two cities. Advertised at 3.1 days,20 actual transit times have ranged from 4 to 12 days:' an unacceptable level of reliability for many manufactured goods. From its 2002 baseline, container traffic has seen cumulative declines of 8 percentin2003,25 percent by end-2004, and 60 percent by end-2005 (Figure 3.6). Figure 3.6: Rail Cargo Traffic Has Been on the Decline Ulaanbaatar to Tianjin Port, 2002-2005 5000 ~ 1 - 1 3 \ 1000 - 0 Source: International Freight Forwarding Center of MongolianRailways. (N.B.2002 volumehas been annualizedbased on 7 months data.) 3.20 Development of higher-value "niche" exports and Mongolia's tiny air cargo sector make sense. Industry experts indicate that any product worth $3-5 per kilogram may be suitable for air cargo. Demandsfor more reliable delivery may explain recent 100-150 percent l6 Staff estimates, based on World Bank, Mongolia Investment Climate and Trade Integration, January 2006; and World Bank, Governance,Investment Climate, and Harmonious Society: CompetitivenessEnhancementsfor 120 Cities in China, October 2006. l7 World Bank, 2006a. JonathanR. Woetzel, Capitalist China: Strategiesfor a RevolutionizedEconomy, (Wiley, 2003), p. 85. l 9World Bank, 2004, p. 25. 2o InternationalFreight ForwardingCentre of Mongolian Railways. 2' World Bank, 2006a, p. - 5 4 - CHAPTER 3: COUNTRY ECONOMICMEMORANDUM increases in air cargo shipments from Ulaanbaatar to selected cities.22 Despite this growth, Mongolia's air cargo shipments are negligible compared with those from Latin America and Africa, which have seen huge increases in the air shipment o f perishable products (Box 3.1). Some countries provide subsidies to encourage use o f air cargo to develop export markets for perishable products.23 Box 3.1: Air Cargo Exportsof Perishables from Developing Regions * Latin America: Of the current northbound air cargo shipments of 721,000 tons from Latin America, about 58 percent are perishableproducts-including about 175,000 tons of fish, 145,000 tons of flowers, and 100,000 tons of fresh h i t s and vegetables. Major producers: Panama, Ecuador, and Chile for fish; Costa Rica, Columbia, Ecuador, and Perufor flowers; and Columbia, Peru, andChile for fresh hitshegetables. * Ethiopia: Meat exports (lamb to Dubai, Cairo, Jeddah; beef to West Africa) make use of extensive cold storage facilities at Addis Ababa airport. Air shipments of cut flowers total about 23,000 tons per year, two- thirds ofwhich are flown out during the December-Aprilpeak season. Dependingonthe time ofyear, air service includesa daily DC-10 (65 tons) to Brussels and a daily 757 (36 tons) to Rome. * Uganda: Annual air shipments of fish total almost 5000 metric tons, of which about 70 percent ends up in Europe and 30 percentinthe U.S.or Japan. Average value i s $3.20 per kilogram. * Tanzania: Air cargo exports ofperishablegoods (fresh vegetables, flowers, seafood) have recently experienced 54 percent growth (compounded), from over 221,000 tons in2001 to over 1,259,000 tons in2005. Source: H. Sofinger, "PreliminaryResults on Air Cargo Research,"undated,processed. 3.21 While mining i s inevitably a priority sector, more attention should be paid to opportunities for horizontal diversification into mining support, knowledge management, and related infrastructure. Large mining operations require many supporting goods and services, including catering, trucking, equipment repair, chemicals supply, and utilities. International mining firms, however, insist that local suppliers meet international quality standards at acceptable cost. Knowledge management opportunities include geological and environmental management services. Local learning o f particular environmental issues (e.g., water management in the desert, treatment o f residues) may have wide applications in other countries. 24 Canada and Australia are good examples o f countries that have successfully exploited their accumulated knowledge about geology, mining, and environmental protection. Mining can also stimulate investment in and development o f such infrastructure as roads, railroads, power, water, and other utility services. The development o f transport infrastructure in remote mining areas may also support development o f specialty tourism, such as mining tourism and geological-interest tourism. 3.22 Turning to meat, it is necessary to consider both bulk and specialty meat products. Efforts to restore the quality (and pricing) for bulk meats are needed. Meat exports have decreased sharply, from 23,200 tons in 2002 to 7,800 tons in 2005. As shown earlier (Figure 3.1), unit prices for meat exports dropped more than 80 percent in 2003. This deterioration "Air cargoshipmentsfromUlaanbaatarto Seoulhaveincreasedfrom 149tonsin2004to 392tons in2006 (annualized). Those to Moscow have increased from 78 tons in2004 to 151tons in 2006 (annualized), according to data from Mongolia's Civil Aviation Authority. 23For instance, the king of Thailand reportedly pays for regular air cargo shipments of Thai fresh produce and other food itemsto specialty grocers in Europe in order to support developmentof a market for such products. 24Buitelaar, p. 17-9. ECONOMIC DIVERSIFICATION INA CHANGING WORLD - 55 - MONGOLIA: reflects the general low-quality of meat production in Mongolia. Access to export markets i s frequently restricted by a number of sanitary and phyto-sanitary (SPS) issues, including the presence of a number of livestock diseases, such as foot and mouth disease (circulating in Mongolia since 2000, after a 25-year absence); sporadic outbreaks of anthrax; avian influenza, in wild birds; and the human form of brucellosis. These diseases severely restrict export opportunities for Mongolian meat. Where countries are willing to import (such as Russia), prices are very low in most cases. The increase in disease outbreaks is partly due to reducedanimal health surveillance. The linkages betweennow-private veterinary services and public agencies need to be strengthened. While nationwide control of animal diseases is a good medium-termobjective, short-term efforts to create disease-freezones would help. 3.23 Mongolian canners appear to have made some inroads into pet food markets in Japan and South Korea. The pet food market is estimated at about $3 billion in those two countries and almost $50 billion worldwide. One assessment suggests that Mongolian suppliers should, at a minimum, seek out foreign partnerships; achieve or maintain conformity with good manufacturing standards (GMS); and encourage large foreign producers to locate processing plants inMongoliato service East Asia.25 3.24 I n addition, opportunities for higher-value meat exports should be explored. Examples include high-quality horsemeat for Japan and lamb for Persian Gulf markets. While these are promising markets, early forays have highlighted cultural, SPS, and supply chain issues (Box 3.2). Since, as noted earlier (Box 3.1), several African countries have successfully usedair cargo to ship meat or fish to marketsinthe MiddleEast, Europe, and Japan, it should be possible for Mongoliato develop similar access. Box 3.2. Issues for Higher-ValueMeat Exports * Japan: Since the mid-l990s, a Japanese fm based in Mongoliahas been exporting high-quality fiesh horse meat servedas expensive basishi (horse meat sushi) inrestaurantsinJapan and frozen horsemeat for barbeque. Basishi can sell for as muchas $90 a kilograminJapaneserestaurants.Consumer interest is highbecausehorses are notknown to be susceptibleto BSE.An inabilityto deliver consistent suppliesto Japan, however, is a major impedimentto expandedexports. SeveralJapanese buyers for chain restaurantsand supermarketshave inquired about larger ordersthat would be severalmultiples of current volume. These orders could not be accepteddue to the firm's inability to meet exacting requirements, including for reliable air shipment. While the fm has discussed expanded air shipments from Ulaanbaatar to Tokyo with MIAT, MIAT has been disinclined to negotiatecompetitive rates. * Persian Guvinvestors have explored the export of tasty range-fedhalal lamb to the Persian Gulf region, in order to fill a large deficit of light-weight lambs not available fiom traditional suppliers in New Zealand or Australia. One issue is the development of hula1 certification systems, facilities, and processes in Mongolia. Supply chain reliability is another issue. A test trans-shipment by rail through China to Tianjin's port in May 2005 is saidto have encountered"extraordinary difficulties" at the border. Source: Nathan Associates. 3-25 Development of supporting services for livestock would reduce livestock sector vulnerabilities, while raising and diversifying rural incomes. Future growth will depend on increasing productivity and value adding activities, rather than increasing livestock numbers, which are already at the limits of sustainability. Degraded natural pasture land (possibly 25NathanAssociates,"Mongolia Meats andHidesIndustriesCompetitivenessStudy -InternationalMarket Review," July 2005, pp.22,38. - 5 6 - CHAPTER3: COUNTRYECONOMICMEMORANDUM compounded by climate change), competition from overseas markets and the mitigation of production risks will be key challenges in the future. To respond, the focus will be on increasing commercialization of the sector, including improving quality of produce. Opportunities exist for intensification of production where market and natural conditions are conducive. In marginal areas, extensive, semi-nomadic herding will remain the dominant form of production. For international markets, the focus will be on improving quality, plus identifyingniche markets. 3.26 Indeed, a key thrust of government strategy for livestock is the intensification of production. Around Ulaanbaatar are a growing number of intensive or semi-intensive livestock farms that cater to urban demands for fresh produce (e.g., beef, pork, poultry, dairy) and substitute for imports. Returns from such farms can be high, so long as several impediments are overcome, including the cost of borrowing; access to breeding services; access to feed and fodder; access to secure land rights; access to high-quality veterinary services; access to informatiodknowledge; and a still-fragmented processingsector. 3-27 Additional income-producing and diversification opportunities lie in such livestock support activities as fodder production, well maintenance, animal health surveillance, animal husbandry extension services, veterinary medicine (also an export possibility), and quality control. 3.28 For environmental as well as economic reasons, Mongolia should focus more on tourism yield and less on tourism numbers.Mongolia's recent growth in international arrivals almost matches the growth rates for such other specialty destinations as Bhutan, Nepal, and Cambodia (Table 3.4). For 2004, Mongolia's international arrivals were up 42 percent from 2002 and 414 percent from 2000. Tourism creates its own sustainability issues. Deleterious impacts from tourism include waste deposits and water pollution around tourist accommodations; steppe erosion, from cross-country vehicles; and poaching o f rare and endangeredspecies. 3.29 Mongolia lags behind other specialty destinations in terms o f tourism yield. Between 2002 and 2004, receipts-per-arrival grew only 8 percent in Mongolia, versus 18 percent in Thailand and 58 percent inNepal. Interms o f actual receipts, Mongolia's $615 per arrival is just 45-60 percent of comparableamounts for suchAsia destinations as South Korea, Bhutan, and Taiwan, China. Greater appeal to high-end tourism would help. Specialties could include eco-tourism, cultural or historical tourism, or even miningtourism. 3.30 To encourage high-end tourism, it will be important to address negatives-some long- standing, others on the rise. While appreciating Mongolia's people, natural environment, and traditional culture, tourist surveys point to a number of problems relating to roads and travel conditions; taxi drivers; service standards and quality of accommodations; quality and variety of food; general hygiene; language barriers; sporadic environmental degradation; alcohol- related incidents; and crime. In a survey of tourists conducted during summer 2005, an astounding 13 percent of respondents indicated that they had been crime victims-including 1.6 percent who claimed to have been victims of a major crime. The scene of the crime was Ulaanbaatar in 92 percent of the cases-and, specifically, Narantuul Market in 36 percent of ECONOMICDIVERSIFICATION INA CHANGING WORLD - 5 7 - MONGOLIA: the cases,26 Table 3.4: Tourism Trends, Selected Countries 2000 2002 2004 Receipts (million US$) Bhutan 10 8 12 Nepal 158 104 230 Cambodia 304 454 604 Thailand 7,483 7,90 1 10,034 Taiwan, China 3,738 4,583 4,054 South Korea 6,811 5,9 19 6,053 Mongolia 36 130 185 International arrivals (thousands) Bhutan 8 6 9 Nepal 464 275 385 Cambodia 466 787 1,055 Thailand 9,579 10,873 11,737 Taiwan, China 2,624 2,978 2,950 South Korea 5,322 5,347 5,818 Mongolia 137 229 301 $per arrival Bhutan 1,250 1,333 1,333 Nepal 341 378 597 Cambodia 652 577 573 Thailand 781 727 855 Taiwan, China 1,425 1,539 1,374 South Korea 1,280 1,107 1,040 Mongolia 263 568 615 Source: World Tourism Organization 3.3 1 Mongolia has some potential for offshore engineering. Software development for foreign clients i s another diversification possibility suited to Mongolia's limited transport services and infrastructure, since requirements for ph sical shipment o f goods are minimal. Mongolia's software sector i s extremely small?` The Government has encouraged development o f an IT park in the university district o f downtown Ulaanbaatar, which now houses 40-50 companies, o f which about 15 are incubator companies that have been selected by a competitive and transparent process and which receive free renuutilities and subsidized internet links as well as some VAT exemptions on hardware. The IT park has begun asking resident firms to focus on software development outsourcing to Japanese firms to take advantage substantially lower cost for Mongolian programmers. 3.32 While Mongolia's software sector is extremely small, especially when compared with 26USAID, EconomicPolicy Reformand CompetitivenessProjectnewsletter, February 2006. 27As of early 2005, Mongolia's entire information and communications technology (ICT) sector includedabout 5,900 workers, almost all located in Ulaanbaatar. Of these, about 4,000 worked in the telecommunications sector. Mongolian Information Development Association, The Mongolian Information and Communications Technology (ICT) Workforce Demand Survey, 2005, July 2005. Industry surveys indicate that Mongolia has about 350 software developers and that ten local universitiesnow produce about 600 IT professionals a years, of whom about one-thirdgo into software development. -58- CHAPTER 3: COUNTRY ECONOMICMEMORANDUM its main competitors for the Japan market (Table 3.5) small size does not necessarily preclude successful development o f some niche businesses. Industry experts suggest that chances of success would improve by targeting one or more specialized industries (e.g., mining, livestock) rather than more common industries (e.g., financial services, telecoms). Table 3.5: Software Sector, Selected Countries China Philippines Vietnam India Employees 300,000 10,000 15,000 (1) 850,000 Revenue (2005) $920 million NA NA $17,300 million Revenue per employee $3,067 N A NA $20,353 Revenue from Japan (2005) $557 million NA NA N A Monthly salary for new employees $400 N A $200 $400 Source: Gartner Research. (1) Employees are all software-related Box 3.3. Prerequisitesfor Entering Japan Software DevelopmentMarket * Staff aualifications: Mongolian software development companies will need a mix o f software architects, engineers, programmers, and quality-assurance testing staff. Training can range fiom 4-year university degrees to 2-year associate degrees. Vendors (e.g., Cisco, Intel, HP, IBM) may provide professional product-related training. It may be possible to partner with universities in Japan, India, China, and/or western countries. Accreditation in key languages (e.g., Java) and certification that IT professionals meet Japanese standards is essential. * Processes will need to be robust. Japanese clients will expect Mongolian software developers to achieve C M M I (Capability Maturity Model Integration) Level 5 certification. C M M I i s a process improvement model usedby the software industryto measure the quality of a software development organization. Allowing time for audits and demonstrations, it should be possible for Mongolian software development firms to achieve C M M I Level 5 within 3 years. * Intellectual propem: Japanese clients will want to have highconfidence that Mongolian software developers will protect both client confidential data and the intellectual property o f client-specific business processes and the IP o fthe delivered software. * Transportation: The main requirements are for reasonable air connections, a few comfortable and well- equipped hotels, and secure and reliable car service. Occasional disruptions in air service (e.g., due to weather) should not be a problem so long as first-class hotels can filly support the needs o f business travelers. As some work for Japanese clients will also need to be done on-site, Mongolian staff will also need to respond within reasonable time frames to requirements to travel to Japan. * IT infrastructure is critical. Software engineering sites and data centers need extremely reliable power supply. For instance, foreign f m s operating in India may have a triple-redundant backup generator system. Mongolia would need very reliable high-bandwidth connectivity and large data storage and servers. A good export/economic development zone with duty-free import on such equipment would be useful. * Language and cultural proficiencv is required for all customer-facing employees - perhaps 10 percent of the software sector workforce oriented toward Japanese business. Read-only language proficiency should suffice for another 40 percent o f this workforce. The former would require time and training inJapan. Source: Industry interviews. 3.33 Beyond some industry specialization, software industry experts suggest that Mongolia's ability to develop software for clients in Japan will depend on technical certification o f Mongolian staff and processes; safeguards for intellectual property (IP); adequate transport and IT infrastructure; and some language and cultural proficiency (Box 3.3). Citing India as a good example, software industry experts note that successful ECONOMICDIVERSIFICATION INA CHANGING WORLD - 59 - MONGOLIA. development o f Mongolia's software sector would require "islands" o f consistency, rather thanexcellence everywhere. 3.34 According to the Government's own analysis, however, the Government could do a lot to support development o f Mongolia's IT sector. This analysis maintains that monopolization o f Mongolia's primary communications network by a state-owned company (MTC) "hinders the launch and development o f new services'' and that "the speed and capacity o f the primary communications network i s unable to meet the constantly increasing demand." The analysis also notes that additional work i s needed on the legal framework to provide information securityn2' While preceding discussions have so far covered sectors identified by the Government as potential growth sectors, it is also worth considering other new and potential sources o f growth. 3.35 The global market for natural foods, food supplements, and beauty products has been largely overlooked. By virtue o f its large and relatively pristine geographic area and long experience with traditional medicines, Mongolia i s well-placed to respond to the large and rapidly-growing world market for health-related foods and personal care products (Box 3.4). As o f 2005, the combined JapadSouth KoredTaiwan market is estimated to be $13 billion, while the worldwide market could be as large as $85-100 billion. Box 3.4. World Markets for Natural PersonalCare Products and HealthFoods/Supplements One market survey sees a new and emerging market for "neutraceuticals" and "functional foods - natural, bioactive compounds with health-promoting, disease mitigating or medicinal properties." Market growth "is driven by an increasing consumer understanding of the link between diet and health, aging populations, rising health-care costs, and advances in food technology and nutrition research." Worldwide revenues for the functional foods and neutriceuticals were estimatedto be almost $60 billion in 2001. Market growthhas been especially rapid in the U.S., Europe, and Japan. Assuming 10-15 percent annual growth, the 2005 worldwide marketwould be $85-100billion. * m:The current Another market survey sees especiallyrapidgrowththroughout East Asia's most developedmarkets: size ofthe nutritionalsupplementsandhealthfoods market exceeds$10billion. "An aging populationand a rise in health consciousness amongthe Japanese have resulted in a tremendous growth in the Japanese health foods market." By 2040, one-third of Japan's population will be over the age of 65. Currently the world's second largest market for dietary supplements (after the U.S.), the Japanese market "is poised for evengreatergrowth inthe future." * Koreais the third largest Asian market for nutritional supplements, with a market size of about $2 billion. Of that, imports account for $432 million. Although already quite large, Korea's nutritional supplement market continuesto see annualgrowth of 15 to 20 percent.This reflects a nationwide"well-being" craze. * Taiwan: About 80 percent of the population uses nutritional supplements of some kind. The nutritional supplement market is expected to reach $770 million by mid-2005. Domestic production supplies only 25 percent ofthe localmarket Sources: Agriculture andAgri-Food Canada; US.Departmentof Commerce,International TradeAdministration 3.36 A variety o f products from Mongolia that might find niches in this market are in various stages o f development (Box 3S). Reliable supply chain linkages (field-to-processor- to-overseas retailer) that preserve both nutritional value and shelf life and a high-confidence ability to meet demanding hygiene and health standards in overseas markets are prerequisites for success inthis market. The typically highretail prices (and potential shelf-life constraints) 28MinistryofIndustry and Trade, supportingexhibits, processed. - 60 - CHAPTER3: COUNTRY ECONOMIC MEMORANDUM warrants reliance on air cargo as the normal mode for shipping specialty health-related and food products. Box 3.5. NaturalProducts from Mongolia A variety o f local products (e.g., mare's milk concentrate, black goat extract, fingus tea, aloe skin lotion) have been identified as potential niche entrants into overseashealth food and supplement markets. Spring 2005 saw some progress on development o f one such product-wild blueberry jam. Recent discussion about the potential for wild bluebeny jam illustrates both the potential market for such products and the obstacles that would needed to be overcome to develop such products. In Japan, blueberries and bluebeny preserves "are believed to have therapeutic properties and are known to the Japanese as the `vision' berry." In Mongolia, around 180 hectares produce an estimated 320 tons o f uncultivated blueberries each year. The berries mainly grow in Zavkhan, Kuvsugul, and Bulgan aimags. Currently, only about 50 tons is harvested and processed into final products, such as jams, juices, and liqueurs. Berries are harvested by local herders to supplement their livestock-related income. Logistical difficulties inbringingthe berries to market are cited as the main reason why much o f the crop remains un-harvested. InJune 2006, Japanese buyers identified an immediate demand for 50,000 bottles (500gm) o fjam, requiring 13 tons o f berries. Mongolianjam producers would "need to implement enhanced quality control to ensure that they can meet the strict hygiene, sanitary, and health standards that Japanese consumers demand. In August 2006, a leading Japanese organic retailer contracted for 60,000 jars o f wild blueberryjam, which are expected to appear on Tokyo and Osaka shelves inlate 2006. Initial samples have attracted high consumer interest because wild blueberries (compared with cultivated blueberries) contain almost twice the amount o f antioxidants. Antioxidants are believed "to alleviate the incidence o f cancers, heart disease, andreduce the effects o faging." Source: USAIDEconomic Policy Reform and competitivenessProject, June 2005 andJuly/August 2005 newsletters. 3.3 7 Assuming appropriate public-private initiatives, Mongolia's export sector could grow significantly and become much more diversified over the next ten-fifteen year period. Table 3.6 compares 2005 exports with two alternative scenarios. The assumptions used to develop these two alternative scenarios are reasonably plausible and conservative. These assumptions are consistent with previous suggestions that growth prospects for meat, natural products, tourism, and software development (or other knowledge industries) are greater than the growth prospects for cashmere or textiles. To allow for volatility in metals prices, Table 3.6 assumes either a 20 percent decrease in export earnings from mining (Scenario A) or a 20 percent decrease (Scenario B). Based on this plausible and conservative set o f assumptions, depending on metals prices, Table 3.6 suggests that Mongolia could see 45-70 percent real growth in export earnings over the next 10-20 years and that mining's share of export earnings could decline from 59 percent to 32-42 percent. All this will depend, however, on appropriate public-private sector initiatives to develop Mongolia's market potential. 3.38 It is entirely possible that some other product or service could emerge as an engine for growth and export diversification. Indeed, the previous discussion of various sectors should not be seen as an attempt to `(pick winners. " 3.39 Developing lasting new sources of growth and export earning will require even greater willingness to introduce new or improved products or services, and will largely depend on achieving an investment climate that i s more conducive and more supportive of innovation. Despite a small population and geographic/transport challenges, Mongolia's business community seems relatively innovative in efforts at export development. Between end-2002 and end-2005, the number of differentproducts exported increasedby almost one-third-from 351 to 462. Each year, during 2003-2005, Mongolia's business community introduced an ECONOMICDIVERSIFICATION INA CHANGING WORLD - 61 - MONGOLIA: average of 135 products into export markets. Also during 2003-2005, rough1 20-25 percent of each year's starting export lines were discontinued during the year?' The apparent readiness of Mongolian entrepreneursto innovate is encouraging. Developing new sources o f growth and export earnings will probably require even greater willingness to introduce new or improved products or services. This, in turn, will largely depend on achieving an investment climate that is more conducive andmore supportive of innovation. Table 3.6: Current ExportSector vs. Alternative Scenarios (constant 2005 U.S.Dmillions) 2005 2020 2020 Actual Scenario A Scenario B Assumptions Mining 729 583 875 Cashmeregarments 18 29 29 Cashmerefiber 54 49 49 Textiles 42 42 42 Meat 10 85 85 Naturalproducts 330 330 Tourism 177 426 426 Softwaredevelopment 50 50 Scrap 8 3 4 Other 206 206 206 Total 1,244 ,803 2,096 Assumcitions: I. CaseA: exportearningsdecline20percer dueto pricedropsandproductioncuts. Case B: exports earningsrise 20 percentdue to productionincreases, but nochange in prices. ii. 50percentriseinproduction;qualityimprovementssupport10percentriseinunit prices. iii. Nochangeinquality;7.5percentofde-hairedcashmereredirectedtodomestic garmentproduction. iv. Quality and supply chain improvementsallow 30,000 tons at $2,00O/tonand 5,000 tons at $5,00O/ton, onaverage. V. Revenuesequivalentto 1percentof current East Asia market and 0.25 percent share of rest of the worldmarket. vi. 15 percent rise in internationalarrivals; doubling o f receipts-per-arrival. vii. ... 5,000 professionalstaffand export sales averaging$10,000 per professionalstaff. v111. Quantity of scrap decreases 50 percent; price either declines20 percent(Case A) or remainsunchanged(Case B). - . ix. Heldconstant, to avoid double-counting(e.g., of naturalproducts, software). Source: B O Mfor 2005; and World Bank staflcalculations based on assumptions. PUBLIC-PRIVATE INITIATIVES 3.40 Faster diversification of Mongolia's economy depends on: (i)investment climate reforms; (ii)investment in needed public goods; and (iii) careful use of Mongolia's mineral wealth. A recent survey of Mongolian firms highlights corruption, access to finance, taxes, crime, anti-competitive behavior, licensing and permits, power supply (and other infrastructure, including roads), and customs (which also relates to transport and supply chain 29Staff estimates basedon UNCOMTRADEdata. - 62 - CHAPTER 3: COUNTRY ECONOMICMEMORANDUM linkages) as major concerns. Mongolian firms are far more concerned about these investment climate impediments than are firms in the other transition countries of Europe and Central Asia or firms elsewhere inEast Asia (Figure 3.7). Figure3.7: Investment ClimateImpediments:Perceptionsof MongolianFirms I 60 50 +Europe and Central Asia.-.*--.EastAsia and Pacific 40 30 20 10 0 B i Source: WorldBank, 2006. 3.41 Almost 80percent of firms see corruption as an obstacle to business operations and growth, with over half calling it a major or severe obstacle. Corruption appears to have worsened in recent years. Perceptions of corruption as a severe obstacle among Mongolian firms (56 percent) exceed such levels for Russia and most Central Asia republics (14-20 percent) and China (27 percent). Among the largest and best-performing firms in Ulaanbaatar-those that should excel in generating growth, employment, and exports-nearly 75 percent see corruption as a severe business problem. 3.42 Causes include opaqueprocessesfor government procurement; complex structures and opaque governance of enterprise groups and financial-industrial groups, which have close ties with government officials and political leaders; opaque processes for urban land registration; tax rules that heretofore encouraged overly complex business structures; non- transparent processes for tax administration; complex licensing requirements; and non- transparent customs procedures. 3.43 Reforms need to go beyond legislativefuces and also restructure the operations of key agencies-e.g., tax administration, customs, and inspections-that directly interact with the business community. Such restructuring should be based on clear definition of the statutory powers, mandate, and functions of each agency and institutional/procedural fixes to administrative shortcomings. Since comprehensive reform of administrative processes takes time, immediate measures (e.g., public information) are also needed to provide transparency ingovernment-business interaction^.^' 3.44 Access to finance remains expensive at best or, at worst, nonexistent. Despite declines in interest rates, real interest rates on tugrig-denominated loans remain far higher than rates in neighboring and transitional countries (Table 3.7). Fewer than 28 percent of 30World Bank, 2006, pp. 19-22,43.4. ECONOMICDIVERSINCATIONA CHANGING WORLD IN - 63 - MONGOLIA: surveyed firms report having a bank loan, and less than 3 percent enjoy an over draft facility. With an overwhelming 90 percent of loans having a maturity of less than one year, debt financing of long-term capital expenditures is extremely difficult or impossible. An almost exclusive emphasis on collateral-based lending and extremely high collateral-to-loan ratios especially disadvantage SMEs, which tendto lack real property assets. Table 3.7: RealInterestRates, Selected Countries (percent per annum) 2000 2001 2002 2003 2004 2005 Mongolia: In domestic currency 25.4 31.1 34.6 23.2 17.9 In foreign currency 16.9 16.9 20.3 11.0 3.8 South Korea 6.3 3.6 4.1 2.3 2.9 China 5.6 5.4 6.1 1.6 3.8 Russia 16.4 15.4 9.1 EasternEurope 8.8 8.6 7.9 Low-incomecountries 14.4 9.3 11.6 Lower middle-incomecountries 0.4 0.7 1.1 Source: various WorldBank 3.45 Both high deposit rates and wide spreads contribute to high real interest on lending. High deposit rates reflect intense competition among financial institutions, plus an unprecedented credit boom. New savings and credit cooperatives, many of which suffer from low liquidity, have been offering extremely high deposit rates. Still-wide spreads are attributable to three factors: (i)requirements for banks to maintain sizable reserves in extremely low-yielding deposits at Mongol Bank; (ii) overhead costs, due to too many high branches and high administrative costs of doing business in remote areas; and (iii)high loan loss provisions due to recent credit over-expansion, lack of a credit culture, and inadequate creditor recourseto remediesthrough liquidationor bankruptcy. 3.46 A narrow base of borrowers may also hurt access to credits3'Many Mongolian banks are owned by enterprise groups (Table 3.8) or otherwise linked to private business groups or families. This has given rise to concerns about extensive self-dealings to the exclusion of potentially bankable outside businesses. 3.47 Mongolia'sjinancial sector is at a crossroads as well. It could rapidly develop into a well-governed system able to provide efficient financial services, or it could see rapid and severe erosion of post-2000 gains. Key recommendations include the following: 0 Laws and regulations on savings and credit cooperatives (SCCs), NGOs, and finance companies should more closely regulate deposit-taking activity and promote the soundness of small and micro financial intermediaries. 0 The inter-bank market should be developed to diversify bank funding sources and strengthenthe monetary policy transmission mechanism. 31Across the entire sector, on average, 36 percent of loans were with the lender's 20 largest borrowers, while 55 percent were with the 50 largest. Over-exposure is even more serious at Mongolia's small banks. - 64 - CHAPTER 3: COUNTRY ECONOMICMEMORANDUM Table 3.8: Selected EnterpriseGroups Enterprise Affiliated banks Other affiliates group Subsidiaries Shareholdings Subsidiaries Shareholdings MCS Spirit Bal Buram; Skytel, Unitel Interpress; MCS Electronics;MCS Construction;Coca-Cola distributor; IrishPub; OrchlonSchool; Mongolian wool & cashmere; Anun; Anungoo; Shangri-latrade center & hotel; Tavan Tolgoi Tavan Bogd KhaanBank KhaanPalacehotel, Palace Hotel, Fuji film studio, Juulchintour, UB flour plant, Technique Import, Tavan Bogd cosmetics; Gobi cashmere Jenco Capitron Bank Trade & Develop- Bayangolhotel, Konica APR, Shunkhlai ment Bank franchise, MakhImpex, petrol imports IkhMongol, Atar Urguu, Jenco tour; Hilton hotel; Tavan Tolgoi Altai Trading ChinggisHotel, Tavan Boroo gold Tolgoi, Altai cashmere Bodi Golomt Bank Incon construction, Magicnet,Bodi computer Petrovis CapitronBank Petrovisgas stations, NIC petroleumdistribution; TavanTolgoi Fortuna Post Bank UBCity Bank American School, UB Mart shopping center Ere1 Ere1Bank Ere1construction,Ere1 cement factory, Ere1 secondaryschool, gold mines in Ult and Zaamar Chingis KhaanBank Savings Bank Source: WorldBank staff compilationfrom press reports; mission interviews. 0 To address credit risks-a contributor to high interest rates-liquidation and bankruptcy procedures should be made more predictable and creditor-friendly; credit reporting and registration o f security interests should be improved; and controls on related-party lending should be strengthened. 0 Cross ownership between financial institutions and non-financial enterprises should be prohibited or more strictly controlled. 0 To further address highrates on loans, the BOM should reduce reserve requirements, raise rates on deposits by member banks, and recognize CBBs as acceptable bank collateral. 0 Consolidation o f the banking sector would help reduce administrative overhead costs and excessive competition for deposits. ECONOMICDIVERSIFICATION CHANGING WORLD INA - 65 - MONGOLIA: 0 To maintain financial services in rural areas, however, efficient micro-lenders should be encouraged to increase penetration o f rural areas. To facilitate longer-term financing o f capital expenditures, leasing should be encourage through passage o f a financial leasing law and parallel changes in accounting and tax treatment o f leasing. 0 Governance reforms should strengthen Bank of Mongolia's readiness to enforce regulations and supervise financial institutions. Corporate governance at banks should be strengthened, especially in the composition, fiduciary duty, and responsibilities o f boards o f directors; disclosure o f conflicts o f interest by owners, directors, and management; and implementation o f external audits. 0 The desirability and alternatives for introducing deposit insurance should be evaluated. 3.48 Mongolia's tax system continues to pose problems. While top corporate tax rates have been comparable to those in other Asian economies, effective tax rates inMongolia have been higher because o f the non-deductibility or limited deductibility o f many items (e.g., insurance premiums, staff training, advertising) that are fully deductible in other countries. The lack o f tax loss carry-forwards or carry-backs has been a disincentive to accept business risk, since any losses could not be recouped at tax time. At least until recently, the corporate tax rate jumped from 15 percent to 30 percent once a firm's net income crosses a 100 MNT threshold. This created strong incentives for firms to stay artificially small, often by splitting into smaller affiliates. This has contributed to complex and opaque corporate structures, which have probably impeded access to finance because it was more difficult for lenders to ascertain consolidated financial position and performance. Social security and other tax rates have been high. Average time spent with tax inspectors has been 3 to 7 times higher for Mongolian firms than for firms in the former Soviet Union. Tax inspectors have used their substantial discretion to seek rents. At the same time, firms' under-reporting o f sales and tax evasion has been rife.32Thus, in terms o f maximizing inefficiency (both in tax compliance and business behavior) and corruption, Mongolia's tax system has been a model o f what not to do. 3.49 A law passed by the Great State Hural in June 2006 appears to have moved Mongolia's corporate tax law closer to international best practices.33 The new law's treatment o f tax loss carry-forwards or carry-backs, however, remains unclear. Given the urgent need to encourage Mongolia's business community to take reasonable risks in developing new sources o f growth and export earnings, very generous treatment o f tax losses is warranted.34 32 World Bank, 2006, pp. 13-8. 33 Tax rates would be lowered from 15 percentto 10 percent and from 30 percentto 25 percent.The threshold for the higher rate would be raised from MNT 100 million to MNT 3 billion, as a result of which 99 percent of corporate tax payers would operate in a "flat tax" environment. More legitimate business expenditures could be deducted. An investment tax credit would encourage capital investment. The draft law included a three-year tax loss carry-forward, but that may not have made it into the final draft. Discretionary tax exemptions would be eliminated. USAID Economic Policy Reform and CompetitivenessProject, June 2006 newsletter. 34Inthe U.S.,for instance, tax losses can be carried forward -years and carried back-years. - 66- CHAPTER3: COUNTRY ECONOMICMEMORANDUM The tax regime for mining companies raises special issues. Inparticular, apart from lacking adequate or appropriate definition^,^^ the Windfall Profits Tax is an ill-considered attempt to promote Mongolia's downstreamprocessingof copper and gold concentrates. 3.50 Tax administration should be restructured to reflect clear definitions of its statutory powers, mandate, and functions and to alleviate institutional and procedural shortcomings. In addition, greater public dissemination of tax administration procedures is needed to promote transparency. 3.5 1 Allegations of anti-competitive behavior warrant closer scrutiny. Anti-competitive behavior is considereda problem by more firms inMongolia (40 percent) than by firms inall of East Asia (about 21 percent) or Europe and Central Asia (about 19 percent). It is difficult, however, to quantify the issues. Although Mongolia established an Unfair Competition Commission in January 2004, the Commission has no analytical capability or enforcement capability. Our own review of available tax data suggests that the banking, gold, hotel, cashmere, construction, and retail sectors are reasonably competitive, but that some enterprises/groupsexceed a 30 percent market share in some sectors, for example, petroleum distribution, vodka.36 In addition, the lack of a regulatory framework for such utilities as power and water, especially in remote areas, may encourage price gouging. Greater authority and capacity building for the Unfair Competition Commission and development of regulatory frameworks for utilities i s neededto address competitiveness concerns. Table 3.9: Startinga Business,SelectedCountries # of procedures Time (days) Cost as YOof per Minimum capital capita GNI as YOof GNI Mongolia 8 20 6.2 140.2 China 13 48 13.6 946.7 South Korea 12 22 15.2 308.8 Japan 11 31 10.7 75.3 Taiwan, China 8 48 6.0 216.3 Kyrgyz Republic 8 21 10.4 0.6 Kazakhstan 7 24 8.6 26.6 Russia 8 33 5.0 4.4 Hungary 6 38 22.4 79.6 Germany 9 24 4.7 47.6 Turkey 8 9 27.7 20.9 United States 5 5 0.5 0.0 Source: WorldBank, Doing Business 2006. China significantly reduced minimum capital requirements in October 2005. Better than Mongolia in bold. 3.52 Cross-country comparisons suggest that Mongolia's business regulation is not burdensome, although 31percent of Mongolian firms surveyedperceive business registration and licensing as a severe impediment. Among eleven other countries-including several 35For example, of gold prices, copper prices, deductible businessexpense. 36Sales and import data suggest that the Petrovis group (which includes NIC) may control half of Mongolia's petroleum products distribution. Data on excise tax revenues suggest that Spirit Bal Buram controls about 40 percent of the domestic market for vodka. While some express concerns about concentration inthe retail sector, for instance in computer sales, data from the company indicate that the largest computer vendor (MCS Electronics) hasjust a 25 percent market share. ECONOMICDIVERSIFICATION INA CHANGING WORLD - 67- MONGOLIA: OECD, several transitional, and China-rules on business start-up are clearly easier in four (Russia, Hungary, Germany, United States), but clearly more difficult in rapidly growing China (Table 3.9). Looking at licensing among this same group, licensing requirements are easier inthree (South Korea, Japan, United States), but more difficult inChina (Table 3.10). Table 3.10: Dealingwith Licenses, Selected Countries # of procedures Time (days) Cost as YOof per capita GNI Mongolia 18 96 58.8 China 30 363 126.0 South Korea 14 60 232.6 Japan 11 87 19.7 Taiwan, China 32 235 250.9 Kyrgyz Republic 16 152 325.2 Kazakhstan 32 258 68.3 Russia 22 528 353.7 Hungary 25 213 279.1 Germany 11 165 82.8 Turkey 32 232 368.7 United States 19 70 16.9 Source: WorldBank, Doing Business 2006. Better than Mongolia in bold. 3.53 It may be that actual administration o f business regulations is more burdensome than what study o f Mongolia's lawshegulations alone would suggest. Inany event, Mongolia faces enough geographic and other challenges. Its rules on business start up and licensing and their implementation should models o f simplicity and transparency. 3.54 Access to land is a special issuefor Mongolia's livestock sector. The feed and fodder sector in Mongolia i s currently weak and the private sector has not filled the void left when the state supported industry collapsed in the early 1990s. Feed and fodder are important sources o f nutrition for livestock and help to both increase the productivity o f animals and also enable animals to survive hard winters. It i s for the latter reason that the state remains engaged in the sector through a national system for distributing feed and fodder reserves in preparation for winter. This undermines efforts by the private sector to enter the industry. Hay production i s at a low level. Herders often do not have the skills, capital or resources to grow, harvest and store hay. Typically, hay production involves group actions, for instance in the joint ownership o f land tenure rights and assets such as fences, irrigation infrastructure, storage facilities and harvesting equipment. Common complaints o f herders center on access to land for hay-production (see below) and access to finance, in particular the perceived excessive interest rates, lack o f term financing and limited options for group (e.g., cooperative or herderNGO) borrowing. 3.55 The government has taken important steps to improve land regulations and administration with the 2002 LandLaw. While it i s an improvement on the earlier 1994 Land Law, there are still gaps and ambiguities (including lack o f clarity on what entities may possess land rights the relationship and consistency between land user rights and water user rights), and in practice has been interpreted differently across the country. The implementation o f the law is determined by local awareness and interpretation, and local land officers do not always have sufficient capacity. Further amendments to the law may be -68- CHAPTER 3: COUNTRY ECONOMICMEMORANDUM necessary to establish a fair and transparent system for allocating pasture land resources, which will be critical for managing pastureland and for the sustained growth o f the sector. 3.56 Most Mongolian exporters or importers regard customs clearance as a major or severe obstacle. Clearance times for exports average 4 days, but can take up to 15 days. For imports, the average i s 3 days, but clearance can take up to 30 days. Customs valuations and exemptions have been a major venue for corruption. Further reform o f processes, administrative procedures, and incentives are needed ifMongolia i s to succeed indiversifying its export sector.37 3.57 Mongolia's infrastructure compares poorly with other countries in the region. For instance, utilities performance seems much worse (Table 3.11). Some 38 percent o f surveyed firms are dissatisfied with Mongolia's transport sector. While overland transport to Russia and China will remain problematic, development o f the roads network within Mongolia would help. So would better access to air cargo services.38 3 -58 Thus, additionalpublic andprivate investment in infrastructure is warranted. Likely candidates for additional investment include inter-city roads; power, watedwaste water, and telecommunications infrastructure; and development o f downtown Ulaanbaatar to enhance its livability. To facilitate the clustering o f new growth businesses, development o f a new industrial park may make sense. For instance, it might make sense to cluster high-value food and natural product exporters, international-standard packaging producers, cold chain facilities, phyto-sanitary labs, and related activities in an industrial estate with good infrastructure near Ulaanbaatar's airport. Establishment as a free trade zone could also facilitate the import o f any critical inputs. Table 3.11: Qualityof InfrastructureServices, Selected Countries Days to obtain an Power outages Days to obtain a Water supply electrical connection (days) water connection failures (days) Mongolia 19.0 22.0 21.0 4.0 East Asia & Pacific 9.9 5.5 8.9 3.1 Europe& Central Asia 12.3 12.3 Na 4.4 China 10.4 na Na Na Russia 11.9 2.7 Na 1.3 Kazakhstan 7.2 4.6 Na 1.9 Source: WorldBank, 2006, p. 30. 3 -59 Key workforce issues are under-utilization of human capital and skill mismatches. Idleness rates exceed 20 percent for 25-29 year-olds. This problem includes both urban populations and those with secondary or higher education. Indeed, idleness i s particularly high (26 percent) for vocational school graduates. Insufficient job opportunities have 37 World Bank, 2006. pp.32-4. Asia Development Bank, "Mongolia: Customs Trade Facilitation and Modernization: Priority Programs," February2006. 38It is not clear what effect an "open skies" policy would have on Mongolian air cargo. The relatively small size of Mongolia's economy may be the mainconstraint now on faster developmentof air cargo. The potential role of air cargo inencouraginghigh-value exports, impediments to air cargo development, and usefulness of temporary subsidies deserves further examination. ECONOMICDIVERSIFICATION INA CHANGING WOUD - 69 - MONGOLIA: encouraged overseas migration39.Higher percentages of workers are either over-qualified or under-qualified for their current assignments. Especially in construction and mining, firms have responded to inadequate skills among local workers by hiring foreign workers, particularly Chinese and Russians. 3.60 Contributing factors include constraints on growth and job creation, as a result of investmentclimate impediments; a structural shift inthe economy that has raised demandfor foreign language skills, I T and technical skills, and behavioral (e.g., communications) skills. In addition, school curricula and teaching methods have not kept up with the new practical demands from the labor market. Vocational education is outdated. Institutions of higher education do not serve the needs of the knowledge economy. 3.61 Such shortcomings in the education system may explain, for instance, foreign domination of Mongolia's mining sector. Consideration of historical experiences in Chile and Australia suggest that Mongolia could become a major worldwide purveyor of industrial knowledge (e.g., in mining, in environmental protection) (Box 3.6) within twenty years, but that it would needto begin establishing the institutional basis for these knowledge businesses now. Box3.6: How Did Australia Cometo Run Chile's Mines? Chile suffered from its historical lack o f an infi-astructure for scientific learning and education. Mathematics was particularly neglected. Traditionally, higher education focused on theology and law. As late as 1915, the National University's 970 graduates included only 19 engineers. This weakened Chile's capacity for innovation and adoption o f new technology, including the capacity to exploit less-rich veins o f copper. There may have been an implicit acknowledgement that technically, Chileans could not manage their resources as well as foreigners could. Reliance on foreigners discouraged development o f indigenous mining universities/institutions and indigenous capacity for innovation and analysis. As late as the 1950s, foreign librariescontained more information about Chilean copper than did Chile's own libraries. Not until 1955 was the Copper Department created to oversee U.S. mining f m s ' operations. According to one assessment, "it took about 40 years, from 1925 to 1965, to develop a domestic capacity to analyze the role o f copper and to educate Chilean professionals andtechnicians" inthe management o f large copper f m s . Australia, starting from humble roots, had been a penal colony for Great Britain Several localuniversities became beachheadsfor foreign research-Sydney Mechanics Institute Technical College in 1878, and a School o f Mines in Ballarat in 1870. Recruitment o f engineers and metallurgists in 1886 firmly linked Australia to innovations in the U.S. The University of New South Wales (UNSW) was founded in 1949, usingthe Massachusetts Instituteof Technology (MIT) and Berlin Universityo f Technology as models, with a focus on research and teaching in science and technology. The UNSW School o f Mining Engineering now ranks as one of the largest worldwide educators of mining engineers. As o f 1920, Australia had only 47 engineers per 100,000 people, compared with 128 for the US. Australia's engineering cadre reached 163 per 100,000 by 1955. Source: WorldBank, 2002 3.62 More joint public and private sector support for R&D institutes may also make sense. While government efforts are most appropriately focused on general factors (e.g., 39Between 1990 and 2003, about 120,000 Mongolians emigrated, mainly to South Korea and Japan. Remittances peaked in 2004 at $202 million (nearly 13 percent o f GDP). Surveys indicate that 60-70 percent o f migrants are aged 20-35, that 50-60 percent has higher educations, and that migrants return to Mongolia after 3.7 years, on average. C. Ridao-Cano, "Labor Market and Skills in Mongolia," background note, December 2006. - 70- CHAPTER 3: COUNTRY ECONOMICMEMORANDUM education, infrastructure), the most significant factors for competing in an innovation-driven economy are specialized and associated with industries or groups o f industries. Government attempts at creating specialized factors (e.g., vocational training, applied technology) on its own are risky. Worldwide experience shows that government should involve indust and encourage industry to play a major role in the creation o f specialized factors?'The development o f Chile's approach to R&D in the fruit sector is illustrates the power o f an appropriate alignment o f public sector and private sector involvement in industry-specific R&D (Box 3.7). Such experiences may be relevant for knowledge development in priority sectors or potential growth sectors for Mongolia (e.g., geological prospecting, environmental protection and remediation, natural personal care products, health foods and supplements." Box 3.7: R&D in Agriculture: Chile's Example Duringthe early 1960s, the Chilean Development Corporation (CORFO), financed by a 15 percent tax on copper, played important roles, for instance, in surveying existing h i t orchards, analyzing foreign demand, elaborating production goals, introducing new varieties, establishing nurseries, constructing cold- chain facilities at strategic locations to extend post-harvest shelf life, and conducting phyto-sanitary inspection o f exported hit.Establishment o f the National Institute of Agriculture Research (INIA) in 1964 supported fiuther research support. Private sector investment in h i t sector research prior to 1975 was negligible.After 1975, several institutions (FONDECYT, FONDEF) were created to promote private sector participation and competition in R&D. The operation o f these institutions required the use o f either collaborative fbnding or research originating in the private sector. In addition, a 1989 law introduced tax incentives for R&D donations to institutions o fhigher education. Between 1973 and 1990,private spending on agriculture R&D increased 19 times, rising from 2 percent o f agriculture R&D in 1973 to 13 percent in 1990 to 20 percent by the late 1990s. After 1975, INIA also moved toward self-financing-by 1985 receiving 40 percent o f its income .from sales and another 20 percent .from grants, loans, and other non- government sources. "The increased availability, diversification, and private direction o f funding sources were associated with greater weight given to research on exportable crops and the investigation o f postproduction technologies, product characteristics and quality, and other topics important to commercial agriculture. For-profit research activities proliferated, especially where the returns to identification and adaptation o f new varieties and methods was more easily internalized." Source: WorldBunk, 2002,pp. 79-82. 3.63 Prudent management of Mongolia's mineral revenues is needed to support investment in infrastructure, education, and innovation. Faced with natural resource windfalls, a number o f countries have established "sovereign wealth funds" to manage resource revenues (Table 3.12). Most are based on oil wealth, but a few draw on mineral legacies.41The best funds rely on professional management and carefully crafted investment strategies, sound corporate governance, and transparency and full public disclosure. Some funds grow their wealth by investing in publicly-tradable securities.42 Others may invest in projects to support the economic development o f their home country. Chile's development fund i s an interesting example o f the latter. 40 Michael Porter, The Competitive Advantage of Nations, (Free Press, 1990),pp. 620, 627. 41 For instance, Kiribati's Revenue Equalization Fund was established in 1956 to manage revenues from local phosphate mines. The mine closed in 1979, but the Fundcontinues to support the Kiribati economy. 42 For instance, 50-70 percent o f the Norway Fund is to be invested in fixed income securities and 30-50 percent in equities, outside Norway. There are also regional guidelines (Europe, North America, Asia, etc.) for asset allocation. In Canada, at the Alberta Heritage Fund, about 30 percent o f assets are in fixed income, 45 percent in equities (including 30 percent in non-Canadian equities), and 25 percent are in a mix o f other assets (e.g., real estate, absolute return hedge funds, private equity, and timberland). ECONOMIC DIVERSIFICATION INA CHANGING WORLD -71 - MONGOLIA. Table 3.12: Sovereign Wealth Funds - Country Fund name Assets (%m) Established Source United Arab Emirates Abu Dhabi Investment Authority 250,000 n.a. Oil Norway Government Pension Fund 266,000 1990 Oil Kuwait Kuwait Investment Authority 65,000 1953 Oil Brunei BIA 30,000 1983 Oil Russia Stabilization Fund 27,700 2003 Oil Canada Alberta HeritageFund 15,400 1976 Oil Iran ForeignExchangeReserve Fund 8,000 1999 Oil Kazakhstan National Fund 5,200 2000 Oil, gas, metals Botswana PulaFund 4,700 1966 Diamonds, etc. Chile Copper Stabilization Fund 3,900 1985 Copper Oman State GeneralReserve Fund 2,000 1980 Oil, gas Azerbaijan StateOil Fund 1,000 1999 Oil Venezuela FIEM 714 1998 Oil Kiribati Revenue Equalization Fund 400 1956 Phosphates Source: State Street Global Advisors, ` IWho Holds the Wealth of Nations?" August 2005; updated in selected cases from fund web-sites. 3.64 Thus, Mongolia should adopt appropriate policies and programs to facilitate export diversification, both to reduce vulnerability to commodity shocks and encourage additional growth. Key investment climate reforms include restructuring of processes at key agencies (e.g., tax, inspections, customs) to enhance government efficiency, transparency, and integrity; tax reforms (e.g., loss carry-forwards) to encourage investment and innovation; regulatory and supervisory actions to help reduce the cost of financing; limits on anti- competitive behavior; and improvements in public safety and quality of life in Ulaanbaatar. Additional investment in education and infrastructure is needed, perhaps including industrial park infrastructure for a new growth cluster inUlaanbaatarand public-private R&D institutes. To marshal the financial resources to support needed investments, it will be important for Mongoliato harnessand efficiently deploy revenuesfrom its richendowment of minerals. Box 3.8: The Chilean Development Corporation The Corporacidn de Fomento (CORFO) was establishedin 1939. Financedby a 15 percent tax on copper, CORFO's efforts "would lay the foundation for the dynamic export industries of the next half century." To develop Chile's fishing sector, CORFO contracted technical assistance missions, established a marine biology station in 1945, granted sizable tax exemptions in 1952, in 1954 joined the army and University of Chile in surveying coastalwaters, andthereafter financedfixed asset and supply chain investments.C O W 0 took the fvst inventoriesof Chile's forests, contractedtechnicalassistance in 1944, and in 1953 financed processingplants for cellulose andnewsprint. To support developmentof Chile's h i t industry, C O W 0 financedtechnical assistance, extended credit for experimentation and cultivation, and invested insupporting infrastructure. In 1941, C O W 0 financed efforts to promote exports of wood products and wine. Subsequently, Chile's export sector and economy stagnatedas aresult of exchange rate controls and other protectionist interventions. Following economic liberalization in 1975, Chile's export drive resumed. Between 1975 and 1995, non- copper exports increasedten-fold and its share of exports fell to 45 percent. Fruit, fishmeal, lumber, and wood furniture rose to 9 percent, 8 percent, and 6 percent, respectively,of exports. More recently, support from C O W 0 and the Fundaci6n Chile (a public-private R&D institute) for initial production, disseminationof know-how and technology, assistance in meeting I S 0 standards, and foreign study tours to help domestic industry keep in touch with the international technology frontier is credited with having helped Chile boost its export of farm-raised salmon from less than $50 million in 1989 to $1.2 billion in 2003 and $1.7 billion in2005. The question now is whether such organizationsas CORFO can move from selling fish to selling fish cultivation knowledge. Source: WorldBank, 2002; Jorge Katz, "Salmon Farming in Chile". - 72 - CHAPTER 3: COUNTRYECONOMICMEMORANDUM 4. THE TYRANNY OF DISTANCEAND THE ROLE OF GEOGRAPHY Mongolia could take more advantage of its unique location between Russia and China by exploiting more systematically its position of a transit corridor for trade between its two neighboring economic giants and beyond. Policies should, therefore, focus on facilitating trade on the China-Russia corridor, both internally by improving internal infrastructure and by streamlining regulations and bureaucratic procedures, and externally by looking at possible tradefacilitation agreements and regulations harmonization. Internally, one cannot escape but see the increasing migration of people into the Ulaanbaatar area and its environs (especially, the Ger-areas) that is occurring today. This may provide the agglomeration effects tofoster growth if appropriate infrastructure andpublic/private services are provided. Appropriate investments in infrastructure and associated policy measures to promote its eflcient development and use may go a long way in facilitating trade-routes, cross-country commerce and foreign direct investment. It would help strengthen supply chains and thus improve the investment climate. 4.1 This chapter endeavors to look into considerations that determine where future growth takes place in Mongolia. Having identified the binding constraints to Mongolia's future growth (Chapter 2) and the need to alleviate them through various policies one needs to be cognizant of the unique geography of Mongolia. This makes the design and implementation of the desirable investments and corresponding activities difficult to undertake and different from countries whose people do not face the tyranny of distance and harsh weather conditions as Mongolia. This will need to be discussed in the context of the ongoing debate about regional development in Mongolia, on the one hand, and the reality of ongoing agglomeration effects that are emerging due to concentration of economic activities in and around Ulaanbaatar. All this will significantly impact on the geography of economic growth in Mongoliaover the long term. 4.2 Key questions that this chapter aims to address are: I s geography a constraint to economic growth in Mongolia and to what extent? Where is economic growth taking place? What can policymaking do about geographical income or growth disparities and constraints? What are the existing regional development tradeoffs for policymaking and in particular infrastructure policy? The low aggregate population density of Mongolia hides the fact that the labor market for Mongolia is segmented, with significant skills mismatches prevalent. Policy recommendations to address this are also provided in this chapter. Specifically, the chapter is organized as follows: the first section presents a snapshot o f Mongolia national physical and human geography, where the unique characteristics of the country are singled out. This section also draws on the recent literature on "economic geography", and cross- country experiences, to assess the extent to which geography can constrain economic growth. The second section focuses on Mongolia's internal geography to analyze where economic THEnRANNY OFDISTANCE AND THEROLEOF GEOGRAPHY - 73 - MONGOLIA: growth is taking and will take place inthe medium-term,what are the other considerations to take into account for policymaking such as the optimal or desired level of urbanization or spatial disparities. Policy recommendations are provided to guide policymakers to design regional development policies, and inparticular for infrastructure development inthe country over the next few years as well as for accommodating labor migration and labor market development. MONGOLIA NATIONAL GEOGRAPHY ECONOMICGROWTH AND 4.3 A vast territory with a small population. Mongolia is often singled out by its unique human and physical geography. The so-called "tyranny of distance" i s commonly used to characterize the challenges posed by the country geographical situation. Mongolia occupies an area (1,564,116 sq km) that is equivalent to France, Italy and Spain combined. Its total population of 2.6 million people translates to an average of 1.6 inhabitant per square kilometer-the country with the lowest population density in the world'. But most of the country outside the capital city of Ulaanbaatar is even less densely populated, with a population density of less than 1 inhabitant per sq km (Figure 4.1). With a moderate population growth rate o f 1.5 percent in recent years, this pattern is unlikely to change inthe mediumrun2. 4.4 Mongolia's weather is characterized by harsh extremes. Summer weather is extremely variable and unpredictable, with multiyear averages concealing wide variations in precipitation, dates of frosts, and occurrences of blizzards and spring dust storms. Summer extremes reach as high as 38" C in the southern Gobi region and 33°C in Ulaanbaatar. Average temperatures over most of the country are below freezing from November through March and are about freezing in April and October. Such extremes make the effective construction period for infrastructure limitedto a few months each year. January and February averages of -20°C are common, with winter nights of -40°C occurring most years. More than half the country is covered by permafrost, which makes construction, road building, and mining difficult. All rivers and freshwater lakes freeze over inthe winter, and smaller streams commonly freeze to the bottom. Although winters are generally cold and clear, there are occasional blizzards known as dzud that do not deposit much snow but cover the grasses with enough snow and ice to make grazing impossible, causing massive losses of livestock. Official statistics list less than 1 percent of the country as arable, 8 to 10 percent as forest; with forest coverage reported to diminish in recent year due to over-logging, and the rest as pasture or desert. Such environmental conditions pose severe challenges to human and livestock survival. Grain, mostly wheat, is grown inthe valleys of the Selenge river system in the north, but yields fluctuate widely and unpredictably as a result of the amount and the timing of rain andthe dates of killing frosts. ' Greenlandhas a lower populationdensity (0.13 inhabitants per sq h) is not a sovereignstate. but 2 By turn of 20" century Mongoliansnumbered only half a million. During seven decades of communism, the population quadrupled, especially after the "baby boom" of 60s, mostly due to the improvementof health care and education systems with the Soviet assistance. Following the independence and the economic turmoil that accompanied the withdrawal of the Soviet support, population growth slowed down markedly. In the recent period, populationgrowthhas remained inthe range of 1.5 percent a year. - 74- CHAPTER 4: COUNTRYECONOMIC MEMORANDUM Figure4.1: Most of Mongolia'sPopulationis inUlaanbaatar. PopulationDensity (end-2006) BuQap 1 2 WS 1 2 Bayan.W 2 2 Zsvkhen 1 &in& 06 Armsnsai 1 7 =people per sq.km = 0.3 - 74.0 74.1 100.0 - 100.1-208.3 People per sq. km. Ulaanbaatar 208.3 Orkhon 100.0 Darkhan-Uul 26.9 Selenge 2.4 Govisumber 2.3 Bayan-Ulgii 2.2 Uvurkhangai 1.8 Arkhangai 1.7 uvs 1.2 Khovd 1.2 Bulgan 1.2 Khuvsgul 1.2 Tuv 1.2 Zavkhan 1 .o Khentii 0.9 Bayankhongor 0.7 Dundgovi 0.7 Sukhbaatar 0.7 Dornod 0.6 Dornogovi 0.5 Govi-Altai 0.4 Umnugovi 0.3 Source: WorldBank staff estimates THEnRANNY OFDISTANCE THEROLE OF GEOGRAPHY AND - 75 - MONGOLIA: 4.5 A landlocked mineral-rich country with a narrow economic base. Mongolia economic base i s concentrated on a few minerals and livestock-based products. As a consequence, Mongoliahas been vulnerable to volatile commodity prices and to adverse climatic shocks. Its landlocked nature, between the two economic giants-China and Russia-has made Mongolia's access to international markets crucially dependent on what happens with and in these neighboring countries. This combination o f circumstances makes the discussion about Mongolia's future sources o f growth all the more challenging and policy prescriptions not as easy to implement incountries with more temperate climates and diverse economies. IMPLICATIONS FOR ECONOMIC GROWTH Beinga sparsely populated,large and landlockedcountry 4.6 Ina sparsely populated country everythingincreases when valued interms o f the per capita cost o f infrastructure and service delivery. In Mongolia, this cost i s even further magnified by the harshness o f its winters, which significantly increases the cost of transportation and road maintenance. The issue o f access to heating becomes a question o f survival o f its population. In the context o f a low income country such as Mongolia, this heightens existing tradeoffs between financial constraints and fiscal space on the one hand, and the need to address the country's basic needs for development and poverty alleviation on the other. 4.7 Economic literature shows that, on average, landlocked countries grow slower than those countries that are not.3 They typically have a lower income per capita, and are less open. They face specific challenges, such as higher trade costs, not only related to the difficulty o f land transportation over great distances, but also because they are dependent on their neighbors to access markets. Indeed, trade from a landlocked country has to pass through sovereign transit country to access international shipping markets. This translates into a heightened dependence on other countries' transit routes to access overseas markets. This dependence can take at least four forms: (i)dependence on transit infrastructure; (ii) dependence on political relations with neighbors; (iii)dependence on peace and stability within transit neighbors; and (iv) dependence on administrative processes in transit. This is true inMongolia as well. 4.8 Weak or ill-adapted infrastructure in transit countries imposes direct trade costs and limits the ability o f landlocked country products to compete in global markets. It also limits the returnto internal investment on landlocked countries' internal infrastructure since market opportunities are constrained. Mongolia's external trade i s almost entirely dependent on a single rail link in its north-south ~ o r r i d o rBut . ~ when the transit cargo arrives at the border with China, either the axles on the wagons need to be changed or containers have to be transferred from one wagon to another. Road transportation options are also extremely limited. There i s a paved road between Ulaanbaatar and the Russian Border but there i s no 3 See Faye, McArthur, Sachs, 2004, "The challengesfacing landlockedcountries", Journal of Human Development, Vol. 5, N.1. Mongolia currently has railway and motoroad network from its northborder in Selenge aimagto Ulaanbaatar city. A 200 km longpavedroad from Ulaanbaatar City to Chinaand on Zamyn Uud City in the southern directionis beingconstructed, - 76- CHAPTER 4: COUNTRY ECONOMICMEMORANDUM paved road connecting the entire lengthbetween Ulaanbaatar and Zamyn Uud (at the border with China). Construction of these crucial land links are under discussion in Government and with its external partners. 4.9 To transit a country, there are cost of direct transit and customs charges. However, these direct costs form only a small part of the picture. International transit also requires burdensome paperwork and bureaucratic procedures that are costly to deal with and place a high administrative burden on shippers. Border crossing also cause long delays on transit route traffic. It is regularly noted that the time delays and the variability of time-in-transit are of greater concern to traders than direct costs, as they hinder the ability to meet delivery contracts without large inventory stocks. Transit costs for Mongolian goods can be very high. First, customs valuations and exemptions have become the locus for rent-seeking, with corruption in the customs valuation process being a very large problem. Over half of the Mongolian exporters surveyed rated customs processes as a major or severe obstacle. Predictability of time taken to clear customs is a concern. Clearances can take four days on average, but can be as long as two weeks. Paper-basedprocesses are the main source of delay incustoms, as pastautomation efforts havenot solvedthe pr~blem.~ Figure4.2: Trade Links: MongoliaMainTrading Partners (2001-2005 AnnualAverage) Key: 0 T o t a l I m p o r t s (Le. f r o m the entire world): $ 3 14 trillion, 0 $660.3 billion, 0 S 4 0 7 8.434 7 billionn,0$191.5-2 5 3 5 billion;0 $ 6 1 I billion, $0.86 billion (European U n i o n ) (United States) (Japan. China) (Korea, Canada) (Russia) ( M o n g o l i a ) 1 1 T o t a l bilateral i m p o r t flows (Le. imports to C o u n t r y A f r o m C o u n t r y B + imports to C o u n t r y B f r o m C o u n t r y A ) : S 5 2 7 05 million. $ 3 2 8 7 6 million, S I 8 0 million, $ 7 7 7 . 91 4 million, $ 3 3 8 million (China) (Russia) I (United Stater, (Japan, ~ o r e a ) I (Canada) European U n i o n )I Source: WorldBank. 'In 2006, the GeneralCustoms Office hastaken several steps to improve itstechnical equipmentand some customsclearanceprocedures,e.g. an ITsystemhas beeninstalledthroughwhich the GeneralCustoms Office in UBcanmonitor customsclearance activities of itsbranches. THE nRANNY OF DISTANCE AND THEROLEOF GEOGRAPHY -77- MONGOLIA: Having no access to the sea is less relevant than having access to markets 4.10 Being sandwiched between Russia and China, Mongolia is dependent on these two countries for external trade, either by trading directly with them or going through their territory to access other markets. On the one hand, accessingother markets i s complicated by trade facilitation challenges beyond the Russian and Chinese borders. Barriers include: (i) dependence on China railways; (ii)custom processes; (iii)lack of harmonization in basic documentary and clearance processes; (iv) animal products restrictions; and (v) trucks prohibition. On the other hand, being sandwiched between China and Russia there are abundant opportunities for Mongolian trade, foreign direct investment and other economic transactions with its two fast- growing neighbors. The problem of Mongolia's constrained access to international markets can be partly solved by increasing its trade with, and FDI from, its two main trading partners-themselves fast growing economies (Figure 4.2 and 4.3 show recent trends in this regard). Inthat sense, having no access to sea is less relevant than having access to markets. Figure 4.3: FDILinks: Mongolia's Main Sources of FDI(2000 -2004Total) Key: Total FDInet inflows(Le. fromthe entire world): 0 743.05billion; $240.39billion; 0$26.9-36.5 billion; $0.78billion (unitedStates) 0 (china) (Korea, Rwi4Japan) (Mongolia) I I I I Total bilateral netFDIinflows to Mongolia (Le. FDIto MongoliafromCountryB FDIto CountryBfromMongolia): + $338.42million; $176.89million; $57.18million; $31.45 million; $13 million. (china) (Canada) (Korea) (Japan) I vnitdStates;bia) Source: WorldBank. - 78- CHAPTER 4: COUNTRY ECONOMICMEMORANDUM 4.1 1 Recent steps toward the improvement o f trade facilitation and customs clearance processes in2006 include: (i) installation o f an X-ray camera November, 2006 inZamin-Uud city (southern border port) to screen cargos (containers) carried by trucks; (ii) Installation o f fiber-optics lines in General Custom Office to monitor customs clearance procedures o f branches. For instance, currently the Zamin-Uud customs branch i s fully connected while the Selenge aimag and "Chinggis Khaan" International Airport customs branches are partially connected with the Customs General Office since 2006. (iii)Also, in 2006, a system o f "e- declaration" secure website was introduced, which helps to speed up the Customs clearance process somewhat. (See: http://www.ecustoms.mn/). Customers can attend online training on this system free o f charge. With a view to track illegal transfers o f precious metals, metal detectors have been installed in ten customs branches, and portable metal detectors were provided to all customs branches in2006. Beinga mineral-richcountryis a mixedblessing 4.12 Being a resource-rich country is a mixed blessing since it has a double-sided impact oy1 economic growth. On the one hand, it brings in much needed financial resources for the country development and can accelerate economic growth through its spillover effects. For instance, Mongolia's mining sector i s attracting foreign direct investment, which in turns contributes to economic growth (Figure 4.3). Since 1990, the country has received over US$1.6 billion in foreign direct investmentfrom 96 countries through 6,066 foreign- invested companies. Around 80 percent o f this amount came in the last six years.6 Of these total FDI inflows, minerals, mines, and the oil sectors together accounted for 43.8 percent, light industry 5.6 percent, the banking sector 5.5 percent, the construction sector 3.5 percent, animal-originated product processing industries 5.5 percent, and the remaining went to the trade and service sectors. 4.13 On the other hand, the "resource-curse" effect common to resource-rich countries can lead to resource diversion from productive uses towards rent-seeking activities and patronage, with a strong deterioration o f governance. Having a long term strategy for the mining sector along with appropriate risk mitigation mechanisms to ensure the prudent use o f mineral revenues over time is imperative in order to sustain high levels o f growth. Chapter 5 o f this report looks at the issues related to natural resources management inMongolia. Beingvulnerableto exogenous shocks 4.14 The geography and natural resource bias in the Mongolian economy make it susceptible to exogenous shocks that can have significant adverse effects on growth7.Natural disasters can affect growth in a variety o f ways. They affect output and incomes, and can destroy physical capital, which unless replaced, will have longer term effects on growth beyond the immediate effects on income. In Mongolia, dzuds have in the past directly affected about half a million rural people. Consecutive dzuds inthe winters o f 1999/2000 and 2000/2001 killed 7 million head o f cattle and other livestock, representing a 30 percent drop in total livestock. The agriculture sector registered a drop in real value-added of 40 percent 6 Source: UB Post Newspaper, January 11, 2007 "96 Countries invest in Mongolia". 'httD:!/ubimst.tnoricolnews.niti~ni~iiii This is supported by bothcountry-specific studies and cross-country comparative analyses. THEnRANNY OFDISTANCE THEROLE OFGEOGRAPHY AND -79- MONGOLIA: between 1999 and 2002. The prolonged impact of these two dzuds on production lasted until 2004, by which time the livestock herdwas slowly recovering to its pre-dzud level. After the disastrous 1999/2001 dzuds, many rural people migrated, at least temporarily, to urban areas. Inone year, the rural population fell by almost 10per cent. Some have returnedto their rural livelihoods, but most have stayed. The population of Ulaanbaatar has grown from 0.8 million in 1999to about 1.5 million today, which was accompaniedby rapid urban creep associated, inparticular, withthe Ger areas inthe outskirts ofthe capital. 4.15 Negative terms-of-trade shocks directly reduce real income and the resources that are available for investment and consumption. The evidence on the adverse effects of terms-of- trade shocks on economic growth is also strong. O f particular interest i s the finding that the secondary effects of negative shocks in terms-of-trade, measured as the impact of shocks on the rate of growth of GDP, can be very large.* Mongolia's income is directly affected by the level of copper and gold prices. Copper exports were valued at $648 million in 2006 or 41% of total exports earnings. In addition, Mongolia economic growth responds strongly to commodity price levels, through the direct effect of prices on mineral production and the indirect effect on output that results from additional investment inflows that occur inresponse to higher mineral prices. 4.16 International experience suggests that the poor are disproportionately affected by exogenous shocks and Mongolia is no exception. Shocks can affect poverty through the i destruction of assets of the poor or near poor and through direct income losses, lower overall growth in the economy, higher inflation, and lower government social spending. Research shows that normally these shocks increase the incidence of poverty. For instance, the poor households in Mongolia were more affected by dzuds than the rest of the population. Indeed, herder households constitute the single largest group amongst poor. The recent World Bank Poverty Assessment (2006) for Mongolia found that of all households with household heads who were engaged in some form of economic activity, the herder households had the highest incidence of poverty (41.2 percent). Analysis o f HIES-LSMS data indicates that livestock mortality shocks translate directly into lower consumption levels for herder households. A counterfactual simulation of the impacts on poverty shows that, in the absence of livestock mortality shocks in2002, the incidence of poverty among herder householdswould have been lower by 2 percentagepoints. Indeed, shocks tend to hurt the poor disproportionately because they generally have limitedlabor skills, they rely heavily on public social services, and their consumption basket is heavily weighted toward food. Moreover, the poor have limited savings to draw on in response to a shock and limited access to credit. The poor also are the most adversely affected by their inability to buy fuel (mainly firewood) for heating stoves during the coldest winter months when they need it the most and market prices of these rise beyond their affordable means. The provision of public utilities (such as adequate heat, water and sanitation facilities) to the rural poor across this vast country with such a low density of population is particularly challenging as well. For example, Collier and Dehn show that, for a sample of cases where the direct income loss from negative export price shocks averaged 6.8 percentof GDP inthe year ofthe shock, the loss of incomethroughthe reduced growthchannel over a four-year periodamountedto about 14 percent of initial output. This secondary impact is, moreover, asymmetric, because positive price shocks were not found to increasethe rate of growth significantly. - 80 - CHAPTER 4: COUNTRYECONOMICMEMORANDUM THEINTERNAL GEOGRAPHYECONOMIC OF GROWTH MONGOLIA IN Migration, Urbanization and Urban Concentration 4.17 As a country of nomadic herdingtraditions, Mongolia has a highly mobile population. With the exception o f Ulaanbaatar-the capital city-and a handful of other cities, the distinction between urban and rural areas is not sharp in Mongolia. Provincial urban centers are small towns, with populations varying between 15,000 and 25,000. During the early transition, migration to rural areas happenedas a way to cope with loss of urban income and service disruption. Since then, rural-to-urban migrationhas dominated population movements, with migration intensification inthe wake of severe winter storms that cause drastic losses of livestock, but reverse waves of migration occur when people return to rural areas and resume herding. 4.18 In2005, 60 percent oftotal population was living inurban areas. Inaddition, since the beginning of the 199Os, there has been increasing concentration of economic activities and population in Ulaanbaatar. Since 1993, while overall population has been growing at a relatively slow pace (by 16%), population in Ulaanbaatar has increasedby 70 percent, fueled by in-migration. Conversely, rural population growth has been stagnant or even decreasing and so is the population in other urban centers. Economic activities have followed a similar pattern. Ulaanbaatar's share of total GDP reached 60 percent in2004, whereas it amounted to only 47 percent of total GDP in 1999. A few places outside Ulaanbaatar retain economic activities, because of their specific strategic location such as located close to the border, next to mineral resourcesor natural resources suchas inthe Khovsgol Lake area. 4.19 What is causing this urbanization and urban concentration? And should further urbanization and urban concentration be encouraged? In other words, has Mongolia reached its optimal level of urbanization and urban concentration or i s there space left for Ulaanbaatar to grow further?Ifurbanization is concentrated in the capital city, what should be the policy response towards Mongolia's existing secondary cities? In addition, while economic growth matters, disparities and equity dimensions in rural Mongolia should also be considered'. These are the questions which are discussed inthis section. Mongolia's urbanization rate is high and on the rise 4.20 Relatively to their GDP per capita, transition countries are over-urbanized, with a higher share of urbanpopulation than is typical for their income level, because of the planned drive towards industrialization under socialism (see Box 4.1). Mongolia is no exception: whereas for centuries, Mongolia's economy had been based on nomadic pastoralism, during the plannedand centralized economy period, the country attempteda shift towards agriculture and industry. Collectivization carried out at the end of the 1950s drew former nomads into structured cooperatives in order to breed livestock. State farms were developed and arable land was extended. Land use was confined to soum brigades, and herding migration was limited to four moves per year. Many of Mongolia's secondary cities which exist today had expanded during the Soviet period with the support of central planning which dictated the 9 "Equity" is defined as an equal accessto opportunity(cf. Equity and Development, World DevelopmentReport 2005). THEnRANNY OFDISTANCEAND THEROLEOFGEOGRAPHY - 81 - MONGOLIA: establishment and location of industrial firms. For instance, mining, processing and energy firms were built up in the industrial complexes of Ulaanbaatar, Darkhan, Erdernet, Choilbaisan and Baganuur. 4.21 As a result, Mongolia urbanization rate was remarkably high at the beginning of the 197Os, reaching 45 percent. This share has regularly increased over the decades to reach 60 percent in2005, making Mongolia one of the most urbanized among countries with an income per capita inthe same range. The urbanization trend was further reinforced by the removal of population movement restrictions in place before 1991, which controlled migrations especially to Ulaanbaatar. The Mongolian Constitution, which was approved in 1992, declares that "Every Mongoliancitizen has the right to choose where to live inMongolia"". Migration and urbanization have gone hand-in-hand 4.22 During the early years of Mongolia's market economy, reverse migration from urban to rural areas was dominant following the dismantling of the state cooperatives. Livestock privatization attracted large numbers of households who had lost their jobs in state-owned enterprises to migrate to the rural countryside. This resulted in an increase in the number of herder households, from 17 percent of total households in 1990 to 35 percent by 1998, with most of this growth concentrated in 1990-92. At that time, Mongolia was one of the only developing countries where internal migrationto rural areas exceededmigrationto cities. ~~~ ~~ Box 4.1: Urbanizationin TransitionCountries Relative to their GDP per capita, the transition countries are over-urbanized. They have a higher share of urban population than is typical for their income per capita, party as a result of the planned drive towards industrialization under socialism. While central planning dictated the establishment and location of industrial f m s , many of the urban expansion and related developments that would accompany market-based urban growth, and that would normally have responded to household demands, were relatively suppressed. In particular, urban land was more heavily tied up for industrial use than is typical in market-basedcities. Where privately-owned housing was a relatively illiquid asset, because of administrative regulations and other factors suppressing the development of a housing market, the residents of state or enterprise-ownedhousing also had little residential mobility. While access to urban infrastructure(such as water, sanitation, electricity, and district heating) was provided to a fairly high share of the urban population in most of the region at the time of the transition, this urban infrastructure was heavily subsidized. Few systems remained commercially viable when state subsidies were reduced. For example, the economies of the CentralAsian republics of the former Soviet Union (FSU), were so heavily industrialized that upon liberalization they inherited the rigidities which hamperedthe supply response in creation of jobs, housing, land, and urban services. Poverty in that region has, therefore, been greater than an economic depressionalone would have implied. Source: WorldBank (2006) "Dimensionsof UrbanPoverty in Europe and CentralAsia Region," WorldBank Report, 2006. 4.23 However, the devastating effects of droughts and dzuds during 1999-2002, combined with the virtual collapse of livestock cooperatives and associated management and support services, decimated much of the livestock, especially those of the relatively inexperienced 10 There still exist some formal conditions to get permissionto reside in Ulaanbaatar (see "Internal Migration and Urbanization in Mongolia: Analysis basedon the 2000 Census", NSO 2003) - 82 - CHAPTER 4: COUNTRY ECONOMICMEMORANDUM herders. As a result, the initial urban-to-rural movement again reverted back to rural-to-urban migration. Other factors, including insufficient quality of education and health services, and lack of work in rural areas, also contributed to this migration. In 1998-99 alone, the rural population fell from 50 to 41 percent of the total population. 4.24 Over the medium-term, rural to urban migration is likely to continue. Because of Ulaanbaatar's "primate city" role (given by the fact that it i s more than twice as large as the next biggest city in the country) and the spatial characteristics of Mongolia's economy, it is unlikely that its population will decline through reverse-migration flows from urban to rural directions (as was the case inthe early 1990s). Today, Ulaanbaatar is the primary destination for migrants countrywide and i s expected to remain so. This and the main secondary cities (Darkhan and Erdenet, for example) will have to be well-managed to enable the exploitation of scale economies: livable and-perhaps even more importantly-well-connected to larger cities. While their livability will depend on city governments, their connectedness to other, especially larger, cities will depend mainly on national and provincial governments. Success depends on good management at the city level, and sound planning and infrastructure investments at the provincial and national levels." Table 4.1: UrbanPopulationDynamics among Asian Countries GNI Growth per Population Proportio rate capita Growth nof total (YO,2000- 2005 rate (YO) 2005) Cambodia 380 2.4 19 5.5 China 1,740 0.7 39 3.2 Indonesia 1,270 1.3 46 3.9 Lao PDR 440 2.3 21 4.6 Malaysia 4,960 1.9 64 3 Mongolia 710 1.3 57 1.4 Myanmar n.a. 1.1 30 3.1 Papua&New Guinea 660 1.1 13 2.3 Philippines 1,250 1.8 61 3.1 Thailand 2,750 1 32 1.9 Vietnam 620 1.3 26 3.2 Average 1,610 0.8 41 3.1 Source: Kharas and Gill (2006), "An East-Asian renaissance: ideasfor economic growth", WorldBank. Urban concentrationis takingplace around Ulaanbaatar 4.25 Most of this urbanization is taking place in Ulaanbaatar, the capital city, with a population which increasedfrom 586.2 thousand in 1990 to 965.3 thousand in2005. In2003, 40,000 people moved from the countryside to the capital city, while only 690 Ulaanbaatar residents moved away from city. In 2005, about 38 percent of Mongolia's population was officially living in Ulaanbaatar. This is hardly surprising, given the city's overwhelming primacy in Mongolia's economy and society. Almost 54.2 percent of national GDP (of MNT 1,227.5 billion) is produced in the capital, which also accounts for 84.2 percent of total IISee Kharas, Homiand IndermitGill (2006). "An East Asian Renaissance:Ideasfor EconomicGrowth" World Bank, 2006, Chapter5 on Cities. THERRANNYOFDISTANCE THEROLEOF GEOGRAPHY AND - 83 - MONGOLIA: industrial output (of MNT 1,457 billion) in2005. It i s the seat o f the central government and of most institutions for higher learning." Almost all trade flows also go through UB (imports and exports), with the exception of the aimags that are immediately bordering with China and Russia. 4.26 Population growth has been stagnant in aimag centers. According to administrative definitions, aimag centers are defined as urbanjurisdictions becausethey have administrative centers. This is despite the fact that in many cases they do not satisfy the other criteria set up inthe Law of Mongoliaon the legal status oftowns and village^'^. Inpractical terms, there is a widely recognized difference betweenthe capital and "primate" city, Ulaanbaatar (UB) and the two secondarycenters ofDarkhan(77,000 people) andErdenet(74,000 people) onthe one hand, and the much smaller aimag centers on the other. These are sometimes defined as `semi-urban', on the grounds that they perform a limited number of `urban' functions within their regions, such as Choilbaisan (38 thousands) and Khovd (3 1 thousands). Urbanization dynamics reveals that population growth is stagnant in most of these towns. In recent years, migration to Ulaanbaatar has increased while inthe above four biggest secondary cities, there has been a net out-migration of people. Overall, the population living in aimag centers has dropped by 10percent since 1993. 4.27 The Law on Regional Development Management and Regulation (2003) aims to implement the Government's Regional Development concept which recommends the reorganization of the aimags into four regions, namely, Western, Hangai, Central and Eastern regions, with Ulaanbaatar as the fifth, and separate, administrative unit in Mongolia. Two towns within each of the four regions were identified as "pillar cities" who would be the main recipients for public investment. Master plans for each of these centers have beenprepared by their respectivelocal authorities that together estimatetheir infrastructure investment needs to be inthe order of US$94 mi1li0n.l~ These exclude investments that needto be made to ensure for geographical connectivity betweenthese pillar cities and Ulaanbaatar. These demarcations were formulated prior to the ongoing mining boom in Mongolia. If one were to use market competitiveness, emerging migration, population densities, and potential for agglomeration benefits as a basis for regional decentralization, one would get a different picture of Mongolia's geography than the one envisaged in the Regional Development Law that was formulated in2003. Understandingfirm location decisionsin Mongolia 4.28 What are the factors which actually drive firm location decision inMongoliatoday? In a market economy, firms make their location choice based on its economic advantages. Box 4.2 presents taxonomy of the various groups of determinants of firm location. While historically, firms chose to locate in places that had some natural advantages, as cities grew and developed, factors related to the firms themselves rather than their external environments have tendedto matter instead. 12MongoliaEnvironmentMonitor 2004 l3Inthat sense, there may well be an overestimation ofurbanizationinofficial figures. 14See World Bank InfrastructureStrategy (forthcoming, 2007), Cross-sectoral issues chapter. - 84 - CHAPTER 4: COUNTRYECONOMICMEMORANDUM 4.29 Before the transition to a market economy, decisions for firm or industry location were made according to principles of central planning. For instance, during the Socialist period, Darkan was the construction materials manufacturing capital of Mongolia, supplying goods to the Council of Mutual Assistance (CMEA) common market within the Soviet Union and its satellite countries. Khovd, in western Mongolia, also supplied construction materials for Mongolia Western's aimags. Choilbaisan was the center for mineral processing factories in that part of the easternpart of the country. When central planning was dismantled and market- basedurban rules applied, existing secondary cities were unable to respondto household basic infrastructure needs while their industrial production suddenly shrunk as the economy was adjusting to its comparative advantage. Left without subsidies, most of these centrally- planned enterprises defaulted on loans and closed operations, thereby contracting the job market and resulting inout-migration primarily to Ulaanbaataror neighboring soums. Box 4.2: How Do Firms Decide Where to Locate?AgglomerationEconomies Two main groups o f factors influence location decisions by f m s . The first includes those that are external to the fm.Some regions have a natural advantage that makes themrelatively more attractive to different types of f m s . Initially, the conditions for the mergence o f agglomeration economies might be due to natural endowment that historically encouraged early settlement and economic activities. These `Sfirst nature geographies" (Venables, 2003) include shelteredharbors, natural resource endowments, access to inputs, proximity to markets and availability o f basic infrastructure. The initial benefits can trigger a self reinforcingprocess that leads to the emergence o f urban-industrial agglomerations to the point where the initial advantage responsible for the growth o fthe center is no longer dominant. These processes o f agglomeration are supported by public infrastructure, especially in the transport sector. Krugman(1991) shows that manufacturing f m s tendto locate inregions with larger market demand to realize scale economies and minimize transport costs. Iftransport costs are very high, then activity is dispersed. Inthe extreme case, under autarky, every location mus firms may be randomly distribut the intermediate transport costs larger scale production, which realize pecuniary externality benefits. Availability o f good infrastructure also increases the potential for input diversity, a larger labor pool, as well as the probability o f technology diffusion through interaction and knowledge spillovers between f m s . Thus improved accessibility has the effect o f reducing geographic barriers. Second, there are reasons for locating in a certain region that are more specific to the firm's production process and its interaction with suppliers, customers and competitors. These are production externalities which relate to the dynamics that directly affect the f m ' s microeconomic decision making. Most fundamentally, clusters o f f m s that are predominantly in the same sector take advantage o f localization economies. They include sharing o f sector specific inputs, skilled labor and knowledge, intra and inter-industry linkages, opportunities for efficient sub-contracting, access to suppliers and informational transfers. Finally, a larger overall size o f the urban agglomeration and its more diverse industry mix i s thou provide external benefits beyond those realized within a single sector or a tight buyer-supplier network. Th benefits are called urbanization economies. Larger cities have greater diversity o f firms. This allow greater specialization since it enables small, innovative f m s to access a larger pool o f potential buyers and complementary services that cannot be provided in-house. Larger cities also provide a larger home market for end products, make it easier to attract skilled employees who are attracted by urban amenities not available in smaller towns, and support a large number o f complementary service providers. Source: Deichmann, Kaiser, La11 and Shalizi, 2005, "Agglomeration, Transport, andRegional Development in Indonesia", WorldBank Policy Research Working Paper, 3477 4.30 The secondary cities which are showing signs of development today are the ones benefiting from natural endowment andor location advantage (the so-called "first nature THETYRANNYOFDISTANCE THEROLEOF GEOGRAPHY AND - 85 - MONGOLIA: geographies"). For instance, proximity to mining resources such as Erdernet city which has developed along with the development of the copper mine or proximity to a border which creates opportunities for trade such as Khovd in the West, which shows recently signs of development in light industry and construction, or potentially Zamyn-Uud border city in the southern part of Mongolia, located at the border of China and close to the UyuTolgoi copper mine. Firstnature geographies can be also related to infrastructure and inparticular transports costs. As explained in Box 4.2, in the extreme case of autarky, every location must produce everything locally. By contrast, no transport costs would entail en even distribution of firms throughout the country (everything hold constant). In Mongolia, given road infrastructure poor conditions and the huge territory, transport cost, especially on the West-East axis, are very high. In that sense, one can indeed attribute the development and survival of many Mongolian towns to high transport costs whichprohibit the region to rely on distant suppliers. 4.3 1 By contrast, Ulaanbaatar concentrates the country nationwide opportunities for firm production externalities. As for all cities, Ulaanbaatar has historically developed on the ground of some natural advantage. Founded in 1639 as a monastery, the capital city moved around 20 times along with nomadic traditions before settling in its present location in 1778 on the bank of the Tuul River. It was positioned on the caravan route between Russia and China, and developed as a trading centre, particularly from the 19th century. Since then, production externalities (see Box 4.2) have taken over natural advantage in Ulaanbaatar, although the Capital location on the route between China and Russia still plays a central role inthe city development. Congestion,in-Migration and Urban Poverty 4.32 The highly skewed population distribution and migration towards Ulaanbaatar has important implications in terms of congestion and urban poverty. Congestion refers to increased costs associated with crime, grime and time. It can undermine efforts to exploit scale and agglomeration economies. There is evidence that congestion and pollution are on the rise inUlaanbaatar(see also Table 4.2 for acomparison of Ulaanbaatar's urbancongestion and pollution with that in selected developed countries). Air pollution is fueled by burning of coal for heating in Ger areas. Water pollution originates from surface water due to untreated sewage, and groundwater due to prevalence of pit-latrines. Soil/land pollution i s due to open dumping of solid waste (See Box 4.3 on access to basic services). In addition, anecdotal evidenced suggests that (i) crimehas risen andthat (ii) commuting time has increased. Table 4.2: Pollution in UlaanbaatarNeeds Urgent Attention Mongolia G7 Particulate matter inthe air (mg/cu.mt) 131-162 45 Sulfur Dioxide (mg/cu.mt) 9 19 Nitrous Oxide 25 56 Source: Mongolia Environment Monitor (2004) 4.33 Although as a whole, poverty incidence is lower in Ulaanbaatar than the national average (27 and 36 percent respectively), the ongoing in-migration and impact on urban poverty has significant implications for economic policy. Migrants are concentrated in the - 86- CHAPTER4: COUNTRYECONOMICMEMORANDUM under-serviced peri-urban ger areas, where poverty is also higher, and face specific non- monetary poverty issues''. According to the 2004 UNDP report on Urban Poverty and Migration, 80 percent of migrants settle in ger areas, where half of the people are poor. 37 percent of migrants are poor in terms of consumption expenditure, 55 percent in terms of access to services and 31percent are poor interms of social inclusion. Migrants face a higher probability of social exclusion or lack of capability (e.g. lower access to health insurance due to lack of registration, lower access to quality education due to overcrowded schools, lower number in adequate housing and lower access to basic infrastructure as migrants concentrate in ger areas). To explain this pattern, the report also stresses that over the years the reasons for migrating have shifted, away from educational purposes toward more economic factors such as: employment location, better livelihoods, and access to markets. Migration patterns thus suggest revealed preferences for locations where economic opportunities exist. In addition, the report shows that migrants in Ulaanbaatar are less educated than non-migrants leading to more poverty and less access to services among the migrant population. An important corollary is that migrants are poorer not because they are migrants, but becausethey have lower educational levels, for example. Migrants seem to have the same opportunities as non-migrants, but because they seem to lack the proper qualifications to take advantage of these opportunities. 4.34 Overall, Ger areas can be defined as pockets of poverty whose residents, despite representing a relatively wide range of income levels and occupations are especially vulnerable because of their living conditions. In-migrationwhich i s concentratedinthese Ger areas has put pressure on existing health and education services, and has increased the demand for basic infrastructure, such as access to water, waste management, sanitation, heating, health, education (See Box 4.3). Migrants pose a specific policy issue, because they tend not to be registered, they tend not to have access to services they are entitled to. Combined with the fact that a majority of migrants are less educated, in-migrants are likely to remain inpoverty under the current status quo situation. Box 4.3: Access to BasicInfrastructure,Health and EducationServicesand Land Ownership in the Ger Areas Water provision inger areas is generally considered insufficient. It is estimated that ger areas residents get about 8-10 litres per day (2-4 times lower than the WHO minimum requirements). Drinkingwater is supplied through communal kiosks, which, at least in the more central areas, appear to be reasonably accessible (i.e. not too far and not overcrowded); although in some areas the kiosks close during the winter season because they are inaccessible to the tankers. Surprisingly, the consumption levels o f water are low. It is not clear whether this is due to the quality ofthe drinking water being provided or its consumptionpattern. By contrast, sanitation is perceivedby Ger residents to be a major problem. Most residents use pit latrines, but poor construction, unsuitable soil conditions and growing population density mean that surface and groundwater contamination are increasingly common. In addition, the largely inefficient pit latrines fill up quickly and there are very limited reliable support services ftom the municipality or elsewhere to empty them periodically. Insome areas, marshy soil conditions make it impossible to dig pit latrines at all. Solid Waste removal is also seen by Ger residents as a key problem. Households living in the unfenced outlying areas do not have access to any such services. Those living on fenced plots in registered streets are entitled to waste collection services that are to be provided by the districts for which they pay a fee to the khoroo. However, these services are not highlyratedby residents, and it is not uncommon for them to stop I S Ger area refers to Ger settlements m the city's outlymgareasin zones that have the disadvantages of urban life, such as overcrowdingand the highcost of foodand semces, and some of the hardshipsof rural life, includingexposureto harsh weather conditions THETYRANNYOFDISTANCE THEROLEOF GEOGRAPHY AND -87- MONGOLIA: Box 4.3 (continued) paying the fee when the waste collection teams do not arrive. Overall, it is estimated that only 40 percent o f households have access to waste collection services inUB, although this may well be an overestimate in view o f the perceived inefficiency o fthe services. Heating was identified as one o f the key issues in the last WB poverty assessment.Unlike other countries, poor households in Mongolia spend an exorbitant share o f their income on heating for the long and harsh winters. Unlike in other developing countries, where the food bill accounts for over three-quarter o f basic consumption needs in poor households, a reasonable basket o f minimal needs in Mongolia consists o f only 44 percent food items and 56 percent non-food items (of which heating supplies is a significant component). Despite its good intentions, the existing system o f subsidies in the energy sector is not targeted at poor or consumers. Mongolia's population has relatively good access to electricity, although there is generating capacity inmanyrural areas. Given the harshwinters, the poor households inUla easily spend at least one-fifth oftheir total consumption over winter months on heating fuels which are dirty fuel. The social costs o f dirty fuel (e.g., health costs, productivity losses and environmental damage) are huge, justifying some forms o fpublic-sector intervention. Many health problems in the ger areas are linked to lack of safe drinkingwater, sanitation facilities and solid waste removal. Incidences o f diarrhea, dysentery and hepatitis are much higher than in the rest o f the country. . The main problems with access to health services are lack o f relevant documents, lack o f registration for migrants, lack of awareness o f the existence o f entitlements. While up to 1990health services usedto be free for all, they now depend on having health insurance. There are provisions for full or partial exemption from payment o f the health insurance fee for some groups (children, pensioners, disabled and unemployed people). These groups also are entitled to access to free treatment and medicines, or refunding o f some medical expenses. However, these entitlements are only available to those who are registered in the health insurance system. Services provided by family clinics are highlyrated, but again, access is only possible for those who have health insurance. For the poorest groups, the health insurance fees are considered to be unaffordable. Education is very important inMongolia, and a major reason for moving to UB. It is also a main strategy for the household to move out o f poverty. In Ger areas, in-migration o f households has increased the number o f children, which far exceeds the capacity of local schools - reflecting insufficient planning capacity at the municipal level, and perhaps also limited decision-making power at the districtikhoroo levels, which cannot respond to local needs and priorities. Class overcrowding and teaching quality are perceived to be low, and families that can afford it prefer to send their children to the city centre, where enrolment is often achieved with the help of friends or relatives. About 40 percent of children in ger areas are estimated to walk for over 30 minutes or take public transport to reach their school. This increases costs, and about one-fifth o f poor households with school-age children have one or two children that have dropped out o f school. Most o f these households are not aware of entitlements to free school supplies (notebooks, bag, pens and pencils for up to 16,000 MNT), or not are accessibleto them since they are typically non-registered migrants. The Land Privatization Law came into effect in 2003. It specifically confers the right to own landto every family officially registered intheir administrative units. All households in UB are entitled to 0.07 ha, and to date landprivatization inapartment areas has been completed. Inthe course o fthis process, residents o f central areas living in `unfit' accommodation (mainly gers but also other makeshift dwellings) have been evicted and relocated to peripheral areas. Cadastral registration o f land inpen-urban areas has also been completed, and an initial land market is emerging, although transactions took place even before the land law implementation, especially involving wealthier city residents securing land for summer houses. The privatization o f land for residential use was a one-off exercise which did not involve payment o f fees. However, land for agricultural use requires buyersto register as a company. In ger areas, land privatization is related to the plot enclosed by the hashaa (fence). Informal criteria for eligibility used by khoroo governors usually include the existence o f a fence, whether the resident household is registered and pays waste collection fees, and whether they have the relevant documents for the certification o f land ownership. Unregistered migrants are clearly excluded, and so are the poorer non-migrant households. Free registration has ended in 2006, but there remains anecdotal evidence that land speculation is rampant in Ger areas. - 88 - CHAPTER 4: COUNTRY ECONOMICMEMORANDUM Rural Mongolia sees disparities and poverty as well Figure4.4: Basic Infrastructure 97 per capita GDP and poverty 1998 2002 1998 2002 1998 2002 incidence betweenUlaanbaatar and UB Aimag centers Rural areas the rest Of the where 1 s Accessto electricity w Improved water sources Improved sanitation I 4.36 Poverty incidence in rural areas is higher than in urban areas (43 percent versus 30 percent in urban areas).I7 Herders constitute the largest group amongst the poor and of all households with household heads engaged in some form of economic activity; herder households have the highest incidence of poverty. While infrastructure access has improved between 1998 and 2002, rural areas lag behind. The 2002 LSMS Survey conducted by NSO shows that basic infrastructure access has increased markedly between 1998 and 2002 (Figure 4), especially in aimag centers. In 2002, 97 percent of households have access to electricity; compared to 70 percent in 1998. Water access has also improved (73 percent in 2002 comparedto 70 percent), while access to sanitation recordedthe greatest increase (from 19 to 69 percent between 1998 and 2002). Rural areas, largely composed of herders, have also recorded an improvement in basic infrastructure. Yet, the level of access remains relatively low. 4.37 As for telecommunication, the tele-density outside Ulaanbaatarremains low, where 10 percent of population subscribes to mobile or fixed telephones (Table 4.3). Mobile technology penetration is higher than fixed technology, accounting for 63 percent of total phones '' 16 There remains the need to examine any data limitations and gather more detailed breakdowns on the composition of regional GDP and population in order to explain this significant disparity between the relative er capita GDP and household disposable incomes over time inMongolia. This result is different from other transition economies, where urbanpoverty is more important. THETYRANNYOFDISTANCE THEROLEOF GEOGRAPHY AND - 89 - MONGOLIA: subscriptions. Yet this share is lagging behind the share of mobile phones in Ulaanbaatar which is as highas 81 percent. Table 4.3: RegionalTele-density 2004 Tele-density Mobiles YOpopulation YOtotal Western 6% 51% Hangai 9% 56% Central 16% 73% Eastern 8% 58% Ulaanbaatar 49% 81% Source: World Bank Staff 4.38 Finally, equity is a concern in rural areas. As explained in the last poverty assessment report for Mongolia (2006), rural households have less access to education. Despite progress in school attendance in the past few years, rural students are still at a disadvantage. In particular, rural students do not have equal access to upper secondary education because rural schools shut down Grades 9 and 10 during the 1997 reorganization and rationalization reform while consolidated urban (aimag center and city) schools have only limited spaces. Attrition rates are significantly higher among rural children and educational quality, measured by examination results, is significantly worse in rural schools. Students in rural schools perform less well in examinations than students from urban areas; furthermore, examination performance in poorer soums is significantly worse than that in richer soums.'8 In addition, poverty directly, through out of- pocket and opportunity costs, and indirectly, through parental background, contributes to dropout at all levels of schooling. Rural students who tend to perform worse and drop out after Grade 8 are highly likely to be poor. This attrition or dropout raises concern given its long term implications from the vicious circle or intergenerational transmission of poverty. For all the good intentions it may have, the rationalization and reorganization effort initiated in 1997 seems to perpetuate the widening gaps in educational outcomes between urban (aimag centers and cities) and rural (soum) schools. POLICY RECOMMENDATIONS 4.39 Mongolia should take more advantage of its unique location between Russia and Mongolia by exploitingmore systematically its positionof a transit corridor for trade between 1. Recent analysis shows that children attending soum level schools are 13 percentage points less likely to score an 'A' on the central exams'*, as a result o f a lower access to quality education. Students in Ulaanbaatar schools score better than those in schools located in all other regions o f the country. The differences ineducation performance across the latter regions are not noticeable. As a result o f these differences in educational performance between UB schools and others, there are significant divergences inthe net enrollment rate between the countryside and the rest, which appear in lower secondary levels and accentuate in upper secondary schooling. These results hold even after controlling for a number o f factors, including parental education, poverty and gender. -90- CHAPTER 4: COUNTRY ECONOMICMEMORANDUM its two neighboring economic giants and beyond. Mongolia's geography i s unique interms of its strategic location in the world. Being landlocked initially appears as a constraint, but may in fact be turned into an asset. Policies should, therefore, focus on facilitating trade on the China-Russia corridor, both internally by improving internal infrastructure and by streamlining regulations and bureaucratic procedures, and externally by looking at possible trade facilitation agreements and regulations harmonization. To this end, the Government needs to place adequate emphasis on developing internal transport infrastructure on the basis of an infrastructure strategy that aims to connect markets and maintain supply chains, while at the same time maintaining fiscal sustainability. Trade is significantly affected by transportation costs, so investments in railways and road-both construction and maintenance-are crucial for keeping these costs down. 4.40 The recent Mongolia Infrastructure Strategy Report of the World Bank report (2007) identified the three major challenges that the Mongolian infrastructure sector faced today, namely, (a) more closely aligning prices with costs; (b) improving efficiency and governance; and (c) planning better. The resulting investment priorities in this sector that this report recommendsare the following: 8 Maintain the existing stock of infrastructure; 8 Exploit the potential of recent mining discoveries, and 8 Avoid national electricity shortages. The overall focus here should be on maintenance(especially on roads), planning for private investmentinmining areas, and for new sources of power. 4.41 Government policies should accompany rather than attempt to offset the ongoing migration and economic concentration. On the location of "growth pole" in Mongolia, given Ulaanbaatar's "primate city" role and the spatial characteristics of Mongolia's economy, it is likely that the population residing in this city will continue to grow, not only due to demographics, but as a result o f the continued migration that the market forces bring. This implies that Government policies should not aim to limit this agglomeration effect that is already underway, but should focus instead on improving the provision of basic services and public infrastructure in Ulaanbaatar, and in particular in the Ger areas. In the rural areas, where most of the poor are, the focus should be on improving both access and quality of education in order to improve equity inrural areas and facilitate migration to areas where the particular skills of a person are inmost demand. 4.42 To this end, non-sector specijk investments and policiesfocusing human capital and infrastructure investments with large positive externalities should be preferred. Many of the big failures of regional development policies concern large industrial investment projects. By contrast, infrastructure investments are location-specific, but their returns are not specific to a particular activity. For example, a road built in a region with good tourism potential will increaseeconomic activity inthis sector, but will not only be usedby the tourism industry but by others. Similarly, human capital investments are multi-purpose in the sense that they are neither activity- nor location-specific. Most of the successful examples of regional development (for example Ireland, the United States) result from exceptional emphasis on such non-sector specific investments by the government. THETYRANNYOFDISTANCE AND THEROLE OF GEOGRAPHY - 91 - MONGOLIA: 4.43 Choices to prioritize connectivity with secondary cities should be made on the basis of the existing natural comparative advantage (such as, mining resources, trade corridors, supply-chain hubs, among others). Connecting secondary cities with markets and inparticular Ulaanbaatar will increase their chance of development. However, such an infrastructure policy might very well be unaffordable, given the country's vastness. The use of Information and Communications Technology (ICT) infrastructure could be made to "virtually" connect the whole country and its people anddeal with national security considerations. 4.44 Indeed, the role of ICT in facilitating the acquisition, dissemination and use of knowledge across a country is critical in today's rapidly growing Mongolian economy, more so given the vast geographical territory that needs to be covered by information. This will influence the way in which manufacturers, service providers and the government (central, provincial and local) are organized and how they perform their functions. ICT plays a crucial role in reducing barriers of cost, time and space to economic transactions, allowing for mass production of customized goods and services and compensating for limited factors of production. Research shows strong linkages between ICT and growth. Figure 4.5 shows that while Mongolia has shown progress intelephone services access relative to other low-income countries, there is the needto improve availability of e-government services, business internet use, and media access (newspaper and TV) across the country. This should not only be translated into the needfor computer hardware and software, butfor institutional reforms in key areas such as ensuring timely access to the public of information on government operations, strategies and actionplans. Figure4.5: Scorecard on Informationand CommunicationTechnologies, SelectedVariables, (Most RecentPeriod) Mongo1ia Total Telephones per 1,000 People (184.40) (n/a) ICT Expenditure as X o f GDP Main Telephone Lines per 1000 People (55.70) (3.10) Extent of Business Internet Use nobile Phones per 1,000 People (128.70) (1.88) Availability o f e-Government Services Computers per 1,000 People (124.10) month) (17.80) Price Basket for Internet (US$ per Households with Television ( X )(29 .OO) (79.50) Internet Users per 1,000 People Daily Newspapers per 1,000 People (18.00) (8.90) International Internet Bandwidth (bits per person) Normalization Group: Lou Income (current) Type: ueighted Year: nost recent Note Values in parenthesis denote actual valuesfor Mongoliafor the most recent periodfor which data are available Each of the 80 variables in the World Bank's Knowledge Assessment Methodology (KAM) is normalized on a scale of 0 to 10for the low income group of countries as defined by the World Bank Thefuller the scorecard, the better poised a country is to embrace the knowledge economy But an economy may not necessarily aim for a score of 10 on all variables because the shape of these scorecards a dependent on the peculiar structural characteristics of an economy or by trade-offs that characterize dtjferent development strategies. Source. World Bank, Knowledge Assessment Methodology, IIItD:!!wt~sltibiml.~)~~~~~~ni. - 92 - CHAPTER 4: COUNTRYECONOMIC MEMORANDUM 4.45 Where then should the infrastructure be located? The World Bank's Infrastructure Strategy Report for Mongolia, 2007 (forthcoming) identifies three groups of factors as key determinantsof infrastructure needs. Namely: To undertake urban-led infiastructure investments. Given the unique feature of the Mongolian urban system, Ulaanbaatar will continue to exert significant pull of physical and human capital, and be the main driver of Mongolian urbanization. Following the demographic projections it can be estimated that by 2015 the bulk of the urban infrastructure assets and investment needs will be concentratedinUlaanbaatarcity. To undertake investment to bring about Connectivity, with the rest of the world and, strategically, within Mongolia. Mongolia would need to carefully examine the opportunities presented by its unique geographical location. It is next door to the most dynamic economy in the world in recent years-China. It is situated between two large economies (China and Russia) whose bilateral trade as recent as 2005 increased by 37 percent to reach US$29 billion. Infrastructure investment and planning would have to incorporate how Mongolia can exploit its landlocked status and turn it into a driving force by connecting to the markets inthe region. This potential is already being manifested in the robust growth oftransit railtraffic. Infrastructure to support mining sector development and the growth of vertically and horizontally integrated industries (including service sector activities). The ramping up of mining activities inMongolia would require new infrastructure (especially, roads, railway, energy and water) to get the outputs to markets in China and elsewhere. Reducing transport costs between poor and rich regions is similar in effect to a reduction in intra- provincialtrade barriers or the removal of a tariff. The local taxation regime and existence of user fees for utilities needs to be factored into the cost benefit calculations when determining public infrastructure investments inorder to build supply chains and access to markets. A case can be made, therefore, for prudent government investments in roads, railways, and other infrastructure of a public-good nature (i.e. that benefit non-mining sectors inthe area and improve the general investmentclimate) to support the mines. 4.46 In all its investment decisions (and especially in the third category above), the government should be cautious about putting its scarce public funds into areas where the private sector may be willing to participate, invest and provide the infrastructure and related- services themselves. But even in these instances, there remains a role for the Mongolian Government to ensure that the minimum quality standards, as per international benchmarks, are met in the infrastructure that the private sector builds and operates. Chapter 6 examines issues the Government and other stakeholders must consider in deciding the strategy towards the country's mining sector and natural resourcemanagementgoing forward-all this without loosing sight of the ultimate goal of maintaining high and broad-based GDP growth in a market-oriented setting. THETYRANNYOFDISTANCE THEROLE OFGEOGRAPHY AND - 93 - MONGOLIA: Box 4.4. RegionalRoadNetwork on the Way Infact, a regional road network is already inthe works with the recent announcement inJanuary 2007 that China plans to invest 2.3bn yuan (294m U S dollars) to upgrade highways linking border trading areas in Xinjiang Uighur Autonomous Region, west China, in the coming five years to facilitate booming trade with neighboring countries. The Chinese central government and the regional government of Xinjiang will jointly find the upgrading of 802 kilometers of highways linking the region with neighboring countries such as Russia, Mongolia, Kazakhstanand Kyrgyzstan. Xinjiang has a border that extends for 5,600 kilometers and has opened 15 customs posts and 101 highways for passenger and cargo transportationbetweenthe region and neighboring countries.19 China's trade with central Asian countries has boomed in recent years. China-Kazakhstan trade volume hit 6bn US dollars in 2005 alone. In the first three of 2006, China-Russia trade volume hit 24.64bn US dollars, up 18.8 per cent, The year-long expected to hit a record high of 36bn dollars. Statistics from China's General Administration w that trade volume between China and Mongolia from January to September 2006 hit 1.13bnU s. Inaddition, between 2006 and 2010, Mongolia and China plan to build six international roads to link the two countries in order to promote bilat cooperation.20 Inparticular, four truck roadsand two passenger vehicle roads are planned. Since 2001 1.64 billion yuan-(roughly 210 million USD)--has been spent by the Provincial Government of Inner Mongolia, China to build eight roads with a view towards developing the international transportation infrastructure between China and Mongolia. In 2006, a passenger turnover of 1.37 million people and freight turnover of 2.73 million tons was registeredthrough the checkpoints of Inner Mongolia, China with the border with Mongolia. These developments provide a significant window of opportunities for Mongolia. 4.47 Finally, the role o f the labor market in accommodating rural-urban migrations, the ongoing economic concentration in Ulaanbaatar, as well as to respond to specific disparities and equity issues faced in rural areas is essential. Simply providing the infrastructure for people to migrate between rural and urban areas may not solve the issues o f poverty and inequity o f opportunities between Mongolia's rural and urban inhabitants and its migrant population. It may, in fact aggravate already stretched public services in the urban areas, especially Ulaanbaatar, and lead to further problem like crime and discontent that accompany situations where people become discontent with the migrants coming in and the previous inhabitants o f urban centers that are receiving them at growing rates. The next chapter provides a detailed analysis o f the labor market with a view towards narrowing down what these specific policy interventions should be to address these challenges and help in creating employment and sustained growth in such a geographically dispersed country as Mongolia. 19Source: Xinhua news agency, Beijing, January 1,2007. 2oThis was said by Zyan Gefen, Deputy Chief of the Department of Road and Communication of the Inner Mongolia, China, at a forum held there on building inter-continental roads to link Asia with Europe. Source: Mongolia MONTSAME News Agency, January 30, 2007 - 94 - CHAPTER 4: COUNTRYECONOMICMEMORANDUM 5. A LABOR MARKETINTRANSITION Broad-based growth in Mongolia will require addressing the binding constraint in the labor market: the inadequacy of the skills produced by the education and training systems to the needs of the labor market. Addressing this constraint tackles the two major challenges in the labor market, namely, the underutilization of human capital-particularly the high incidence of idleness among the working-age population-and the mismatch between the skills that workers bring to the labor market and those demanded by the labor market. To this end, policies thatfocus on human development need to be instituted with a view towards removing existing skills mismatches and bringing about flexibility in the labor market. These skill enhancement efforts must be especially directed to the migratingpopulation, who are mainly comingfrom rural areas, as well as the urbanyouth. 5.1 The previous chapter has shown that in this vast country one is seeing rapid rural- urban migration take place, with most of the traffic to the Ulaanbaatar metropolitan area. While this is good from the point of view of availability of labor for the growing urban economic activities, it calls for important policy interventions to address the skills mismatch that one is seeing today and to create more jobs and broad-based growth in future. Chapters land 2 showed that two major challenges in the Mongolian labor market are: (i)the underutilization of human capital-particularly the high incidence of idleness among the working-age population-and (ii) mismatchbetweentheskillsthatworkersbringtothe the labor market and those demanded by the labor market. This chapter examines the labor market demandand supply and provides evidence of a significant skill mismatch at all levels. SKILLS MISMATCH AT ALL LEVELS 5.2 The changes in the structure of the economy, greater openness and competition, as well as greater use of technology have all resulted in increased demand for skilled and educatedlabor inrecent times. Researchsuggests that there are several types of skills that one needs today in order to enhance a person's ability to do well, either as entrepreneurs, or workers in the private sector (See Box 5.1). Intoday's complex and changing environment, the challenge is to buildthese skills that allow young people to think critically and creatively, to process information, to make decisions, to manage conflict, and to work in teams. The ability to process information starts to develop early in school. Cross-country evidence suggests that an education system that emphasizes rote learning o f facts fails to develop these skills.' ' These programshavebeen well tested indeveloped country settings such as the Netherlandsand the United States and are now beginning to emerge indeveloping countries as well. Source: World Bank, Development and the Next Generation, World Development Report, 2007. A LABORMARKETIN TRANSITION - 95 - MONGOLIA: Box. 5.1: Skills and Knowledgehave many Aspects The types of Skills discussed inthis Report follows from the definition inthe World Bank's most recent World Development Report 2007. They include thinking skills (critical and creative thinking), behavioral skills (perseverance, self-discipline, teamwork, the ability to negotiate conflict and manage risks), specific knowledge (including numeracy and literacy), and vocational skills (a mix o f specific knowledge and skills to performjobs that rely on clearly defined tasks). Basic skills denote the set of minimal abilities needed for further learning, work, and life, including numeracy and literacy and basic levels o f behavioral skills such as perseverance, self- discipline, and self-confidence. Post-basic skills include thinking skills, higher order behavioral skills (decision- making skills, teamwork, the ability to negotiate conflict and manage risks), specific knowledge applied to real- life situations, andvocational skills. Source: World Bank, Development and the Next Generation, World Development Report 2007, pp. 71. 5.3 As a result o fpast successesineducation policy, Mongolia produces a large number o f school graduates every year-77 percent complete lower secondary school or higher- relative to labor market demands (more on that below). This naturally produces some friction in the labor market whereby many young graduates end up doing jobs requiring skills and education levels below theirs. Data from World Bank Investment Climate Survey (2004) shows some evidence o f over-qualification, particularly among vocational education graduates. About 22 o f secondary school graduates and 13 percent o f college graduates feel theirjobs require a lower level of education thantheirs (Table 5.1). There is also evidence that employers tend to hire college graduates because they signal the skills employers are really interested in rather than their direct value to business (more on that below). Most workers with vocational education (81percent) feel they are overqualified. Table 5.1: What is the Most Appropriate Level of Education for Your Work? Tertiary Vocational Complete Incomplete Primary None Obs. secondary secondary Education level completed Tertiary 87.19*** 0.92 8.7 2.06 0 1.14 43 7 Vocational+ 18.84 O*** 57.25 15.94 2.17 5.8 138 Complete 10.23 0.53 66.84*** 13.05 1.76 7.58 secondary 567 Notes: *** notesthat the difference across rows is signijicant at 1%. Stars inparenthesis show the signi$cance level that values in diagonal differsfiom the other values in a same column. (***); (**); and (*) indicate significances at I percent, 5 percent and 10percent, respectively. 5.4 According to the LSMS 2002-03, about 57 percent o f workers are family labor or self- employed (79 percent in rural areas). The importance of agriculture is declining but it continues to be the main sector o f employment (40 percent), and it i s low skill-intensive (small scale and low technology). And the sectors that have increased the most in terms o f employment (mining, construction and retail & wholesale trade) are not high skill-intensive. The skills-content o f non-agricultural jobs is relatively low (Table 5.2). About 47 percent o f employees hold skilled occupations.2 The highest proportion o f skilled jobs is in the health Skilled occupations are: legislators, senior officials, managers, professionals, technicians and associated professionals. Unskilled occupations are: clerks, service and sales workers, craft and related trade workers, plantlmachine operators and assemblers, and elementary occupations. - 96- CHAPTER 5: COUNTRYECONOMIC MEMORANDUM sector (80 percent), education, public administration and business activities sectors respectively. Table 5.2: Schoolingand Skill Content of Non-agriculturalWage Sectors Urban Rural National Skilled M Y S Skilled M Y S Skilled M Y S Occupation Occupation Occupation (%)s (%)s (%)s Mining & Quarrying 25.2 11.6 8.1 10.4 20.3 11.25 Manufacturing 14.0 10.8 17.9 10.9 14.5 10.82 Electricity, water supply 36.2 11.4 22.7 11.6 34.2 11.39 Construction 21.9 10.6 3.0 7.1 20.2 10.32 Wholesale & Retail trade 39.5 12.1 12.7 9.8 36.3 11.83 Transport & Communication 21.7 11.2 18.1 10.8 21.0 11.1 Business activities 61.6 12.7 46.3 11.7 59.9 12.55 Public administration 59.1 12.9 62.3 11.5 59.9 12.54 Education 76.2 13.2 68.5 12.1 73.5 12.81 Health 85.0 12.9 68.6 11.4 80.4 12.49 Other services 22.9 11.2 27.3 11.4 23.4 11.27 Others 49.7 12.1 20.0 8.7 46.0 11.7 Total non agricultural wage sector 46.6 12.1 49.0 11.3 47.I 11.9 Notes: MYS refers to "Mean years of schooling". Source: LSMS (2002). 5.5 The returns to higher education beyond primary education for an individual are large-but this has to do more with the `signaling' effect of higher education. The returns to education only payoff once upper secondary education is completed and they are particularly large for higher education graduates working in the urban private sector (Table 5.3). O f the total vacancies submitted in 2005 by employers to the Labor and Social Welfare Assistance Division, 17 percent were for higher education graduates, 22 percent for vocational graduates and 51 percent for secondary education graduates. But the high premium attached to higher education is not mainly a reflection of the valued added of higher education degrees but rather the `signaling' effect of higher education-employers tendto hirehigher education graduates because they signal the skills employers are really interested in (IT, English, thinking and behavioral skills as defined in Box 5.1 above). Mongolia has done relatively well in producing a large number of high school graduates and beyond. Table 5.3: Returnsto Educationby Level (Relative primary educationor less) (%) National Urban Rural Private Public Lower secondary 0 0 0 58 0 Upper secondary 32 37 24 65 0 Vocational 38 42 31 74 0 Diploma 66 71 61 121 32 Bachelor [85 93 69 147 5 11 Note: Estimates are based on log wage regressionsfor wage earners aged 25-65. Source: LSMS 2002-03 A LABOR MARKETTRANSITION IN - 9 7 - MONGOLIA: SUPPLY-SIDE FACTORSINTHE LABORMARKETNEEDATTENTIONAS WELL 5.6 To improve the skills o f young people for work and life, education opportunities must be made more relevant to the needs o f all young people. This involves improving educational preparation for adolescence by providing quality basic education for all. It also involves meeting the growing demand for post-basic skills, by providing diverse and flexible learning options inupper secondary and tertiary education; by implementing a relevant curriculum that teaches practical subjects, thinking skills, and behavioral skills; by blendingthe academic and vocational curricula, and by connecting school and work. And second chance education opportunities must also be provided for young people who failed to acquire basic skills the first time around, such as equivalence education and skills training program^.^ Formaleducationopportunitiesand curricula 5.7 Mongolia's education system does well in terms o f producing school graduates, but it does not prepare them well for work and life in today's changing economy. Although there are large disparities between urban and rural areas, overall 77 o f percent o f children complete lower secondary school while 52 percent complete upper secondary school. The latter would be significantly higher if there was no quota on the number o f children that are allowed to move to upper secondary. These figures reflect the effect o f past education policies focused on getting children through school. However, the educational preparation o f adolescents for additional learning, work and life is poor. The National Assessment o f Students' achievement (NASA) was conducted in 2005 among students at the end o f basic education (Sth grade) in mathematics and civic education, based on the adaptation to the local context o f two international tests, TIMSS and CIVED.4 The instruments did not only test knowledge but also, and more importantly, the ability o f students to apply this knowledge (Le. competencies). The average learning achievement for mathematics and civic education was 50 percent and 47 percent respectively, with large disparities between urban and rural areas (Table 5.4). Table 5.4: Student Achievement by School Location Ulaanbaatar Aimag Soums Total centers General /A+B/ 49.5 49.2 42.7 48.6 Mathematics/A/ 51.4 51.2 42.3 50.3 Civic Education/B/ 47.2 46.9 43.2 46.6 Source: Education and Evaluation Center (2006). 5.8 Particular attention i s needed to enhance the skills o f adolescent youth. Recent survey data suggest that in algebra (where, on average, students perform better than in geometry), these students did relatively well in knowledge items (67 percent) and in performing routine procedures (55 percent). They had difficulty, however, with complex procedures (21 percent) and problem solving tasks (42 percent). Civic education also needed attention. One cannot Much ofthe framework and examples inthis section is taken from the 2007 World Development Report (World Bank, 2006~). Civic education includeddomains in politics anddemocracy, Humanrights and freedom, State structure and Mongolianhistory. -98- CHAPTER 5: COUNTRY ECONOMICMEMORANDUM therefore get away from arriving at the conclusion that Mongolia's schools seem to be failing to prepare young people for work and life intoday's rapidly changing economy. 5.9 Fortunately, if accompaniedby the right reforms in curriculum and teaching practices, the expansion of the school system to 12 years in 2008 could improve the preparation of adolescents for further learning, work and life by providing them with 9 years of basic education. Mongolia initiated a standards-based curriculum reform in 1998 and a year later, began standardized testing. The Secondary Education Standards were introduced in 2003. These standards emphasize the importance of comprehensive skills-learning to know, learning to perform, learning to exist and learning to socialize. General subject areas do include practical knowledge areas such as science and technology and English. While these standards are consistent with the acquisition of skills that are needed for work and life, the enacted curriculum and teaching practices are not very consistent with these goals. 5.10 Inhigher education, new higher education standards are being developed buthave not yet been introduced. These standards emphasize important skills, such as pluralism, foreign language competence, computer skills and team work skills. Inpractice, however, the names of academic programs have changed but their content has not. In vocational education, there remains the need to revise the curriculum to accommodate it to the needs of a market economy. The Government is cognizant of this and many of these challenges are being addressed in the new Education Sector Master Plan (ESMP 2006-2015) and the Millennium Challenge Account (MCA) proposal for the reform of the TVET sector. 5.11 The school curriculum and teaching methods have not kept up with the new demands in the labor market. The curriculum continues to be too theoretical and focused on traditional academic subjects, while teaching continues to teacher-centered rather than interactive, as well as to encourage memorization rather than critical and creative thinking and individualistic learning rather than teamwork. While I T and English language subjects are part of the curriculum,teachers are generally not well preparedto teach them. Also, inmany cases, the teaching of IT is very limited by the poor availability of computers in schools. The teaching of thinking and behavioral skills can be integrated into every aspect of the curriculum through discovery-oriented teaching methods that include interactive learning, applying knowledge to real-life problems, integrating teamwork and peer tutoring into the learning process, and inviting student input into the structure and subject matter of lessons. 5.12 It should be noted that the implementation of student-centered teaching methods will take time and will require substantial investments in pre- and in-service training. Inthe short run, teaching life skills as a separate subject (e.g., health, citizenship, or financial literacy education) can be a practical option. For example, Japan and Malaysia have recently included life skills as a subject in their secondary school curriculum. To improve teaching, teachers also should have adequate materials and routine assessments of student progress be conducted. These assessments should focus more on the ability of students to use knowledge acquired. The Government is currently working on developing such a national assessment system for primary education. Such initiative should be extended to secondary education. IT can facilitate, but never replace, teaching and learning. A LABOR MARKETIN TRANSITION - 99 - MONGOLIA: 5.13 The supply of vocational education does not serve the needs of the labor market. Upper secondary and tertiary education have to accommodate diverse student needs, interests, and capabilities. Vocational education should be part o f a diverse system o f learning options. Vocational education can be accessed after completing lower secondary or upper secondary, while technical education requires upper secondary. Vocational and technical education in Mongolia, however, only accounts for 9 percent o f total enrollment in post-basic education, which reflects the heavy bias o f post-basic education towards academic university degrees. Also, the system needs enough flexibility to allow students to experiment and develop their full potential. While technical education is fully integrated with higher education, vocational education in Mongolia, however, i s a terminal track with no connection with technical colleges or the academic education track (secondary and higher education). Recent successful reforms in secondary education in other countries have upgraded previously terminal vocational tracks, allowing vocational education graduates entry to higher education after taking school-leaving examinations (e.g., Tunisia and SouthAfrica). 5.14 In terms of quality and relevance o f vocational education, there has not been any serious effort to update the existing vocational education curricula to the needs o f the labor market. International evidence shows that effective feedback from the labor market and regular consultations with employers and alumni are indispensable for adjusting curricula to meet changing needs, as in Chile, where vocational training institutes are governed by representatives o f employers, workers, and the government. Standard setting and quality assurance i s a major weakness o f the TVET system, and only technical colleges are subject to the accreditation system. Much could be done to improve vocational education through built- inquality control and competency-based skills testing and certification system. 5.15 Vocational fields o f specialization are outdated and comprehensive skills are not present in the current vocational education curriculum in Mongolia. These comprehensive skills (such as subject knowledge in IT and English, as well as cognitive thinking and behavioral skills) are needed for vocational graduates to succeed in today's labor market. Recent successful education reforms in a number o f countries are making the academic and vocational curricula more integrated, bringing more vocational content into the general curriculum (Malaysia) and more vocationally relevant academic subjects (Chile) into the vocational curriculum. New curriculum and teaching practices need to be accompanied by improved learning materials and facilities. The current facilities and equipment in vocational school are very old and outdated. 5.16 To facilitate transition to work life, the connection between school and work needs to be improved. This goes beyond just providing vocational education and involves strengthening the partnership between industry and schools. For example, Career Academies in the United States combine academic and technical curricula around a career theme and establish partnerships with local employers to provide work-based learning opportunities.6 Universities and research institutes have contributed much to the growth o f the Chinese economy. In Beijing, such institutions collaborate with local industry through joint projects A recent comprehensive analysis of Technical and Vocational Education and Training (TVET) has been conducted by the Asian Development Bank and the MinistryofEducation, Culture and Science (2005). Kemple and Scott-Clayton (2004). - 100- CHAPTER 5: COUNTRYECONOMICMEMORANDUM and technology transfers and establish firms (spin-offs) to commercialize their inventions. Some o f those firms (Lenovo, Tongfang) are among the largest Chinese high-technology firms.7 5.17 Currently, the higher education institutions do not fully serve the needs of the knowledge economy. Universities are subject to an accreditation system since 1998, but this system is voluntary and very weak in terms o f the assessment done.* In addition to introducing more student-centered teaching practices and more practical programs, the higher education system needs to be more flexible. Open systems can facilitate student mobility by recognizing relevant prior experience, degree equivalences, and credits earned elsewhere. In Thailand, for example, all courses inthe entire national university system are credit-based. In Colombia, people already in the labor market can get university-equivalent certification through any accredited training institution. A well-designed and unified system o f higher education admission tests is likely to be beneficial, because educating the most capable students can foster innovation, driving the economy. The U.S. state o f Georgia recently reformed its tertiary entrance exam, which limited access and improved the quality o f students. A remaining challenge, however, i s to provide alternatives to those students that do not make the cut. A good example i s the California higher education system in the U.S.A., which combines selective admissions to centers o f excellence with more open admissions to other two and four year tertiary institutions.' 5.18 The expansion and improvement o f vocational and technical education as well as higher education can be greatly facilitated by reaching out to the private sector. Public-private Partnerships (PPPs) allow systems to expand in a fiscally constrained environment. The private sector (including foreign institutions) i s well established inthe higher education sector (73 percent o f institutions and 32 percent o f students), but less so in the vocational and technical education sector (14 percent o f institutions). PPPs can also improve learning outcomes and efficiency overall by increasing choices and injecting competition. For that competition to work, however, public institutions need sufficient autonomy and resources to manage for results and private institutions need to be accountable for meeting well-defined quality standards. International evidence shows that governments should provide information and quality assurance while promoting diversity. The Philippines and the Republic o f Korea set quality standards lower at the entry point (licensing) to give new institutions the chance to grow, and later make the standards more stringent (accreditation) for both public and private institutions to allow fair competition. 5.19 With the ongoing recentralization reform in Mongolia, education institutions were given more autonomy. However, the current funding o f public vocational schools, technical colleges and universities remains inadequate not only in terms o f levels but also in their form-most o f the funding depends on the number o f students (per student grants in the case o f vocational and technical schools and regulated fees in the case of universities) rather than on performance. The current accreditation system in Mongolia has very little effect on the public funding that an institution receives. In addition to linking public funding to 'Chen and Kenney (2005). See Asian Development Bank and the Ministry o f Education, Culture and Science (2005) for details. 9See litt~:/h nw cgec.ca.gov/. A LABOR MARKET IN TRANSITION -101- MONGOLIA: accreditation, the Government could also consider competitive funding like Indonesia did, for example, where about 25 percent of the recurrent budget to public universities is allocated through competitive funding. Second chance educationopportunities 5.20 Improvingthe skills of young people for work and life also involves providing second chance education opportunities for young people who failed to acquire basic skills the first time around. About 38 percent of 18- to 35-year-olds dropped out of school without completing basic education. Even among those who completed basic education, some seem to lack minimal levels of general skills-including numeracy and literacy and basic levels of behavioral skills such as perseverance, self-discipline, and self-confidence, and the technical skills to be productively employed. The needs of out-of-school youths are thus diverse because they leave school at different points in the schooling cycle, with different levels of skills attainment. Even among youths who have the same skills (or lack thereof), the second chances likely to be appealing and effective depend on the age of the young people. Finally, second chances also need to be tailored to the local environment, which might be rural or urban. 5.21 A policy and organizational framework for second chances-learly linked to the formal school system and informed by the demands from the labor market and society-is missing in Mongolia. In its place are non-formal education and training programs that focus on disadvantagedyouths but are not linked to each other or to the school system. Non formal education programs run in parallel to, and independent from, the formal school system. For those children and youths who are still in school but performing poorly, or have dropped out recently, one policy response is to offer remedial education to put them back on track. But identifying who needs such supplementary instruction is a key step. In some developed countries, such as Australia, Canada, and the United States, the results of standardized tests trigger a remedial education program. This will be easier to implement once standardized testing is introduced inMongolia. Inthe meantime, another option could be to ask teachers to informally identify students that were falling behind, such as in the successful Balsakhi program inIndia. 5.22 To appeal to out-of-school youth, second-chance programs must take into account why young people dropped out or never attended school, the challenges they will face to stay in a program, and how they can be integrated into the formal education sector or find employment. All these vary by age, skill, and the local environment. Equivalence and job trainingprograms may serve different youth populations, but their common aim of providing competencies for work and life requires a more integrated approach: literacy and equivalency programs that include life skills and vocational training, and vocational training programs that include life skills. Equivalence systems use more practical curricula, more flexible schedules, and less formal instruction methods than regular schools. They dependon a strong partnership between the formal education sector, private providers of programs, and prospective employers. Without this partnership,the graduates of equivalence systems will be left holding diplomas that allow neither reintegration into the regular school system nor employment in jobs requiring a certain level of competency. - 102- CHAPTER5: COUNTRY ECONOMICMEMORANDUM 5.23 The mode of delivery must take into account why young people dropped out. For example, to bring programs closer to homes in rural areas of Mexico, the Telesecundaria program offers lessons by video. To accommodate the pressure for adolescents to work, the Tutorial Learning System in Colombia allows students in rural areas and their facilitators to determine the preferred schedule and pace. Successful equivalence programs that hope to reintegrate people inthe formal education system often use teaching methods that are similar to those recommended above for formal schools-student-centered learning, regular assessment, and remedial sessions to involve students intheir learning progress. Programs for older youth, however, often use very different approaches. The MexicanNational Institutefor Adult Education (INEA) has developed an innovative education model for out-of-school individuals 15 or older to learn how to complete the equivalent of primary, lower secondary or upper secondary education. It provides a curriculum based on acquiring skills for work and life through a flexible system of modules-individuals can choose among the modules andthe length o f the program is attuned to their needs, covering subjects such as health and civic education, and vocational skills. 5.24 Interms ofjob training, firms inMongolia do, indeed, respond to the inadequacy of skills of the workforce by providing training to their workers, but this response is limited and does not cover unskilled workers. According to the 2004 ICs, only 51 percent of firms provide some training. Larger firms that export, have foreign direct investment and adapt technology are more likely to train. However, almost none of the firms provide training to unskilledworkers-who need it most. Their decision reflects the fact that the spillover effect of training is higher among skilled and educated workers. Hence, job training for unskilled workers is clearly needed, but public vocational training programs in Mongolia do not really help trainees. Mongolia has had vocational training programs since 2000, with very mediocre results in terms of making trainees more employable. Vocational training i s conducted at the Vocational Training Centers (VTCs) in the form of non-credit courses with duration ranging from one to three months. There are no strict entry qualifications for taking up vocational courses. VTCs are mostly operated by private owners. This active private sector participation has been possible thanks to the Skills Training Voucher Program (STVP), but the potentially positive effects on training quality are minimized by the lack of a formal accreditation system. 5.25 With the new amendments to the Labor Law, the duration of job training is now allowed to vary by field, and vouchers given to trainees also vary accordingly. These recent changes, however, do not address the lack o f relevance and impact of vocational training. Again, fields of training are outdated and do not reflect the needs in the labor market. Employers need to play a more active role in determining the types and contents of training programs. As with vocational education, the curriculumneeds to be modular and competency- based rather than the current rigid field-based curriculum. Also, the successful experience of skills training programs, such as the Jovenes and Entra 21 programs in Latin America, shows that training intechnical skills alone is unlikely to pay off unless combined with thinking and behavioral skills and employment services, such as job counseling, which is currently lacking in the system. A system of skills assessment and grading of workers is not yet operational. Standards need to be developed and trainees assessed on those standards. This needs to be accompanied by a proper accreditation of training institutions to be able to qualify for the voucher program. The quicker the authorities begin to initiate the above reforms, the better A LABOR MARKETIN TRANSITION - 103 - MONGOLIA: position will be the position of the Mongolian labor force to help alleviate the binding constraints to growth related to skills. POLICY RECOMMENDATIONS 5.26 Given that the agenda for addressingthe binding constraint to broad-basedgrowth that emanates from the existing labor market in Mongolia, the following policies should be considered by the Mongolian authorities for implementation inthe short runso as to have the greatest near-term impact on generating employment and fueling growth going forward. The rest of the policy actions will take more time to bear fruit, and must continue. Fortunately, with the recent formulation of the Education Master Plan by the Government, some of these are already under way. To Improvethe EducationalPreparationof Adolescents, the Focus inthe ShortRun Shouldbe on: 0 Ensuring that general schools have the necessaryresourcesto cope with the expansion ofthe school systemto 12 years in2008. As the school system expands, adapting the curriculum and teaching practices to the Secondary Education Standards (e.g. teachers training on student-centered methods, IT and English) and a student assessment systemdeveloped. T o Meetthe GrowingDemandfor Post-basicSkills 5.27 Technical and vocational education needs to become a real alternative to (yet articulated with) the academic track, and produce skills that are relevant to the labor market. New guidelines for the sector need to be developed now and then implemented. Guidelines should cover the following areas: 0 Occupational standards (with the input of employers) as well as a testing and certification system 0 A modular, competency-basedcurriculum to attainthose standards 0 An accreditation system of TVET institutions 0 Partnershipswith employers to connect TVET institutions to the workplace 0 Alternative forms of financing of TVET institutions (vouchers, performance-based financing and competitive funding) 5.28 Higher education needs to become the engine of the knowledge economy. To do so, the focus should benow on: 0 strengtheningthe current accreditation systemand make it compulsory 0 introducing a well-designed andunifiedhigher education admission test 0 developing guidelines for alternative forms of financing (vouchers, performance-based financing and competitive funding) and partnershipswith employers. -104- CHAPTER5: COUNTRYECONOMICMEMORANDUM 5.29 Over the medium run, new financing models need to be implemented, more student- centered teaching practices and practical programs needto be introduced, and the partnerships with industry strengthened. 5.30 And for young people who failed to acquire basic skills the first time around the focus right now should be on developing a coherent strategy for second chances that meets the diverse needs o f youth, i s clearly linked to the formal school system and informed by the demands from the labor market. The next step is to design and implement second chance programs-remedial education, equivalence education, literacy and skills training consistent with this strategy. A LABORMARKETTRANSITION IN -10.5- MONGOLIA: 6. MANAGINGNATURALRESOURCESFOR LONG-RUN BROAD-BASEDGROWTH Unlike other East Asian countries, "natural capital" occupies the largest share of MongoliaS wealth. Within this category, its mineral resources take up the lion's share. Hence, Mongolia's economic development will depend on sustaining and enhancing traditional sectors, particularly mining and livestock, while nurturing new sources of growth and export earnings. The adoption of a stable, competitive and transparent legal, regulatory andfiscal regime for the mining sector will be essential for its continued growth and development. Investment agreements in the mining sector need to be structured toprimarily define the basic rights and obligations of both the government and investors and to stabilize fiscal provisions upon which investment decisions are based. It is important to ensure that such agreements remain subordinate to existing legislation and apply to the sector as a whole, rather than provisions which result in discriminatory treatment of individual firms. Therecent changes to the fiscal and policy regime in Mongolia undermine its competitiveness and could impact negatively on investor confidence which has been building over the period 2001-2005. The main issues that the Government might want to reconsiderheevaluate are the mining royalty rates, the windfall profits tax, and the share of equity participation by the State in mining projects. 6.1 It is undisputable that Mongolia's mining and natural resource sector will remain a dominant source of its long-term growth. But given that these are exhaustible resources-in the sense that once they are taken out of the ground they cannot be put back-it calls for a prudent strategy to use these resources efficiently over time and at the same time promote the vertical and horizontal linkages inproduction to generate broad-basedgrowth inthe economy. Failing to do this will lead to a tendency for miningto develop as an "enclave", an experience that many less-developed and isolated regions have faced in other countries. The capital- intensive nature of direct mineral exploration and extraction activities in these instances had not created as much broad-basedemployment and growth as was initially expected. Mongolia has the benefitof learning from these past experiences of others inmaking the most of its own mineral resources (including copper, gold and oil) as well as other natural resources from the long-term development point of view. 6.2 Mongolia's mining sector output has the potential to increase substantially over the next decade. It is projected to double or even triple from 2003 levels by 2010 provided large projects get development approvals and are successfully commissioned. To this end, it is imperative to provide a mining taxation regime that allows for efficient mining operations, encourages value-added processing, and encourages exploration, research and development (R&D) and, at the same time, generate revenues for the government to spend prudently. International experience suggests that almost all Governments of mineral resource-rich countries choose to have some specific provisions for Mining, and some Governments have -106- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM entirely separate but transparent mining fiscal codes. In analyzing mining tax systems, it i s essential to look at the complete system o f &l and fees rather than at individual rates in taxes isolation. Need to estimate total effective tax rate (ETR) as a first step in comparing mining tax packages. ETR does not tell you about the timing o f tax payments. For instance, a country that gives accelerated depreciation provisions gives mine operator a higher up-front revenue for the same ETR as a country that does not give this incentive. A mineral taxation policy which promotes resource wastage, e.g. royalties, levies and other taxes on revenue, and input taxes such as duties and land use fees cause companies to increase cut-off-grade and waste potentially viable resources. This results in reduction o f the size o f the resource, reduced total value o f production and shorter mine life. 6.3 Common incentives that other countries have given to mining operators include: accelerated depreciation, loss carry forward, no-ring-fencing rules (Le. level o f consolidation o f tax base. Ring-fencing favors existing operators and i s complex to implement.), carry forward and amortization o f exploration, feasibility and development costs, deductible environmental and closure costs, and deductible community and public infrastructure costs. Less common incentives include: fiscal stabilization, tax holiday or initially reduced rates, depletion allowances and loss carry back. Meanwhile, it is imperative to build capacity o f tax agency, especially to collect the mineral taxes owed to Government under the existing tax laws. In addition, prudent management o f windfall revenues and an internationally competitive investment climate inthe miningsector i s needed as well. 6.4 This chapter aims to assist informulating a prudent long-term strategy for sustainable development and the use o f natural resources inMongolia, with particular attention to mining. To this end, one must appropriately define the "wealth" o f the country using an analytical framework that incorporates the intrinsic benefits o f these natural resources and costs o f environmental degradation involved in their use. With this framework in mind, this chapter addresses the issues and policies that the Government may want to consider fostering the efficient and sustainable development o f the Mongolian mining sector in an effort to bring about inclusive broad-based long-run growth. In addition, the chapter also looks at the country's wild-life and forestry resources , which provide rich additional sources o f output and export diversification possibilities (as Chapter 3 showed) in the near-term, but also threaten Mongolia's biodiversity over the long-run if utilized inappropriately. Any strategy to develop the country's miningand natural resource sectors should take these related long-term sustainability issues into account. In Mongolia, this includes looking at the economic impact o f illegal wildlife and forest resource trade, and factoring this into policy decision-making process. ESTIMATING "TRUE"WEALTHOFMONGOLIA THE 6.5 The process o f economic development and growth entails the conversion o f Mongolia's abundant natural capital into produced capital (represented by man-made capital equipment and structures) and institutional and human capital. The sum o f these different types o f capital then provides a measure o f the true "wealth" o f the country. This framework clearly highlights the critical importance o f managing a country's natural capital-both renewable and non-renewable-so as to ensure that an adequate rate of return i s generated in the conversion process whereby physical and human capital are created. This will, in turn, MANAGINGNATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH - 107- MONGOLIA: increase the overall wealth of the economy inan environmentally sustainable manner.Failure to do so may result in short-term growth that is instead accompanied by a reduction inoverall wealth over the long term.' Before formulating a mining sector strategy, the government needs to recognize this trade-off and make every effort to incorporate this dimension into the strategy. Table 6.1: Wealth Estimates for Mongolia ($ per capita, 2000) Asset type $ per capita (2000) Subsoil assets 113 Timber resources 90 Non-timber forest resources (NTFR) 1,006 Protectedareas (PA) 387 Crop land 405 Pasture land 2,779 Natural capital 4,780 Producedcapital + Urban land 2,300 Intangible capital 1,160 Total wealth 8,239 Share Natural Capital 58% Share ProducedCapital 28% Share Intangible Capital 14% Source: World Bank, 2006i, Where is the Wealth of Nations? WashingtonDC. WorldBank Staffestimates. 6.6 A recent World Bank Report entitled "Where is the Wealth of Nations?" (2006i) estimates the "true" wealth for 120 countries using internationally available data. The study shows that the average Mongolianhas a total "true" wealth of roughly $8,200 when definedto include physical (natural and produced), non-tangible and human capital (Table 6.1). This estimate includes not only produced assets, such as buildings and machinery, but also natural wealth in the form of land, forests and subsoil assets, and intangible capital, such as human resources and institutions.2 1Economic literature suggests that in order to measure social welfare correctly one should rely on wealth-like magnitudes. The fact that income or consumption does not have a direct welfare interpretation is highlighted ina seminal paper by Samuelson (1961). Equally important is the notion that wealth should be measured in a comprehensive way. Irving Fisher (1906) provided the original insight that current wealth equals the present value of future consumption. Fisher's argument was motivated by the need to find a measure of comprehensive wealth. This led to the intuition that the value of an asset is the capitalization of the stream of future services expected to be produced by the asset. For the relationship between future consumption and wealth to hold, it is important to ensure that the full range of assets which generate well being are included in the analysis. Fisher identified three types of assets: immovable wealth, comprising of land and the fixed structures upon it, movable assets or commodities, and human beings. In World Bank (2006i) natural wealth or natural capital is the sum of non-renewableresources (including oil, natural gas, coal, and mineral resources), cropland, pastureland, forested areas (including areas used for timber extraction and non-timber forest products), and protected areas. Most commercial natural resources are valued by taking the present value of resource rents-the economic profit on exploitation-over an assumed lifetime. While forests can, in principle, yield benefits forever if sustainably managed, we account for overexploitation by calculating the effective lifetime o fthe resourcegiven current harvestrates. Agricultural land rents are estimated calculating profits from different types of crops, assumingthat the products of the land are sold at world prices. -108- CHAPTER 6 COUNTRY ECONOMICMEMORANDUM 6.7 A quick glance at the wealth composition (Figure 6.1) for Mongoliashows that natural capital is a very important component of its wealth. Natural capital constitutes 58 percent of total wealth, produced capital accounts for 28 percent and intangible capital (a combination of human and institutional capital) for 14 percent. The very low level of intangible capital is an aspect that makes Mongolia qualitatively different to the rest of East Asia and PaciJc, where the largestform of wealth is intangible capital. Figure6.1: Total Wealth Compositionin Mongolia (Yo,2000) 100% 90% 80% 70% 0Intangible 60% I 50% HProducedcapital + Urban land 40% Naturalcapital 30% 20% 10% 0% Mongolia EastAsia Low and Pacific Income Source: World Bank, 2006i, Where is the Wealth ofNations? Washington DC, The efficiency and productivity of natural resource use has beenlow 6.8 According to the World Bank Study (2006i), across the world intangible capital was found to occupy the dominant share amongst the three main components of "true" wealth. Nearly 85 percent of the countries analyzed in this report attributed over half of their true wealth to intangible capital. This outcome validates the standard economic premise that human capital and other intangibles play a major role in economic development. While human capital helps explain a large portion of the variations in intangible capital, there are other factors that are relevant. The quality of institutions, social capital, and ultimately, the efficiency with which resources are used inthe economy, all matter inthis regard. 6.9 Available data suggests that Mongolia's public expenditure on education has been around 8 percent of national income and the level of human capital is high, however, the country's average intangible capital is very low at 14 percent (Figure 6.1) compared to the East Asia and Pacific region and low income countries averages. Inother words, Mongolia is achieving extremely low levels of returns on its produced, natural and human capital The values for non-timber forest resources and protected areas are estimated only crudely. In the case of non- timber forest products, world average values of benefits per hectare, distinguishing developed and developing countries are applied to a share of the country's forested area. Protectedareas are valued using country-specific per-hectare values for cropland or pastureland (whichever is lower). For more details on estimation methodologiesrefer to World Bank, 2006a, Where is the Wealth of Nations? Washington DC. MANAGING NATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH -109- MONGOLIA: investment^.^ This suggests that Mongolia's assets could be usedmore effi~iently.~ further To support the point that the productivity of investment in Mongolia has been very low as well compared to EAP and low-income country averages over the past 20 years Table 6.2 shows that the capital-output ratio for a number of countries. The ratio for Mongolia is much higher than those of the other countries in the region. The average capital-output ratio for the countries in East Asia and Pacific is 3.2, while Mongolia's corresponding value is 5.8. Estimates of intangible capital and produced capital over the past 20-year period also seems to suggest the inefficientuse of the country's assets.' Table 6.2: CapitalOutputRatiosfor Selected Countriesand CountryGroups Country I output raiio Mongolia 5.8 Thailand 3.8 Malaysia 3.4 China 3.1 Indonesia 3.0 Philippines 2.7 Low income (all regions) 3.1 East Asia and Pacific region 3.2 Source: World Bank (2006a) and World Bank (20066) 6.10 How about natural capital? Table 6.3 identifies countries similar to Mongolia where pasture land is a very important share of the country's natural capital. (It is important to note that the countries shown in Table 6.3 span various regions and a variety of climate zones so comparisons should be made with caution.) 6.11 High income countries, such as Ireland, Belgium, Netherlands and New Zealand are characterized by very high value added in agriculture. Belgium and the Netherlands, in addition, have very high pasture land rents. The picture is very different in Central Asia and other developing regions. Table 6.3 suggests that Mongolia has the lowest level of pasture land rents (US$2 per hectare). The next lowest value is the one for Kazakhstan (US$7 per hectare). In addition, Mongolia's agricultural value added per worker i s low if compared to other countries in the region such as Georgia, Uzbekistan and Kazakhstan. Only Kyrgyz Republic and Tajikistan have lower values. Producedcapitalplus land. In the World Bank study (2006i), a number of countries appeared to have very low or even negative levels of intangible capital. A low intangible capital is possible by constructionbecause intangible capital is calculated as a residual-the difference between total wealth (the present value of future consumption) and the sum of produced and natural capital. It follows then that if tangible assets, such as buildings and machinery, and land assets, such as pastures, are usedinefficiently,the effect will be capturedinthe intangible capitalresidual. 5Produced capital canbe estimatedusingthe perpetualinventory method(PIM) which computes the cumulative investmentsthat took place in the past 20 years while taking into account asset depreciation (assumed to be 5 percent). Estimatesfor Mongoliashow that, duringthe 1980s investmentwas very high(averaging 57 percent of GDP, a patternthat was commonto many countries inthe Communistblock at the time.) - IIO- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM Table 6.3: Low Productivityin MongolianAgriculture Country Pastureland share Pastureland Ag value added of natural capital rent per worker (Percent) ($ha) (9 Ireland 77% 542 Belgium-Luxembourg 71% 1596 38683 Uruguay 60% 64 6755 Mongolia 58% 2 888 Kyrgyz Republic 54% 43 845 Netherlands 46% 2849 38127 New Zealand 46% 336 25613 Georgia 45% 103 1195 Estonia 41% 558 3219 Albania 40% 521 1274 Kenya 39% 35 306 Poland 38% 747 1743 Tajikistan 36% 27 304 Latvia 34% 345 2110 Denmark 32% 3301 35252 Bulgaria 32% 265 5270 Argentina 27% 33 9085 Romania 26% 248 2527 Libya 25% 8 Jordan 25% 68 907 Uzbekistan 19% 57 1391 Kazakhstan 16% 7 1107 Source: World Bank (2006) "Where is the Wealth of Nations=Measuring Capitalfor the 21'' Century" and World Bank staff calculations What does all this mean?A counterfactualanalysis 6.12 What if Mongolia's investments had been similar in terms of efficiency to other low income countries? Scenario analysis using the above-mentioned "Green Accounting" methodology shows that a level of produced capital per capita of US$2,300 would be producing a 2000 income o f nearly US$730-an eighty-five percent increasecomparedto the actual 2000 income level of US$400. If natural capital, and in particular pasture land, were productive as inother neighbor countries (see table 6.3)' the income per capita would be even higher. Hence, more efficient use of Mongolia's pasture land could in fact yield higher agricultural output which would, in tum, lead to both higher land values and higher total wealth. This counterfactual analysis demonstrates that Mongolia's tangible assets have been unable to generate the level of output that similar levels of capital have generated elsewhere. 6.13 Results of deriving a counterfactual "true" wealth profile for Mongolia using the above "green accounting" methodology yields interesting results as well. Assuming that produced capital had been invested efficiently using a conservative capital-output ratio similar to the one for low income countries (Le., a ratio of 3.1); this would result in a level of income of at least US$ 730. Using a Hamilton and Hartwick (2005) methodology where the This is a crude assumption but it is useful in highlighting the peculiarities of Mongolia: high historic investmentlevelsthat have generated very low productivecapacity. MANAGINGNATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH - I11 - MONGOLIA: current value of wealth i s equal to the present value of future consumption, and under standard assumptions', the total estimated "true" wealth generated by Mongolia's tangible assets would be as high as US$ 15,000. On this basis, a counterfactual wealth profile for Mongolia is shown in Table 6.4. Under this scenario, the level of intangible capital of 53 percent of total wealth would be very similar to Indonesia where natural resources (especially oil and crop land) also play an important role inits total wealth. Table 6.4: Mongolia:Actualand CounterfactualWealth Compositions composition composition US$ per Percent US$ per Percent Producedcapital 2,300 28% 2,300 15% Intangible capital 1,160 14% 7,920 53% Total "True" 8,240 100% 15,000 100% Wealth Source: World Bank staff estimates. ESTIMATINGMONGOLIA'S "GENUINE"SAVINGS RATE 6.14 High savings rates have been the basis for sustained growth in East Asian countries. Mongolia's story tells us that the profitability of investments financed by this saving is of paramount importance. "Sustainable development" is defined as the situation where the benefits of economic development accrue not only to the present generation, but also the future generationsto come. A critical aspect insustainable development is the way inwhich a country manages its current national wealth or the rate at which a country spends its national wealth-where "true" wealth has been computed for Mongolia using the above methodology that accounts for the country's natural, physical and natural capital. Under this approach, if a country's "true" wealth is spent faster than it i s accumulated, future generations will be worse off than the current ones. Any long term strategy to develop a country's natural resources, particularly its mineral resources, must take this consideration into account. 6.15 One way to measure the change in a country's wealth is by analyzing the standard national accounts. Here the "gross" national saving is defined as the total output producedthat i s not consumed. However, one downside to this measure i s that it only includes produced assets and does not take into account asset depreciation. The "net" national saving can be obtained by subtracting depreciation of assets from the gross national saving. However, even this measureis far from perfect, since it doesn't include the human and natural componentsof wealth discussed earlier in the "true" wealth framework (a la World Bank 2006i). Indeed, components such as the environment, natural resources and human capital can provide a considerably more complex measure of sustainability then simply focusing on changes in 'Assumption used: consumption is 89 percent of GDP (equivalent to the actual level for the period 1998-2002), consumption is expectedto grow at a constant rate, pure rate of time preference is 1.5 percent and elasticity o f utility with respect to consumption is 1. In addition, Hamilton and Hartwick show that their result holds when asset prices are efficient (exhaustible prices follow the Hotelling rule, for example), and the economy exhibits constantreturns to scale. - 112- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM produced assets measuredby the concept of net savings. These are incorporated inthe concept of "genuine savings" that one can derive as well. 6.16 The concept of genuine saving is discussed in more detail in the World Bank publication entitled--"Where I s the Wealth of Nations?" (2006i). This was previously known as "adjusted net saving", first developedby Pearce and Atkinson (1993) and Hamilton(1994). Genuine saving includes wealth considerations in terms of net saving, as well as changes in natural andhumancapital. Figure 6.2 illustrates how the concept of genuine saving is derived. Figure6.2: Methodologyto Estimatethe "GenuineSavings" in an Economy Source' WorldBank (2006i), Where is the Wealth ofNations? Washington DC 6.17 Table 6.5 summarizes the genuine saving for Mongolia, East Asia and Pacific region and the group of low income countries for 2004. With an adjusted net saving of 26.6 percent of GNI, Mongolia is slightly above the East Asian average of 23.9 percent and considerably above the average for low income countries of 7.3 percent. However, even with Mongolia's rather strong adjustednet saving for 2004, three issues are worth emphasizing. First, Mongolia's saving rate declined by nearly one third in 2004, when accounting for depreciation of produced capital, the depletion of natural resources, particularly minerals, and damage from global and local air pollutants. MANAGINGNATURALRESOURCESFOR LONG-RUN BROAD-BASED GROWTH - 113- MONGOLIA: Second, the depletion figures for Mongolia do not include soil depletion, for which information is not available. Mongolia, however, depends heavily on agricultural land resources. A relatively high deforestation is likely to be associated with soil depletion and a more careful study of this phenomenon is required,and Finally, given Mongolia's rather unique wealth composition-with natural capital accounting for almost 60 percent of the true wealth of the country-it implies that natural resource management is particularly important for Mongolia. Indeed, mismanaging these resources could have major negative implications for Mongolia's long rungrowth. Table 6.5: Measuresof Saving in Mongolia (Yo of GNI, 2004) East Asia Low and the Income NationalAccounting Aggregates, 2004 Mongolia Pacific countries Gross saving 40.8 39.1 22.7 Consumption of fixed capital 9.3 10.5 9.2 Net saving 31.5 28.6 13.5 Educationexpenditures 8.1 2.3 3.4 Energy depletion 0.9 4.1 6.7 Mineraldepletion 8.4 0.4 0.4 Net forest depletion 0.0 0.0 0.7 COZ damage 3.8 1.2 1.1 Particulateemission damage 0.0 1.2 0.8 Adjusted net saving 26.6 23.9 7.3 6.18 Thus, in order to develop a strategy to use Mongolia's natural resources efficiently, one needs to keep inmindthe fact that Mongolia's abundant natural capital must be usedin a manner that makes the productivity of the economy (and the corresponding utilization of its physical capital includingland) high and depletion of its "true" wealth low. Boxes 6.1 and 6.2 summarize the status of Mongolia's urban and rural Land, institutions for its management and related constraints. While increasingly visible and tangible, the economic impacts o f natural resource mismanagement in Mongolia remain difficult to assess mostly due to the lack of reliable and accessible data on environmental and natural resources management monitoring data and information. However, existing empirical and anecdotal evidence clearly indicates that illegal logging and wildlife trade, artisanal gold mining, and water and air pollution are responsible for the increasing economic costs of environmental degradation. - 114- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM Box 6.1: Urban Land was Free in Mongolia until 2005 The Mongolian Constitution provides for the private ownership o f non-pastoral land. Nevertheless, all land was owned by the State until 2002, when the Parliament approved both the new Land Law (regulating possession and use o f state-owned land) and the Law on Mongolian Citizens' Ownership o f Land (regulating allocation o f landto Mongolian families for ownership). The 2002 legislation thus introduced measured reforms towards improving security o f tenure for residents inGer areas and for formalizing transfer o f possession rights. The 2002 Land Law recognizes the right o f possession holders to transfer the certificate o f land possession to others (after approval by the relevant local authorities), or to use it as collateral. However, it only gives households the right o f ownership, not individuals. The implementation o f this law remains constrained by burdensome permission requirements and political consensus remains fragile on land-related issues, especially on how to proceed with more ambitious reforms. Meanwhile, an informal land market has allegedly been in existence, especially inthe Ulaanbaatar area, since 1994. Both the mining cadastreand land registrationsystem are still in their infancy. Without effective coordination o f the two registries (Le. sub-soil miningrights and surface rights - free-hold land) rent seeking and conflict can arise that result in costly delays inminingoperations since a mining company needs "land use permission" from the private owner and local authorities for the surface land necessary for its processing plant and for surface inhstructure needed for its mining operations. A national cadastre has been established at the outset o f implementation o f the land privatization, with priority given to the Ulaanbaatar municipality. Inger areas there are a number o f barriers to land registration; an inefficient process for issuance o f land permits and residency certificates, high annual land fees and registration costs, and lack o f public access to official land registry information. In2003, the local Representative Khural inUlaanbaatar approved a land privatization plan whereby state- owned land that is to be privatized in and around the Ulaanbaatar area for household use in amounts to about 0.01 percent o f the total land area. The privatization was to be completed by 2005/2006 but is still underway. Families in the capital city are entitled to 0.07 ha o f land free o f charge, while subsequent acquisitions o f land will require payment. In aimag centers, families are entitled to 0.35 ha o f land, while in soum centers they are entitled to 0.5 ha. This impliesthat a rural families' land entitlement may be five to seven times larger than that o f an urban family. As a result, inUlaanbaatar, about 90 percent o f apartments in Ulaanbaatar became privately owned between 2003 and 2006, and 2,868 hectares o f land have beenprivatized. Most o f the privatization went on in the Ger districts, where 80 percent o f residents now own their plots o f land. Private ownership o f land increased roughly 31 percent from 21,870 hectares in2003 to 69,924 hectares in2005. Privatization o f land was free up to 2005. However, individuals often incur administrative costs to acquire their land. The latest available estimates suggest that an additional 13,000 to 15,000 hectares o f urban land was privatized in 2006-a rate lower than previous years. Economic entities are entitled to possession o f land only; the ownership o f the land stays with the local authorities. Economic entities are entitled to a possession certificate spanning between 15 to 60 years the first time the possession certificates is issued. Extension o f the certificates can be issuedup to forty years, and can be grantedmultiple times. The housingfinance market is still in an embryonic stage. There is little information on existing prices or trends in land and housing prices, and little clarity on how to value land for sale and purchase. To date, it remains unclear whether or not the 2002 legal framework is being effective in formalizing the existing real estate market as well as the implementation o f the land taxation system. Some 18 to 20 percent o f the GOM's revenue is expected to come from property tax associated with land. The authorities lack adequate capacity to assess and collect this tax at present. It is further complicated by inconsistent enforcement, and the fact that there is no publicly announced standard valuation system for commercial land in Mongolia. Under current land fee assessments, apartment dwellers, usually considered the higher income groups, are exempted from land fees as prescribed by the Land Law, as the land on which apartments are built is categorized as community land. In addition, 90 percent o f the property tax values in the Ger districts o f Ulaanbaatar are not collected. There are discussions ongoing within the Government to allow for a tax payment exemption for Ger area residents for the foreseeable future on equity grounds. MANAGINGNATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH - 115- MONGOLIA: Box 6.2: Rural Land Managementin M The preference for a nomadic way o f life in m a l Mongolia, and the are the great strengths o f the Mongolian pastoral economy. This commi flected inthe 1994 LandLaw and the Mongolian Constitution. The existing legal framework and local attitudes stand in clear opposition to the implied goal o f landregistration and titling. The 1994 Land Law authorized local soum governors and bugh leaders to regulate pastoral land use, including seasonal movements and stocking rates, and to allocate land under "possession and use contracts". Anecdotal evidence suggests that many o f the local officials are unaware o f this mandate given to them, while others are not clear about the limits o fthis mandate. This Land Law was amended in2002. The 2002 LandLaw includes provisions specifying the authority to enforce seasonal use patterns rather than allocating possession over pasture. However, some ambiguities o f the 1994 Land Law, particularly related to pastureland management, remain. Specifically: 9 Absence of a clear definition of "common tenure land', "land for c mmon purpose", "collective use of land", and"joint possession o fland"by citizens. 9 By designating all wells and water points as "common use resources", this provision seems to undermine the allocation of pastures to individuals andor a group. As a result, it would allow any herder to enter a possessedpasture inorder to obtain water. 9 There is lack ofclarity on what alandmanagement planentails. Confusionremains regardingthe areas for different type o f land use activities and/or whether these designations include specific prescriptions for the management o f grazing etc. Between 2005 and 2006, a preliminary assessment o f the progress and outcomes o f the implementation o f the 2002 LandLaw was carried out inseven aimags o f Mongolia (out o fa total o f 18). It finds that: 9 The implementation of the 2002 LandLaw seems to be proceeding slowly inthe with regards to the allocation o f possession licenses over pastureland, This is partly reduction inthe numbers o f livestock and herding households due to climatic and de made the allocation o fpossession rights somewhat less urgent than it was inthe mid-late 1990s. 9 The pattern of allocating formal tenure to campsites only to a sub-set of households (primarily the wealthier ones) in each soum. By excluding poorer herders, it may very well accelerate the downward trajectory o f the herder households that are vulnerable to poverty. Hence, the current legislation and local attempts at implementing it may hinder efforts to solve current pasture use problems that could bringorder to the steppes while ensuring sustainability o f land and livelihoods. THEROLEOFTHE MINING SECTOR INTHE MONGOLIAN ECONOMY 6.19 The mining sector is a major contributor to the Mongolian economy and its importance is likely to remain high in theforeseeable future. In 2005, the mining sector directly accounted for 18 percent of GDP, 65.5 percent of industrial output, almost 76 percent of export earnings and 20 percent of Government revenue. The economy grew at about 10.7 percent in 2004 (supported by the investment in and the initial gold production from Boroo Gold) and 6.2 percentin2005. A significant proportion ofthe new GDP growth attributable to the mining sector which has somewhat offset some declines in other sectors including - 116- CHAPTER 6 COUNTRY ECONOMICMEMORANDUM agriculture. The formal mining industry sector employs over 14,500 people and the informal (artisanal) mining sector may involve more than twice this number.8 6.20 Mongolia's geology is complex and its mineral potential is extensive with over 6,000 mineral occurrences comprising 80 different mineral commodities currently identified. The most economically significant of these are base metals (most notably copper and zinc), gold, coal and fluorspar. The mining industry's historic output i s largely based on copper and gold. Mongolia has only one copper mine (Erdenet), whose exports of copper and molybdenum concentrates earn about half of all foreign exchange and provide almost 25 percent of government revenues. Erdenet's production has progressively declined and is expected to deteriorate even further as the head-grade decreases with depth. Gold production increased substantially over the period 1995-2005 although there was a slight decrease in production between 2001 and 2003. Production from newly commissioned mines lifted gold production substantially in 2004 and 2005 to the current level of over 24 tons per annum. Until the commencement of hard rock gold production in 2003, most gold production came primarily from placer operations (shallow alluvial concentrations of gold). The placer operations are showing signs of progressive depletion of mineral reserves. Without active exploration for newplacer deposits, this declining trend inplacer goldproduction is likely to continue. Table 6.6 MongolianMining Sector Contributionto GDP and Exports 1995 2000 2001 2002 2003 2004 2005 % o fGDP 12.0 11.2 11.7 10.1 12.7 17.3 18.0 %of Value 65.5 40.5 44.2 56.7 58.9 70.8 75.8 o f Exports Source: MRPAM,2007. 6.21 Based on figures provided by the Foreign Investment Agency, foreign direct investment in mineral and petroleum exploration and development activities was US$148 million in 2004 and US$191 million in 2005 of which US$40 million was for grass roots exploration activities. FDI for the sector constituted 68 percent of the total FDI for 2005. Given the rapid increase in exploration and development activities, the outlook for continued strong growth of the sector should be bright. Exploration activities have resulted in the discovery and delineation of a pipelineof potential mineral project developments that include Oyu Tolgoi (copper and gold), Tavan Tolgoi (coal), Tsagaan Suvraga (Copper and Molybdenum), Tumurtei (Iron Ore), and Ulaan(Lead and Zinc). 6.22 In addition to production constraints at Erdenet, the mining sector has experienced a volatile spike ininternational commodity prices. Although copper production remained steady over the period 1995 to 2005, the world copper market experienced significantly depressed prices between 1997 and 2003, and the value of Mongolia's copper exports fell as a result. Gold production also increased steadily until2001,mostly from placer operations, also during Source: National Statistics Office, 2005 MANAGINGNATURAL RESOURCESFORLONG-RUN BROAD-BASED GROWTH - 117- MONGOLIA: a period o f depressed world prices. In 2002, gold prices started to increase followed shortly thereafter by a substantial increase in copper prices. Despite these price increases the quantity o f copper and molybdenum production remained largely static or in the case o f molybdenum declined. This resulted from an absence o f any new coppedmolybdenum mine developments or any investment inproject expansions by the existing mine. Table 6.7: Changes in Production, 1995-2005 Miningand 1995 2000 2001 2002 2003 2004 2005 Y O Ya quarrying Change Change since since Coal (mn. Tonnes) 5.0 5.0 5.1 5.3 5.6 6.8 8.3 +65% +65% Crude oil (thousand 183 215.7 200.7 bbl.) Ironore (thousand 33.5 167.7 tonnes) Copper concentrate (thousand 346.4 357.8 381.4 376.3 372.2 371.4 361.6 +I% +4% tonnes) Molybdenum concentrate 3906 2843 3028 3384 3837 2428 2528 -11% -36% (tonnes) Gold (kg) 4504 11808 13675 12097 11119 19237 24122 104% 435% Fluor spar concentrate (thousand 130 210 209 159.8 198 148 134 -36% +3% tonnes) Zinc ore (tonnes) 22,841 Source: MRPAM, 2007. FactorsAffectingMineralSector Contributionto GDP 6.23 The increase in GDP due to the mineral sector can be attributed to five main factors, namely: 0 The increase in mineral commodity prices (particularly copper and gold prices) since 2003 has boosted the value o f exports despite a generally declining trend in copper, molybdenum and flourspar concentrate production. The increased commodity prices have masked the static or declining contribution o f copper, molybdenum and flourspar. 0 Increased gold production from new hard rock operations mainly at Boroo has not only replaced the declining production from placer operations but increased the total tonnage o f gold production 0 Increased coal production resulting in increased exports o f coal to China and Russia. Total coal production has increased by over 3 million tonnes per annum since 2002, mainly from the development of the Narain Sukhait deposit near the Chinese border in the south Gobi. Domestic consumption o f low grade coal for power generation (mostly -118- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM lignite from Bagga Nuur and Shivee Ovoo) has remained relatively flat at 5 million tonnes per annum. Meanwhile, the increase in coal production of 3 million tonnes per annum is mainly high quality hard coal. Commissioning of iron ore and zinc production as well a small quantity of oil fiom new operations has helpedto diversify the industry away from copper and gold. While these contributions remain relatively small at present, they demonstrate Mongolia's capacity to diversify into new mineral commodities which may in future contribute more substantially to exports. The final contributor to increased GDP from the sector is the dramatic increase in exploration expenditures by mineral explorers. These contribute broadly across the economy into such sectors as the suppliers of goods and services such as laboratory services, catering, logistics, and drilling. Whilst this is not usually directly reported as mineral sector GDP growth, it can have a significant impact on a small economy such as Mongolia. Mineral exploration is an industry in its own right and with exploration expenditurestotaling $127 million in2005, equivalent to almost 10 percent of GDP. 6.24 The issue of concern relating to the recent rise incontribution of the mineral sector to GDP is that a significant proportion of the recent gains are essentially cyclical in nature. Commodity prices are high but unlikelyto stay there inthe mediumterm as newproduction is commissioned, and as global demand growth moderates. High levels of exploration expenditure also follow commodity price trends. As prices decline exploration expenditures are also likely to decline. As a result, a downward trend in contribution to GDP can be expected unless there are further developments of mineral deposits which add production as commodity prices fall. Thus, an appropriately structured and stable fiscal and policy environment will be required in order to sustain the levels of exploration and development in the medium term. The lack of a stable legal environment and imposition of unpopular windfall taxes are unhelpful and likely to undermine Mongolia s competitiveness in the region. Mineral Exploration 6.25 There has been a rapid rise inmineral exploration inMongolia. This is inpart due to the 1997 Minerals Law, which has played a pivotal role in attracting foreign exploration companies. Other important factors were the government's abolition of a 10 percent gold tax and the widely publicized discovery of the Oyu Tolgoi copper/gold deposit in2001. Since this discovery, the number of exploration licenses held, and the amount of land held by licensees, has increased fivefold. There are now 2,595 exploration licenses in Mongolia covering 40 million hectares, or 26 percent of its territory. The government's Office o f Geology remains the largest landholder although there are moves under way to reduce the exploration title holdings ofthe State. 6.26 Non-governmental holdings are concentrated in a small number of companies that control a significant percentage of the remaining license areas. The largest o f these companies are foreign. Explorationexpenditures have rapidly increased following the rise in commodity prices from US$6 million in 2000 to US$18 million in 2002 to US$98 million in 2004 and US$127 million in 2005. This dramatic increase in expenditure was the largest percentage increase in the world over this period with Mongolia accounting for 4 percent of global MANAGINGNATURALRESOURCESFORLONG-RUN BROAD-BASEDGROWTH - 119- MONGOLIA: exploration expenditures and 50 percent of expenditures within the Asia Pacific region. The increase in exploration activity has led to a number o f discoveries which could potentially lead to new developments given the right investment regime. These discoveries are in a diverse range of commodities including iron ore, copper, lead-zinc, uranium and coal which could strengthen the diversification o f the industry away from its current focus on copper, gold and coal. 6.27 Mongolia has a number of small mines either newly in production or under development consideration. Small hard rock gold operations at Borro, Bumbat and Olon Ovoot and the Tsairt zinc mine at Tumurtiin are either inoperation or nearing operations. Due to the small scale of most of these new mines they are not expected to have a significant impact on the value of production or GDP inthe short term but are important to the sector and the economy for the long term. Larger scale economic impacts can be expected from the development of the large Oyu Tolgoi copper-gold deposit and Tavan Tolgoi coal deposit in the south of the country. These two operations have the potential to treble or even quadruple the current volume andvalue ofmineral exports. ArtisanalMining 6.28 Artisanal mining in Mongolia is not a longstanding traditional activity but primarily a response to the adverse effects of economic restructuring, which has resulted injob losses, inflation, and declining real incomes. Some people have been forced to find their own solutions to these problems, most often outside the formal economy. Artisanal mining i s a viable solution for many because it is a highly labor intensive, technologically simple, and low-cost activity. The growth of artisanal mining and its sales on the informal market have become important to Mongoliainboth economic and politicalterms. 6.29 Much artisanal mining has emerged in areas adjacent to and within the gold-bearing tailings discarded by commercial placer mines. The surge in commercial development of Mongolia's extensive placer deposits in the early 1990s left large amounts of waste material that provided a relatively rich and readily accessible resource base for artisanal miners that can be tapped with simple, affordable tools. 6.30 Artisanal gold mining started as a seasonal activity involving hundreds of people. Over the past ten years it has escalated into a year-round livelihood involving an estimated 30,000 people. During summer this number has been estimated to increase up to 100,000 people.' This activity poses a significant development challenge for Mongolia. While it has provided significant economic opportunities for poor Mongolians during difficult economic times, commercial miners and local government authorities have been critical, assertingthat it i s outside the legal and regulatory framework, degrades the environment and exposes miners to hazardouswork conditions and toxic chemicals. 6.31 Because artisanal miners in Mongolia have few rights and no claim to land or minerals, conflicts have emerged between informal miners and licensed commercial mining operations, usually when there has been direct competition for access to mineral resources. Source: MRPAM - 120- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM Many companies have relied on security forces to defend their interests. Conflicts between local authorities and informal miners have to date beenminor, although local authorities have also used police to evict miners. The informal miners have not resisted eviction and harassment but are upset and have been pushing for legislative recognition to regularize and legalize their activities. In 2001 the government attempted to accommodate artisanal mining by enacting an interim regulation of this informal activity. That regulation proved ineffective and unworkable; it lapsed after one year and was not renewed. The government is now inthe process of drafting a legal framework for artisanal mining-a commendable step that is inthe right direction. The next challenge inthis regard will beto implementthat new law. MINERAL TAXATION REGIME 6.32 To accomplish the effective conversion of its mineral endowment by the private sector, Mongolia should ensure that the government realizes a fair and equitable share of the value added from the exploitation of its mineral resources after providing for: 0 the acceleratedrecovery of large lumpy investmentsto reduce risk and facilitate debt financing; the mitigationof environmental and social impacts of miningto address all externalities; and 0 an attractive risk adjustedreturnto investors to encouragethe huge investments required to locate, evaluate and exploit Mongolia's hiddentreasures. 6.33 Mining is a global business and international mining companies have infinitechoice in the countries in which to invest. Generally, nations with political stability, good and transparent governance arrangements and an enabling investment climate have better prospects for long-term mineral sector development than those where these factors are absent. In analysing investment conditions a firm will typically analyze a host of key criteria, especially those relating to the fiscal environment. The types o f criteria used and their respectiveimportance, of course varies greatly betweenfirms. 6.34 Several surveys have been undertaken of foreign direct exploration and mining investment decision-making, the most comprehensive of which was undertakenby the United Nations in 1992." This included a comprehensive list of over 60 that international mining companies routinely take into account in their investment decisions, which include in order of importance the country's geological prospectivity, a measure of profitability, security of tenure of mineralrights, the right to repatriateprofits andthe long-term stability ofmining policies. 6.35 Among the top 10 factors, all but one, geological prospectivity, are related to, of affected by the regulatory framework, and of the top 20 factors, four relate directly to taxation and include: "James Otto; "A Global Survey of Mineral Company Investment Preferences", Mineral Investment Conditions in Selected Countries of the Asia-Pacific Region, United Nations ST/ESCAP/ll97, New York, 1992, pp.330- 342 MANAGINGNATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH -121 - MONGOLIA: measure o f profitability, 0 ability to predeterminetax liability, 0 stability o f fiscal regime, and 0 method and level o f tax levies. 6.36 None o f these four tax factors need pose a barrier to investment inthe mineral sector if Mongolia seriously wishes to create and sustain the interest o f international investors to locate and develop the country's mineral deposits. To accomplish this, the country needs to reestablish a track record o f legal, regulatory and fiscal stability; a fair fiscal take, or effective tax rate (ETR), commensurate with competing jurisdictions and international benchmark; and the adoption ofa model investment agreement to ensure consistency among investors. Figure 6.3: The Optimal Effective Tax Rate" NPV of Government Revenues 0 T" Tax Rate (Percent) 100 NPV -net presentvalue (the amount of all taxes and fees paid by mines to the government as adjustedfor the time value of money) Source: Mining Royalties: A Global Study of their Impact on Investors, Government and Civil Society, WorldBank Press, 2006. 6.37 An important part o f mineral sector fiscal policy is for the authorities to clearly articulate the government's primary tax objective and to decide between maximizing its fiscal receipts in the short-run and optimizing the present-value o f its share over the medium term, or some combination o f the two. For short term gains, the tax regime induces one to impose a high effective tax rate (ETR).12However, if the ETR is too high, individual mines will pay more, but in the longer term exploration will be discouraged and there may be fewer mines willing to so business inthe country. This, inturn, will narrow the tax base inthis sector and, hence, tend to lower the contribution o f mining revenues to the state treasury. If the ETR is too low, the returns on investment will exceed those necessary to induce the investment inthe first place and the government will needlessly forego fiscal revenues. A good policy, I'The "Laffer curve" illustratesthe notion that government can maximizetax revenues by setting tax rates at an optimumpoint. Although widely known among economists for some time, this curve was popularizedby Arther Laffer in the mid-1970s to demonstratethe benefits o f reducingtax rates (such as those on capital gains, among others) whenever it appearedthey exceeded this "optimum" level. '*The combined rate that takes into account the present value of all taxes, duties and user fees paidby a mine over its life as a proportionofthe net-present-valueof its projectedcash flow. -122 - CHAPTER 6: COUNTRY ECONOMICMEMORANDUM therefore, will strive to strike an optimal balance where the effective tax rate is set at T* in Figure 6.3. For most nations, this optimal ETR is usually between40 and 50 percent. 6.38 Mongolia's mining tax system includes corporate taxes, personal income taxes, mineral royalties, value-addedtaxes, customs and excise duties, social insurance, and stability arrangements. The previous Minerals Law, which was introduced in 1997, required the Ministryof Financeto implementregulations to govern the income of mining enterprises. At that time the Minerals Law includedprovisions relating to the amortization of exploration and development expenditures, depreciation of fixed assets, a three-year loss carry forward provision, and rules relating to the deduction of infrastructure costs. These regulations were never implemented and were subsequently dropped or modified in the Law's most recent amendment in2006. However, the Mineral Law still contains a number of tax provisions that apparently conflict with the Corporate Income Tax Act that should be removed since the General Law on Taxation provides that all taxes be regulated solely by the tax laws administered by the Ministry of Finance. 6.39 Recent amendments (2006) to the income tax law reduced the income tax rate to 25 percent and abolished the ten-year tax holiday bring the fiscal regime for mining to within international bench marks. The removal of the tax holiday is positive as it will remove the tendency to high grade short lived mines. It will also assist inreducing public calls for higher taxes to be applied on the industry, as in the case of earlier mine development in Mongolia, when there appears to be little benefit flowing to the general population from profitable operations currently benefiting from the tax holiday provisions. The removal of the tax holiday, absent the introduction of more appropriate capital recovery and loss carry forward provisions, has increasedthe level of investment risk experiencedby investors due to the very high levels of capital cost involved in most mining developments. To address this serious omission, the Government is encouraged to consider the introduction of accelerated depreciation and longer loss carried forward provisions for the mining sector in order to reduceproject risk as a substitute for the tax holiday. 6.40 Royalty rates for mineral products have recently been increased to levels which are uncommonly high by international standards.Ad valorem royalty rates for gold and copper in most producing nations lie in the range 2-3 percent. Rates of 5 percent now apply to copper, gold and other base metals from hard rock operations. (Annex Table 1 at the end of this chapter provides information on the prevailing mining royalty rates in selected developing countries inAfrica, East Asia and Latin America.). While high by international standards, this i s to some extent offset by the reduction inthe corporate tax rate to 25 percent. 6.41 A windfall profits tax of 68 percent, based on un-indexed commodity price thresholds, i s also now in place in Mongolia, which applies very high levels of tax during periods subjectedto cyclical high commodity price spikes. MANAGINGNATURALRESOURCESFOR LONG-RUN BROAD-BASEDGROWTH - 123- MONGOLIA: Table 6.8: Mongolia'sMineralTaxationRegimein Transition, 2002-2006 2002 2003-2005 2006 15-40?'0 15-40% 13-30% Provides a tax holidayfor the first 5 years of Corporate IncomeTax operations, followed by the second 5 years at halfthe tax rate.Beyondyear 10taxes will be paid at the full rate of 30% taxable income. Withholdingtax 20% 20% 20% Customs Duty Exempteda specific list of constructionitems 5Yo includingmining VAT Exempted 0% Royalty 2.5% 2.5% 5.O% Exporttax on minerals (gold, copper etc.) 10% 0 0 Source: Ministry ofFinance, 2006. 6.42 A new provision of the Mineral Law introduced in 2006 entitles the holders of mining licenses to enter into investment agreements with the government that can stabilize tax rates for defined periods o f time. These "InvestmentAgreements", formerly known as "Stability Agreements", establish in law that mineral projects involving an investment o f US$50-100 million will be eligible for fiscal stabilization for a period of 10 years; US$lOO-300 million projects for 15 years, and projects investing more than US$300 million will have 30 year investment agreements. 6.43 The investment agreements not only stabilize tax rates, but can also confirm a licensee's right to export and sell its products in international markets, guarantee that licensees may receive and dispose o f hard currency derived from sales. Three mining companies have entered into stability agreements under the old law and several are awaiting themunder the new arrangements inorder to commence development, including OyuTolgoi. 6.44 Value-added Tax. The purchase o f imported goods was until 2006 subject to a 15 percent VAT. This has since been reduced, which from the beginning o f 2007 will be at 10 percent. In addition, a number o f exemptions have been eliminated. Among these, the exemption for technological equipment and heavy machinery imported by foreign firms for use in priority sectors and export-oriented industries was removed (However, this exemption i s retained in the Customs Law). The recent VAT reforms now treat the mining sector at par with other importers and will be able to benefit from potential VAT refundsagainst payments o f taxes due to the state or local budgets, as long as they are refunded by the authorities in a timely manner. 6.45 State Equity Participation. With few exceptions, mainly in West Africa region where mining investment is comparatively low, most nations do not require an equity participation innew mines. A state equity requirementor option is viewed negatively by most investors as this reduces the financial viability o f a mineral deposit, amplifies risk and potentially complicates the management structure. State equity participation was in the past based primarily on the desire to maintain in the public interest greater control over its mineral - 124 - CHAPTER6: COUNTRY ECONOMICMEMORANDUM endowment and to secure greater financial benefits. However, with improvements in mining, tax and environmental laws, and with a greater understanding of the risks involved, most countries have abandoned this approach in favor of: i)exerting the desired level of control through the implementation of appropriate laws and regulations; ii)participating more directly through fiscal proxies such as income taxes and dividend withholding taxes; and iii)avoiding the diversion of State funds form more pressing public priorities. Improvements in modern mining tax systems have prompted governments to focus more on risk-free fiscal measures rather than on risky equity investments as the primary means of securing financial benefits from the private development of its natural capital. 6.46 The Government should exercise caution in taking anything other than a nominal equity position in new mining ventures in response to public sentiment. Inthe event that this i s unavoidable, there are many approachesto government equity, but three dominated primary forms have emerged over the past two decades. These include paid (working) interest; free equity (government does not contribute to costs); and, more rarely, a carried interest (government pays its share of costs but these are initially paid by the investor who is repaid from the government's dividend share or forgone taxes). Government free equity requirements are very rare today. If a government takes an equity stake and pays for it through a working interest, the opportunity cost can be substantial. Returns on State revenues, which are diverted from other possible uses and invested in the mine, are entirely dependent on the operational success of a mineover which ithas little control. 6.47 Inassessing alternative fiscal regimes for the mining sector, it is the effective tax rate of the entire fiscal package (that looks at the combined effects o f income taxes, the windfall tax, import taxes, contractors withholding taxes, royalty rates, VAT refunds and other tax exemptions (if, any) that matters. (See Table 6.9 for examples of Royalty rates in selected countries.) A recent comparative analysis of 20 competing jurisdiction^'^ indicates that with an estimated ETR in excess of 68 percent for a representative large scale copper mine, Mongolia imposes a hightax burdenby international standardsand ranks inthe top quartile o f the countries studied. The development of appropriate fiscal model/s and conductive scenario analyses using alternative fiscal and commodity price assumptions to restore Mongolia's competitiveness should be undertakeninthis regard as amatter of some urgency.I4 l3Otter, James (2007), Competitive Position of Mongolia's Mineral Sector Fiscal System l4 See Otto, et. A1 (2006) and Lederman & Maloney (2006) for international comparisons o f taxation and royalty regimes inthe miningsector. MANAGINGNATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH - 125- n t 8P - r B d 8 z 0- 3m n .-C i r C 3 z0 Id c Id C 4 c -E6B 3.n 2 2I COUNTRY ECONOMICMEMORANDUM REFORMINGTHE LEGAL REGULATORYFRAMEWORK MINING AND FOR 6.48 Inthe past decade up to early 2006 the role of the government has evolved from being predominantly the owner/operator of mines to being a managerhegulator of the sector. During the past 5 years, the Mongolian mineral sector has received significant foreign direct investment attention and corresponding national private sector expansion. The sector has established a prominent international profile as a result of its reform initiatives, geological prospectivity, and media exposure of its potential world-class copper and gold deposits in the south Gobi area. The stability of the overall legalhegulatory framework has been an important component in sustaining the private sector expansion to date. 6.49 To many the 1997 minerals law represented international best practice and was designed to accommodate government's existing institutional capacity by providing a simple but robust framework supported by a large number of appropriate regulations. Clarifying regulations have not yet been developed for many licensees' obligations, including the environmental and social obligations of the license holder. Consequently the implementation of the law came under increasing pressure in regulating a growing sector and was finally discredited. 6.50 Recent amendments to the legislation in the form of a new Mineral Law were passed in mid 2006 and in some respects have taken a step backward particularly in relation to Government intervention inmining equity arrangements. The introduction of a classification of Strategic Mineral Deposits in which the Government can compulsorily acquire equity in operations. This creates significant uncertainty, increases the risks to boththe state and the investor and is likely to be viewed negatively by potential investors. Two classes of equity acquisition options have been defined. The first allows the Government to acquire up to a 50 percent interest in operations where "Proven Reserves" have beenidentified by State FundedExploration. The second allows the Government to acquire up to 3 percent of any other operation if deemed to be of strategic importance to the Government. In this case the term strategic is defined as any deposit "where it is possible to maintain production that has a potential impact on national securiv, economic and social development of the country at national and regional levels or deposits which are producing or have the potential of producing above 5 percent of Gross Domestic Product of the year". Given the small size of the Mongolian economy and minimal economic activity in most provinces any medium scale mining project will have an impact on the regional economy andthus be subject to equity participation under the above definition. 6.51 The involvement of the State in direct equity participation results in the State taking considerable commercial investment risk in a volatile industry. For a newly developing economy with many priorities and varied calls on the State Treasury for investment in infrastructure and services, it is difficult to see why the State should be increasing its exposure to such risk. The size of capital investments required to commission a large scale mine would require the Government to raise considerable debt or forgo substantial fiscal receipts in order to meet capital calls for mine development. This could result in the Government reaching country lending limits for most major MANAGING NATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH 131 MONGOLIA: institutions and result in the government being constrained in future borrowing for essential infrastructure. In effect the government would be sacrificing investment in infrastructure and services inorder to service debt on a risky commercial investment. 6.52 It must also be recognized that the return on investment to a private investor in such a miningventure i s higher than the return to Government from an investment in the same operation. This i s due to the tax leverage or tax shield that private companies enjoy with respect to interest payments. A private company deducts interest payments for the calculation o f taxation whereas the State has no such capability to offset interest costs and thus bears the full cost o ffinancing. 6.53 Perhaps the most compelling argument against State equity participation is that it can compromise its role as a regulator o f the sector. This has occurred in other countries where the companies were permitted to operate with lower environmental and social standards because the Treasury (as shareholder) interfered with the decision-making process o f the Ministry o f Environment because the Treasury could not afford to pay for the necessary environmental and social safeguards. In addition to direct State equity participation, the new amendments to the legislation require each new miningventure to be owned by a unique legal entity which shall sell 10 percent o f the shares o f the entity on the Mongolian Stock Exchange which may not have the liquidity to absorb the size o f investments envisaged inthe short to medium-term. 6.54 These provisions will require the formulation of a substantial body o f implementing regulations in order to clarify the clauses in the Law. These include the requirement to define what constitutes "proven reserves" and the criteria to be used to establish reserves; clarify what the Government's rights are with respect to a deposit which may have only a small proportion of the proven reserves identified by State funded exploration and the balance proven by private sector exploration; and what equity stake the government will take and how this i s to valued and be financed. 6.55 In 2002 the government issued policy guidelines outlining mineral development and sector promotional goals for 2002-10 and committed itself to improving mining sector performance. A key element inthese guidelines was a commitment to reinforce the favorable legal environment for private mineral exploration activities. The guidelines also recognized the importance o f the transition away from state ownership and control and focused on a market-driven, private-sector-oriented industry that i s regulated by the government. However, the government has chosen not to privatize and relinquish control o f the two largest mining companies, Erdenet and Mongolrostsvetment, because o f their importance to the economy. These guidelines now appear to have been reversed by these latest policy shifts and the directive to set up a state owned entity within SPC to hold and manage the State's investmentsinthe miningsector. ProjectedMedium-termImpactof the MiningSector on the Economy 6.56 International investors in mineral exploration in Mongolia are focusing attention on identifying and exploiting hard-rock deposits and large, highquality coal deposits, and the future growth potential of the mining sector lies in such deposits. There is also an -132- CHAPTER 6 COUNTRY ECONOMIC MEMORANDUM ongoing assessment of significant exploration prospects, which could lead to substantial increases in output in the medium to long term. These prospects include Oyu Tolgoi (copper/gold), Tavan Tolgoi (Coal), Gatsuurt (gold), and Golden Hills(gold). 6.57 The mining sector output has the potential to increase substantially over the next decade. It is projected to double or even threefold from 2003 levels by 2010 provided large projects get development approvals and are successfully commissioned. The mining sector is poised to make a robust economic contribution and support the government's average annual GDP forecast o f between 6 percent and 10 percent annually till at least 2010. 6.58 Between 2006 and 2010 copper exports are projected to almost threefold (provided Oyu Tolgoi is developed) with the contribution of copper to GDP potentially increasing to over 25 percent of GDP. The share of copper intotal exports is projected to increase from 27 percent to 45 percent over the same period. These significant increases in export revenue would support a returnto current account surpluses. The current high gains inthe value of copper exports are not expected to continue inthe longer term as the increases to date are based purely on increased commodity prices and are not a result of production increases. 6.59 On the fiscal side, total contribution of copper to overall revenue will also grow but with a time lag as it is likely to take several years to amortize the capital invested in such a large operation as Oyu Tolgoi and have corporate taxes become payable. The recent removal of tax holidays by the government will go some way to bringing forward intime tax payments from newlydevelopedoperations. Key Factors Affecting Future Performanceof the Mining Sector 6.60 Mining activities can provide considerable revenue for the government through taxes and royalties. Most mines in Mongolia are likely to be small to medium in size and geographically diverse although both the Oyu Tolgoi and Tavan Tolgoi mines have the potential to become world class projects. Mining operations could very well create significant domestic demand for suppliers of good and services. In addition, the large informal mining sector and related services could transform themselves into viable SMEs. With the potential growth inmining over the next ten years, there is a significant potential to develop SMEs to provide basic goods and services related to mining expansion. 6.61 The acquisition of land is often a prerequisite for increasing mining production. For local populations making a living from traditional agriculture, monetary compensation is often not a viable solution. The most advanced compensation agreements being used globally for displaced landowners or occupiers combine mine employment with the creation of spin-off businesses relating to mining activities, and some training/capacity-building.Such an approach effectively compensates landowners by helping them acquire the capabilities to use financial resources as alternative assets to land. Suchpractices are not yet prevalent inMongolia. MANAGINGNATURAL RESOURCESFOR LONG-RUN BROAD-BASEDGROWTH 133 MONGOLIA: 6.62 Globally, mining companies have also responded to the need to support social programs that benefit the surrounding communities by developing independent foundations that are capable of leveraging funds for community development and social programs from other sources such as private donors and public funds. EstablishingAdequateInfrastructureto Meet MiningSector Growth 6.63 A mining prospect's proximity to road, railway, and power infrastructure has a major impact on the capital costs of development. Geological prospects that would normally be viable become uneconomic if the costs of providing the necessary infrastructure are too high. Mongolia needs to give serious consideration on how best to develop infrastructure over the next ten years, as the location of new roads, railways and power plants will have major impact on mining development. Almost all medium and large mine developments likely to occur in Mongolia will require significant new power, water, andtransportation infrastructure. 6.64 Mongolia's largest prospect, Oyu Tolgoi, i s located in one of the most remote partsof the country and has no water, power, or transportation withinmore than 300 kms. While it is possible to find water through drilling in the vicinity, a road andor railway needs to be built to the site to connect with China, which would be both a major market and source of inputs and supplies for the project. It will also be necessary build a power plant or provide high-voltage transmission lines from either the Mongolian or Chinese national grid. The prospect's operators are examining the possibility o f building a railway line from China to the deposit site financed by a range of possible options includingusing state funding. However, it is likely that the cost of providing the necessary infrastructure will dramatically increase the capital cost of developing this prospect and may end up delaying its commissioning. The Tsairt zinc mine also is far from a railway line and i s trucking concentrate to market at substantial cost. The Government should conduct a cost-benefit analysis of supporting infrastructure for each major mine development to determine if the mine provides a sufficient catalyst to justify the State's entry into new infrastructure projects insupport of regional development. PotentialInstitutionaland PolicyConstraintsto MiningDevelopment 6.65 Foreign investors will be the key driving force in locating and developing mining in the medium to long term and a survey of perceptions of the largest mining sector investors was carried out in 2003. The survey was based on a questionnaire asking their overall views of the current investment climate, constraints to development, and problems. The questionnaire also asked for recommendations on how to improve the investment climate for mining. 6.66 The survey indicates that investors generally viewed Mongolia as a favorable location for mining investment. Most respondents had a high regard for Mongolia's mineral potential and felt the government was responsive and reasonably investor friendly. The Mineral Resources and Petroleum Authority of Mongolia (MRPAM) had a high rating and compared favorably with similar organizations in Asia. Investors found the mining and exploration licensing system in Mongolia reasonably effective. Most of -134- CHAPTER 6 COUNTRY ECONOMICMEMORANDUM the respondents considered the Minerals Law internationally competitive. These views, however, are likely to be tempered by adverse changes to the Mining Law, more direct government participation in mining, and the introduction o f excess profits tax and proposedexport duties. 6.67 While most investors found the overall legal and regulatory framework favorable, they were concerned about the stability o f the system and government corruption, particularly at the local level. Investorshave also claimed that implementation o f the laws i s less than satisfactory, and expressed serious concerns over the government's intentions and repeated attempts to amend laws without stakeholder consultations. While the respondents generally considered reporting requirements for mining and exploration activities reasonable, most felt unsure about confidentiality when reporting to the government. Investors would like to see an improvement in the collection and dissemination o f geological data and believed the government could be more effective in promoting Mongolia's mineral potential internationally. 6.68 Respondents found levels o f taxation not competitive compared to other countries in Asia. They considered Mongolia's tax legislation complex and difficult to comprehend. In addition, all respondents felt the Mongolian authorities did not understand international best practices inmining taxation, and that the implementation of legislation often appeared to contradict other laws. Consequently stability or investment agreements were widely regarded as very important indoing business inMongolia. 6.69 Investors also identified weaknesses in environmental and social management within the Government. It will also be important to ensure that improvements in environmental law and enforcement are implemented. This aspect i s addressed later in this chapter. 6.70 Investors pointed to a number o f specific areas in the business environment that they would like the government to address. These included the drafting and implementation o f enabling regulations to clarify licensing and other procedures in the law. They were also concerned about the Office o f Geology's direct holding o f exploration licenses and a lack o f consistency in the implementation o f legislation, particularly taxation regulations, and also a lack of transparency within the MRPAM Cadastre Office. The Government has recently taken steps to improve the operation o fthe Mining Cadastre Office with assistance from the donor community. The new Mineral Law o f 2006 similarly requires the completion o f regulations in order to clarify definitions and give specify the details of regulatory processes. 6.71 There has been growing public pressure on the Government to strengthen environmental safeguards, increase the tax take and government control on the mining sector which came to a head in early 2006 with demonstrations on the streets o f Ulaanbaatar. This in part resulted from poor rehabilitation o f existing alluvial gold workings and the absence o f any taxes being paid by profitable new miningventures due to their tax holidays. This domestic public pressure has been the driving force behind recent political moves to change the Mineral Law, mining fiscal provisions, and equity participation by the State. This is yet another example why tax holidays are not good MANAGINGNATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH I35 MONGOLIA: public policy as they often create animosity and a public perception that the industry is not paying its way. 6.72 Since this survey of mining sector investors was carried out, royalty rates have increased, the tax holiday has been abolished, a windfall profits tax has been introduced and new State equity participation provisions have been passed (all in 2006). These new provisions will all have negatively impacted on investor perceptions of Mongolia. Already this appears to be negatively affecting the level of investment innew exploration and is also reflected ina significant drop in gold sales to the Central Bank since the new measures were introduced. KEY ISSUES THE MINING INMANAGING SECTOR IMPACT ON THE NATIONAL ECONOMY 6.73 Mongolia's mining sector has the potential to contribute significantly to economic growth but its development will to a large extent depend on the government's ability to establish and maintain a competitive and stable fiscal regime for mining, manage its mineral wealth, and ensure sound governance for the sector. Inherent in the optimal conversion of Mongolia's natural capital the need for government to deploy its receipts from mining in productive investments including infrastructure and human capital that survive way beyond the life of the mine and contribute to a net gin in national wealth. Experience from Latin American countries suggests that natural resources are neither a curse nor something destined to result in sub optimal growth. Empirical and historical evidence in Latin America suggests that "resources do spur economic development when combined with accumulation of knowledge for economic innovation". 6.74 Cross-country evidence from countries that depended on mining for growth suggests that a government should try to address the challenges associated with the structure of its production and diversification of the economy while at the same time prevent the development of unsustainable fiscal policy and mounting debt; avoid rent- seeking behavior in weak institutional settings, and overcome absorptive capacity constraints and adverse impacts on non-mineral exports. What countries produce and export and how firms and workers produce any particular type of good will all be determinedby the accumulation of knowledge, level of infrastructure, and the equality of governance in the economy. On infrastructure, the quality of public infrastructure will influence the cost of doing business, in turn, the provision of private infrastructure (i.e. each type of public expenditure will have externalities and each type of spending has gestation lags before their benefits can be reaped.) The effect of natural resources on the pace of growth crucially depends on the availability of human capital. 6.75 Economic literature also suggest that a significant increase in mineral production might also have an impact on growth by adversely affecting the competitiveness of the non-minerals export industry, notably manufacturing (the so-called "Dutch Disease" or "Resource Curse" effect. See also Chapter 7 of this report). This can to some extent be managed by ensuring that the currency value does not appreciate to levels where the competitivenessof agricultural and manufacturing are adversely affected. ''Source:Lederman, Daniel, and William Maloney (2007), World Bank. -136- CHAPTER 6 COUNTRY ECONOMICMEMORANDUM Box 6:3: Australia and the UnitedStates: MineralRich but with Different Outcomes Australia was a leading gold-mining country inthe 19th-century, but it also has abundant resources o f coal, iron ore, and bauxite, among others and a strong mining sector and a cultural heritage similar to that o f the United States o f America (U.S.A.). Yet, mining activities did not take-off in Australia relative to the western USA (namely, Arizona, Montana, and Utah) even though they both had small populations relative to their land area, harsh climates o f the large desert areas and forces motivating migration out o f these remote areas to other parts of the country. Australia lagged well behind other developed countries in engineers per capita and was heavily dependent on foreign science. In the 188Os, foreigners who managed the mines had a lot o f practical experience but were untrained in metallurgy and resistant to new technology. Relative to the USA, the technology used lacked economies o f scale and protectionist policies inhibited inflows o f knowledge embodied in goods and services. As a result the pace o f learning inthe Australian mining sector decreased considerably. Pessimism led to misguided mining sector policies and lack o f exploration effort. In 1938, the Australian government imposed an embargo on all iron ore shipments with a view to conserve the remaining supply and effectively raised the barrier to exploration fkther which remained in place for the next 25 years. In 1960, this policy regime was changed and new exploration activities began. By 1967, proven reserves o f high-grade iron were more than 40 times the level o f 10 years earlier. New discoveries o f previously unknown deposits o f copper, nickel, bauxite, uranium, phosphate rock and petroleum were found. Meanwhile, the American minerals economy had developed significantly through: (a) an accommodating legal environment; (b) investment ininfrastructure o f public knowledge; and (c) education in mining, minerals and metallurgy. In fact, resource extraction in the USA was more fundamentally associated with ongoing processes o f learning, investment, technological progress, cost reduction, and generating expansion o fthe sector. Source: Wright, Gavin andJesse Czelusta (2007) "Resource-basedGrowthPast and Present. In Lederman and Maloney (2007) Chapter 7. EnvironmentalImpact of MiningActivities 6.76 It is not only the efficiency ofthe miningexploration and extraction activities that matter in the conversion o f its natural capital, but the way in which these are undertaken that could lead to significant environmental damage, production losses, and a reduction in national wealth. Moreover, little has been done to systematically assess and address the costs of possible environmental damage from this dominant sector's ongoing and planned activities in Mongolia. The paucity o f available data, uncertainty about the long-term impacts of mining activities and reluctance o f the private sector to invest in such assessments does not help either. 6.77 Recent World Bank research in this regard suggested several environmental impacts o f mining in Mongolia that need to be addressed over the long run.16Current practices in alluvial gold mining, the major source o f gold to date in Mongolia, are inefficient and use excessive process water. This overtaxes surface waters and underground supplies, and also generates excessive effluent, which are difficult to manage and poses a threat o f uncontrolled discharges o f slurry. Inaddition, where rivers l6 See World Bank (2006j). Mongolia: A Review of Environmental and Social Impacts in the Mining Sector. World Bank, Washington, D.C. May 2006. MANAGINGNATURALRESOURCESFORLONG-RUN BROAD-BASED GROWTH 137 MONGOLIA: are illegally dredged and where tailings are discharged into surface waters, turbidity of surface waters is a major concern. The water pumped from the mines i s discharged into open surface areas and often cause flooding. This leadsto the formation of new, transient wetlands, which generally fall dry once the mine ceases to operate. There are increased risks of water-related infectious diseases due to unsanitary conditions o f thousands of artisanal miners living by the rivers and streams. The burning of dung and rubber tires in these areas to melt the permafrost also leadsto toxic poisoning. Insteadthe waste water in these wetlands could be treated and dedicated to cleaning up seepage water from waste rock piles or from mines. 6.78 In Mongolia, most waste-rock dumps from industrial mining are unstable and prone to erosion. Rainfall washes gravel and soil down into valleys, where valuable grazing land can become polluted. In some cases, waste-rock dumps and tailings are reworked by artisanal miners under unsafe conditions and risk injury or loss of life. Air and mercury pollution is also a mounting problem, especially among the artisanal miners.l7 POLICYRECOMMENDATIONS ToIMPROVE INVESTMENT MINING SECTOR CLIMATE 6.79 To realize mining sector growthpotential the government should aim at achieving a stable legal, regulatory and fiscal framework that is transparent and internationally competitive for private sector development of the minerals industry. It needs to be responsive to the key concerns expressedby private sector investors, inparticular putting in place the enabling regulations for the new Minerals Law and developing and maintaining a competitive mining sector fiscal regime (i.e. taxes, royalties, withholding taxes etc.). The government should continue to improve the application and granting o f mineral licenses, regulation of mining and environmental activities, its awareness of best practices in the international mining sector and emphasize issues relating to the management of mining revenues. This is necessary to avoid the policy errors of other mineral dependent countries, and ensure that the mining sector becomes an engine of long-term growth for Mongolia. Policies should include macroeconomic policies and policies for institutional capacity building, at both the national and sub-national level. Finally, the government should carefully formulate a suitable regulatory framework to integrate this socially important activity into the current large-scalemining framework by providing for the licensing of small scale miners and their lease areas, as well as, providing a suitable occupational health and safely and environmental management framework to guide their operations. 6.80 Provide the enabling regulations for the otherwise acceptable overall legal framework. A key element in achieving planned mining sector growth will be establishing and maintaining the legislative and institutional stability that spurred l7Mercury was banned from gold mines in the former Soviet Union in 1982 and today is used illegally in only a few placer and hard-rock mines in Mongolia. Dust generated by placer artisanal mines-by shovelling, scraping, chiselling, bagging, and spillages in a confined space with poor ventilation-causes eye injuries, bronchial complaints, and silicosis. Even more dangerous is the smoke from fires to melt permafrost, particularly black smoke from tires, which contains carbon particles, carbon monoxide, polyaromatic hydrocarbons,benzene, phenol, and cyanide. -138- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM investmentinMongolia's mineral sector over the past few years. Inthe period leading up to 2006, investors were generally satisfied with the legal and regulatory framework. However, the investor survey showed that improvements are required interms of putting in place the enabling regulations for the law. Stability, clarity and certainty would be strengthenedby drafting regulations for implementing the Minerals Law. 6.81 The passingof the new Mineral Law brings with it the urgent and critical needto establish the legal basis for a regulatory framework and authority for the Cabinet to pass enabling regulations to effectively clarify and implement the law. Many issues inthe law will require elaboration, as well as clarification of specific processes, such as the Cadastre Office functions for the receipt of applications, and the granting, relinquishment and cancellation of mining rights. Provisions will also be required that explain the processes relating to the tendering of mineral properties by the State. Maintaining the transparency of the Cadastre office function is critical to maintaining confidence in the licensing system. Regulations will also be requiredto clarify the rights and obligations of the State intaking up equity inmining projects, how these are to be valued and financed, as well as mine safety, environmental protection, operational reporting and disclosure amongst others. 6.82 Improve the fiscal regime to enhance investor confidence. The following recommendationsare made based on international bestpractice: Movement towards accelerated depreciation and loss carriedforward provisions to reduce project risk. The global trend in tax policy i s away from tax holidays and this has been followed by Mongolia in the most recent fiscal reforms. The removal of the tax holiday has been offset by a reduction in income tax rates to more competitive levels, but should also be supplementedby the implementation of accelerated depreciation provisions to allow early capital recovery by investors and the ability to carry forward losses for tax purposes for at least seven years in order to reduce project risk. It also increases the capacity of the private sector to mobilize capital and expandthe tax base through investing infurther development of new projects inthe sector. Review the royalty applicable to mining in an international context: The newly implemented rate of 5 percent is relatively high by international standards. However, it i s a reasonable rate given Mongolia's low corporate income tax of 25 percent and generous capital recovery rules. In deciding whether to maintain the current 5 percent royalty rate, the Government might want to consider royalty regimes in other countries, including a sliding scale royalty based on commodity prices, which are presented inAnnex 1.l8 Reassess the Windfall profits tax: The Government might want to reconsider the windfall profits tax. If it wishes to capture a larger share of the benefits during periods of high commodity prices there are more effective measures such as a IsFor a more detailed analysis of mining royalties regimes across the globe, see "Mining Royalties: A GlobalStudy of Their Impacton Investors, Government, and Civil Society", The World Bank(2006). MANAGINGNATURALRESOURCESFOR LONG-RUN BROAD-BASED GROWTH 139 MONGOLIA: progressive royalty based on the value o f contained mineral at some reference. The recent repealing o f the exemption o f gold sales from VAT was a step in the right direction. Ensure that distributed tax revenues are effectively managed. The new provisions relating to miningleases call for payment o f fees and a proportion o f the royalties directly to beneficiaries both at regional and local levels as well as to the agency responsible for Geological Surveys. It i s important that local communities affected by mining operations benefit directly from such operations and that local government has the capacity to effectively utilize the money to bring improved quality o f life to the communities in the mining impacted areas. It i s also important that a pre determined proportion o f these funds are provided under this mechanism to both the Geological Survey to develop and distribute pre- competitive geological maps and data products to stimulate private sector exploration (rather than being used by the agency to compete with the private sector to carry out high risk exploration); and also to maintain and operate an independent and efficient service to provide easy, transparent and fair access to minerals by investors. Amend the law to permit all companies in the mineral sector to register for VAT purposes: All companies operating inthe exploration and development phases o f the minerals industry should also be allowed to register for VAT purposes and be entitled to VAT refbnds. Exemption from VAT increases the cost o f exploring and mining in Mongolia, and presents a barrier to investment. Such a VAT provision i s not consistent with international best practices. Ensure that the new investment agreements are fair and encourage private investment: The new Mineral Law provides for the introduction o f Investment Agreements to replace the previous Stability Agreements. The government must be mindful that, based on the experience o f other countries, such agreements can be counterproductive if they are not handled in a transparent and consistent manner, and in accordance with clear guidelines. It is recommended that the Government adopts a Model Investment Agreement as a draft standard agreement from which minor points can be negotiated to achieve any site specific objectives. They should also refrain from providing any commitment which is contrary to any other law including any special fiscal arrangements other than to stabilize such rates as are in general force by reference to the law at the time o f the agreement. Unlikethe provisions of the new MiningLaw that provides for stability period o f up to 30 years, the term o f such agreements should be limited in duration to the greater o f the financing period or ten years. This reduces issues o f sovereign or political risk issues, thereby making it easier for companies to secure financing for mine development. Once the debt has been redeemed fiscal stability no longer becomes such a critical issue. 6.83 Maintain relevant statistical information about the taxes paid by the mining sector and sub-sectors: At present, statistical information concerning tax collections -140- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM from the mining sector i s consolidated with other tax payers and i s difficult to obtain and unreliable. 6.84 Improve investor confidence in the administration of the tax system: There are several improvements that could boost this confidence. First, this law should prescribe the tax treatment o f exploration and development expenditures. These expenditurescan be substantial, but the current law does not address their tax deductibility. Second, the tax treatment of mine reclamation and closure costs should be addressed in the corporate income tax law. Third, the corporate income tax law should confirm the deductibility o f mineral royalties in determining taxable income. 6.85 Reconsider the new provisions relating to strategic mineral deposits and State equity participation. Government equity participation in mineral projects i s an important political symbol in many developing countries, including Mongolia. The current law stipulates that the government may participate with up to 34 percent stake in a project that was not identified through state funds, and up to 50 percent stake in a project that was identified through state funds. However, the law as currently drafted does not specify the basis upon which the State will take up its equity, whether by fully funding their share o f exploration and development expenditures, through a carried equity stake, or free o f any costs to the State. 6.86 In the case o f projects developed where there may have been State Funded Exploration the government will need to clearly specify by way of regulations how the Government will determine what percentage it will take up and how to define "Proven Reserves". Proven reserves generally means reserves identified on the basis o f certain criteria and consistent with a code for reporting of ore reserves such as the Australasian Joint Ore Reserves Committee Code (JORC) for the reporting o f mineral resources and ore reserves. If the State were to take up equity that was proportional to the share o f reserves it "Proved" up relative to the total reserve base, then it may be somewhat more equitable and acceptable to the private sector. If, however, the right to take up to a 50 percent exists where the State may have only proved the existence o f a very small tonnage relative to the total size o f the whole deposit then this will be rejected by the private sector and considered by most observers as expropriation with or without compensation. 6.87 Given the various risks related to investments in miningprojects, as well as the opportunity cost of such investments, the Government might want to consider a more cautious stance on equity participation in such projects, by not taking the maximum amount o f equity provided for under the new Minerals Law. 6.88 Improve the management of artisanal mining. An institutional needs assessment across agencies at the central and local levels and adoption of legislation to accommodate the needs o f artisanal miners is important and long overdue. This assessment could identify resources and capabilities for the design and implementation o f policies, laws and regulations relating to artisanal mining, its licensing and occupational health and safety management as well as its social and environmental impacts. It could MANAGING NATURAL RESOURCESFOR LONG-RUN BROAD-BASED GROWTH 141 MONGOLIA: then make recommendations for the adoption of a regulatory framework to ameliorate any deficiencies. 6.89 Continue Implementation of the Extractive Industries Transparency Initiative (EITI). The Government has publicly committed to, and is in the process of accelerating the implementation the Extractive Industries Transparency Initiative (EITI). This is a necessary and welcome development and, if properly implemented, should increase public awareness of the contribution of the mineral industry to the national economy and confidence in the Government's stewardship of its mineral resources. The Government will need to maintain an ongoing financial commitment to implementation of the initiativeto collect, audit, compile and publishrevenue statistics over time. WILDLIFEAND FOREST RESOURCES 6.90 Many Mongolians are dependent on natural resources such as wildlife and forests for their livelihoods. Although their contribution to the GDP i s increasing, the quality of these resources is eroding. This i s a result of unsustainable overuse, a rapid growth of illegal activities in these sub-sectors that is depriving the government of a lucrative revenue base. IllegalWildlifeTrade 6.91 Mongolia's biodiversity is facing significant threats from a host of sources, and one of the greatest threats facing many species i s hunting for commercial wildlife trade.lg Following the collapse of the USSR, this tightly controlled industry fell into disarray; wildlife became a valuable open access resource that directly feeds an increased demand for wildlife products, as well as an increase inthe types and values of the species traded, both domestically and internationally. Wildlife trade is an important part of an overall strong trade growth, even ifthe full volume has never been documented. China, followed by Russia, Korea, and Japan are the largest trading partners for Mongolia wildlife. The most visible change in Mongolia's international wildlife trade is the increase in the number of species traded, from 24 species pre-1990 to 34 species, including many that are globally endangered. 6.92 There has been a significant increase in both the volume and the price of traded wildlife, internationally as well as domestically. The largest portion of wildlife trade, both in terms of volume and value, consists of furs sold on the international market, primarily to China, with some trade going to Russia and a limited amount sold on the domestic market.20The single largest volume of fur trade is for Siberian marmot, of which an estimated 3 million animals were harvested in 2004 alone, at an estimated l9 Wingard J.R. and P. Zahler. 2006. Silent Steppe: The Illegal Wildlife Trade Crisis in Mongolia. Mongolia Discussion Papers, Washington D.C.: World Bank. See also Kaczensky P., D.P. Sheehy, C. Walzer, D.E. Johnson, D. Lhkagvasuren and C.M. Sheehy. 2006. Impacts of Well Rehabilitation and Human Intrusion on Khulan (Wild Ass) and Other Threatened Species in the Gobi Desert. Washington, D.C.: World Bank. 20The primary fur trade targets are Siberian and Altai marmot, wolf, red fox, corsac fox, red squirrel, snow leopard, brown bear, lynx and Pallas' cat. Limited fur trade exists for sable, badger, mink, weasels, steppe polecat, hare, muskrat, pika, chipmunk, androe deer skins. -142- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM marketvalue of $30 to $40 million. Although not traded inlarge volumes, rare and highly threatened species such as snow leopard are also traded. Driving the increase in trade volumes are the never before-seenprices paid by traders. Marmot skins sold to Russiafor $0.19 per pelt in the 1980s now sell for fifty times as much on the Chinese border. A good wolf skin can command as much as $250 compared to just $5 twenty years ago. Red fox skins have gone from $4 to as much as $18 in the last decade. Corsac fox has jumped from $1 to $28 per skin. Lenok and Siberianwhite fish both sell for as much as $3 per kilo to markets in China. An average elk shed antler fetches $18 per kilo, blood antler $70 er kilo, genitals $30, and tail $30. Musk deer pods sell for as much as $45 per 100 grams E . Similar to the international market, domestic prices have steadily increased over the last decade, makingit a lucrative business for many22. 6.93 As a result, wildlife trade is causing severe population declines, with direct consequences for the overall Mongolian economy. There i s near unanimous agreement among hunters, traders, and biologists in Mongolia that continued wildlife trade at the volumes reported is unsustainable. Inthe absence of other factors, the recorded declines appear to be directly linked to trade and over hunting, most of it illegal. Estimates suggest that 220,000 to 250,000 Mongolians actively harvest wildlife for personal consumption, domestic and international trade. More than 1 million Mongolians use wildlife in some form. Wildlife trade has skyrocketed in volume and value, and in 2004 was worth as much as $100 million to the Mongolian economy23.The associated declines have been rapid and drastic. Population surveys conducted over the last 30 ears record dramatic declines for a suite of species, all of them of economic importance2 . 2 6.94 Unfortunately, declining wildlife numbers do not automatically mean decreased wildlife trade for two reasons. First, as a species decreases in number, it becomes more valuable. So long as profits exceed the costs of harvesting, there remains a market incentive to poach. This trend is already seen in Mongolia. Second, the productive capacity o f the country (Mongolia's hunters) does not disappear; instead it turns its attention to new resources and the development of new markets. This happened in the 21 Figuresbasedon statisticsprovided by the UNCommon Database at htpp://globalis,gvu.unu.edu 22For example, marmot that has doubled since the hunting ban instituted in 2005. Asiatic wild ass had no known market value, but can now be purchased for $0.80/kg in soum centers, black markets, and local container shops. Roe deer blood, corsac fox meat, Yakut moose meat, and many other local wildlife products are all now for sale. Taimen filets, once unknown in Ulaanbaatar's restaurant, now sell for $1O.OO/plate. 23Volumes include over 3 million marmots annually, 250,000 Mongolian gazelles, 200,000 corsac fox, 185,000 red fox, 170,000 red squirrel, 100,000 roe deer, 30,000 wild boar, 6,000 red deer, 4,500 Siberian ibex, and 3,000 Asiatic wild asses. 24Siberian marmots, numbering over 40 million in the wild in the 1940s, had dwindled to only a few million by 2002 (Batbold 2002); as few as 170,000 were reported for the eastern steppe in 2005, a region that once counted millions (Townsend and Zahler inpress). Red deer were 130,000 strong in 1986.Twenty years later, there are only 8,000 to 10,000-a 92 percent decline in 18 years. Argali populations were recorded at 60,000 in 1985, but only 15,000 in 2001-a 75 percent decline in 16 years. Saiga antelope, counted at 2,500 in 1998, decreased about 50 percent in seven years (WWF 2004, Amgalan pers. comm.). Even the saker falcon, which in 1999 numbered 3,000 breeding pairs in Mongolia, had been reduced to 2,000 breedingpairs by 2004 (Shagdarsuren et al. 2004) MANAGINGNATURALRESOURCESFORLONG-RUN BROAD-BASED GROWTH 143 MONGOLIA: 1960s and 1970s in Mongolia when the hunting brigades, faced with decreasing wildlife populations, did not quit but insteadexpandedthe number of targeted species. 6.95 The depletion of wildlife resources has larger implications for the overall economy, which can probably best be compared to the depletion of a trust account. The wildlife resources in Mongolia can be thought of as a trust fund where the principal is made up of wildlife populations. The principal produces interest in the form of wildlife production used for medicine, food, and leather products. From a longer-term perspective, while present benefits from over harvesting may be impressive, they compare poorly with benefits that could be obtained with a lower harvest rate over time. Given the magnitude of the problem, the costs of policy neglect are having serious negative impacts to the present value and future earning potential of the country. 6.96 The Ministry of Nature and Environment (MNE) receives the second smallest budget of all ministries,and recent increases inthe Ministry ofNature and Environment's budget have had no real impact on actual funding available for wildlife2', despite the responsibility to engage in wildlife conservation and the legal obligation to earmark 50 percent of hunting-related revenues for conservation of the resource. In fact, the law requiring investment in the resource is generally not followed. In addition, the Public Sector Management and Finance Law (PSMFL) nullifies funding opportunities for local governments inthis area. T h e Illegal Economy for Forest Resources 6.97 Establishing an efficient and sustainable forest industry has been prevented by factors ranging from poor government policy to corruption. Forestry has been an important industry for Mongolia, and has great potential today as a source of sustainable livelihoods for those in forested aimags. However, lack of planning and active management, lack of inventory, loss of capacity, and corruption have together led to a significant degradation of forest quality, and have created virtual anarchy inthe industry. Moreover, the forest sector suffers from poorly conceived and uncoordinated government policy. This policy vacuum, combined with poor law enforcement and the significant financial gains to be made from illegal forest harvesting, is preventing the establishment of an efficient and sustainable forest industry. 6.98 The government's policy of trying to reduce consumption, by restricting supply and setting a low harvest limit each year, has resultedin an increase in illegal logging, considerably above the sustainable harvest level. Statistics on deforestation and forest depletion in Mongolia are confusing and often conflicting. Mongolia lost an estimated 4 million hectares of forest in the last century, averaging 40,000 hdyear, although the 25Due to changes in accounting procedures brought on by the Public Sector Management and Finance Law, it appears that the MNE's budget has increased significantly in recent years, going from $2.3 million in 2001 to $3.8 million in 2004 (65.2 percent increase). But this is a misleading picture. Pursuant to the finance law, the h4NE receives a consolidated budget that includes amounts for MNE's local branches, such as protected areas, Aimag environment offices, and local hydro meteorological stations. The apparent increases inthe MNE's budget are due almost entirely to the inclusion of these local budgets as opposed to more money for the ministry's activities. -144- CHAPTER 6 COUNTRY ECONOMICMEMORANDUM deforestation rate increased during the last decade of the century to approximately 60,000 hdyear (World Bank, 2003). Today, Mongolia's "forest territory" is estimated as 17.9 million hectares, of which around 1.8 million hectares are non-forested areas, 4.5 million are the southern saxaul scrub forests, and the remainder are the 11.5 million hectares of northern coniferous forests (Crisp et al., 2004). The lack of regular forest inventories makes it impossible to know the true extent or quality of forest resources. 6.99 The sustainable annual harvest volume for Mongolia's forests has not yet been unequivocally determined, although the most recent calculations put the amount at between 0.9 and 1.4 million m3. The current rates of consumption are difficult to calculate, due to the lack of reliable data and the differences of opinion concerning the annual household consumption of fuelwood inareas outside the capital. The lower end of the estimatedconsumption, 1.74 million m3 annually, is far above the sustainableharvest level, and the upper end, 5.5 million m3, exceeds the sustainable harvest by a factor of five. Wood consumption also appears to be growing, due to factors suchas the increasing population, booming construction industry, high rates of migration to urban areas, rising incomes for some, and the privatization of land. As a result, illegal forestry trade has a significant ecological and economic impact. 6.100 Ecological impact: Illegal timber harvesting clearly has reduced the size of forest inventories in those stands that are readily accessible or near urban areas, with valleys stripped bare of timber. In areas that are being utilized for private-use timber or fuelwood, non-professionals selectively cut trees of around 20-cm diameter to produce rough-sawn timber, as well as smaller trees to be used as scaffolding in construction work. In fact, removal of smaller trees could play an important role in thinning forest stands and making them more fire resistant if this was done according to a management plan. Currently, there is no effective management of this process and the benefitsare not being realized. In areas where high-value timber is being felled, only the largest, most fire- and wind-resistant individuals are taken, damaging the structure of the forest and making it more vulnerable to fire. Inaddition, the wood that loggers consider to be scrap i s trimmed from the trees and left inthe forest. This dead wood results in a high fuel load, increasing the chances that a forest fire will burn fiercely and spread to the crowns of trees, rather than merely burning the undergrowth and keeping the fuel load low. Other potential problems resulting from the depletion of forest cover include impacts on the quantity and quality of water resources inthe area, although the relationship i s complex, as well as soil erosion. 6.101 Economic impact: By preventing people from harvesting timber legally and according to transparent procedures, the government denies itself important revenues. The Law on Fees for the Harvest of Timber and Fuelwood, enacted since 1995, incorporates fee schedules to raise revenues from resource use. Forestry companies are supposed to pay both license fees and stumpage fees in order to undertake forestry activities. Although difficult to estimate, collecting fees for all of the wood sold at timber markets could raise an additional 6.5 billion Tg ($5.4 million) annually. That is ten times the state revenue currently raised from forest-use fees, which was only 630 million Tg in 2003 (MNE, MOSTEC, Open Government Website in Wingard and Zahler, 2006). In addition, a large proportiono f all timber usedi s not actively traded, being mostly usedas MANAGINGNATURALRESOURCESFOR LONG-RUN BROAD-BASEDGROWTH 145 MONGOLIA: Fuelwood and private-use timber inrural areas. This wood should also be subject to fees, as should construction poles and pit props. In2003, the 678 businessentities operating in timber production and timber products paid 1.1 billion Tg in taxes (Report of the National Taxation Authority, 2004). This amount is insufficient, as the majority of timber cut by companies is done so secretly and illegally, and consequently all associated activities are inevitably hidden. If full taxes were collected on all forestry operations and cut wood, this sum would reachseveral billionTg. 6.102 Last, but not least, illegal logging is also harming the national economy by preventing the development of the forestry industry and constituting a barrier to the establishment of a positive business environment. Illegal loggers have minimal costs- only fuel and labor-and do not pay taxes. They are thus able to sell their timber and wood products at a relatively low cost, hindering the competitiveness of those working within the law. This undercutting of the market value for timber lessens the economic contribution of the legal Mongolian forest sector; in fact, the Mongolia Forestry Sector Review (Crisp et al., 2004) found it to be marginal. In addition to the lessened contribution to the formal economy, unsustainableand illegal logging can also harm the livelihoods of those citizens dependent on natural resources. If timber supplies become depleted in an area, rural residents may have to travel further to get fuelwood, or buy supplies. 6.103 The lack o f a coherent government policy for the forest industry is the main obstacle in achieving efficiency and sustainability in this industry. One of the main constraints to a sustainable and efficient forest industry results from the Mongolian government's policy o f trying to reduce consumption. This is done by restricting supply and setting a low harvest limit each year-617,200 m3 in2006. Not only is this far below any estimates of actual annual consumption, creating a situation where illegal logging and trade is bound to occur and corruption i s becoming endemic, but it i s even lower than the estimated sustainable harvest level, which has the dual effect of denying the state its proper revenue from forest-use fees, and denying companies the opportunity to operate legally inthe industry.The policy has had no real benefit as far as the conservation of the resource is concerned; illegal operators have stepped in to supply the high demand for timber and have met no real resistance from the authorities charged with controlling the industry. Other constraints include corruption, weak law enforcement and an uncoordinated government policy towards the forest industry in general. Addressing these issues will take time and resources, which should be incorporated in the medium- term budget planning process and in implementing Mongolia's National Development Strategy. -146- CHAPTER 6: COUNTRY ECONOMICMEMORANDUM 7. POLICIESTO MANAGETHE EXTERNALAND INTERNALLY-GENERATEDRISKS Mongolia must contend with risks to its ongoing high GDP growth path that could emanate from circumstances beyond its control and some due to policies or the nature of their implementation within the country. This calls for caution by the authorities in managing windfalls wellfor maintaining macroeconomic stability, with due consideration tofiscal and debt sustainability; investing such windfalls prudently to support productive investments and broad-based growth; and institutionalizing counter-cyclical fiscal policy through the budget rather than off-budget vehicles. Attention to implementing the new anti-corruption law and the Extractive Industries Transparency Initiative (EITI) in mining must take precedence as well. 7.1 Mongolia has weathered the transition to a market economy remarkably well and in the process established a good track record of economic management. Yet it faces a considerable variety of risks to its continued growth-both exogenous and policy induced-a number of which have been touched upon here. Exogenous shocks include the risks associated with sharp downturns in international markets for gold and copper which have achieved historical highs during the past year and have helped cushion the impact of other adverse developments such as the still ongoing demise of the Mongolian garment industry. Another source of potential shock arises from rising global energy prices. There is also the threat of weather-related phenomena (e.g. dzuds) which have had catastrophic consequences inthe past. 7.2 The country also remains vulnerable on the fiscal front and with respect to external debt. Inorder to manage these risks, the Mongolian society ingeneral, andthe Government in particular, will have to introduce policies to address issues related to: managing windfalls well for macroeconomic stability; investing such windfalls prudently to support broad-based growth; and institutionalizing counter-cyclical fiscal policy through the budget rather than off- budget vehicles. The Government i s under pressure to spend its fiscal surpluses in good times on politically-induced populist public spending plans, especially during times of impending national elections (and to increase its fiscal deficit when times were bad). These pressures typically threaten fiscal sustainability over the long term. Existing perceptions in the country about weak governance and corruption that impose additional costs of doing business in Mongolia' pose risks that could derail the ongoing high GDP growth performance as well. 1According to the results of the recent World Bank Investment Climate Assessment (2006), survey respondents in Mongolia were unanimous in the view that corruptionpervades every sphere of business activity in Mongolia today. More recently, in late 2006, Parliamentarians supported a move to allocate MTN 250 million to every electoral district of Parliament for "investing in the rural people". Some analysts have called this move "legalized corruption". (Source: UB Post, November 30, 2006). POLICIES TOMANAGE THEEXTERNAL AND INTERNALLY-GENERATED RISKS -147- MONGOLIA: This chapter aims to inform the policy decision-making process about identifyingthese risks andtheir management, and aims to stimulate debate among all stakeholders inthis regard. Figure 7.1: Recent and long run gold and Figure7.2:...masktheir inherrentvobtilii copper price rises ... I 125 yo 250 100 0 t m 4n 0 6 lW 75 im 50 50 199091 199291 1994P1 199691 199891 200091 200291 2004' 1 RISKS THAT NEEDTO BE MONITORED AND MANAGEDARE MANY CommodityPriceand Trade-relatedRisks 7.3 The present boom in global commodity prices for copper has sent its price skyrocketing to unprecedented highs over the course o f 2005-06. In real terms the price o f copper has now recovered to highs last achieved in the early 1970s. To the extent that the major driver o f the price increase may be a permanent increase in demand from the rapidly growing economies o f Asia-principally China and India-the current high prices should prevail. But these high prices also contain an element o f speculation by commodities traders on international markets, so that the present prices will inevitably not be sustained, and that the current boom will end, with potentially adverse economic consequences for Mongolia. 7.4 With copper and gold accounting for more than half o f the country's export receipts a simulation o f the effects of a sharp price decline i s instructive. Assuming that copper and gold prices fall by 35 and 25 percent, respectively in 2010 the immediate effect o f the terms o f trade shock would be to reduce GDP growth by 0.5 percent that year. Even if these prices were to recover modestly, GDP growth would remain significantly lower. A sharp deterioration would also occur inthe debt indicators with the NPV o f debt-to-GDP rising by 5 percentage points and the debt-to-exports ratio increasing by 17 percentage points. Infact, this type o f adverse shock occurred in 1996 when the international copper price crashed resulting in considerable economic and financial distress in Mongolia. In the current environment of buoyant prices it is easy to forget the inherent high volatility in copper prices which have in the past been so damaging for the country (Figure 7.1 and 7.2). Muchthe same is true for gold which has also seen its price on international markets rise to an all time highin2006. - 148- CHAPTER 7: COUNTRY ECONOMICMEMORANDUM 7.5 Mongolia i s also quite vulnerable to the effects o f an oil price shock.* This i s compounded by the fact that almost all its oil imports currently come from one source- Russia. Between 2004 and 2006, the cumulative rise in oil prices has been US$39 a barrel, representing a price increase o f 133 percent. 7.6 Increased trade and openness has meant that Mongolia i s vulnerable on a number o f accounts-from dependence on a narrow range o f export commodities, increasing dependence on foreign direct investment, and remittances from Mongolians living overseas. Other sources o f vulnerability arise from global developments such as the management o f current global imbalances, rising oil prices and, eventually, an end to the current boom inmineral prices. All o f these are risk factors for Mongolia and could derail the prospects for continued high growth in the absence of policy measures to reduce the adverse effect o f these risks. Treading a careful path to ensure that these vulnerabilities are avoided or that their disruptive effects are minimized will require greater efforts to promote economic diversification and the private sector, a pragmatic approach to the challenges o f economic geography and regionalism, and careful management o f natural resource wealth and the environment. The previous three chapters have tried to address these economy-wide structural characteristics o f Mongolia. 7.7 Vulnerabilities in the livestock sector exist as well that can derail the growth process. In fact, history has shown this to be true in Mongolia itself. With the outbreak o f the "Hoof and Mouth Disease" inMongolia in2001, China and Russia banned Mongolian exports o f all animal products. This has resulted in substantial losses in herder incomes and that o f the cashmere processors, along with a dramatic decline in Mongolia's exports o f meat products. This is one example o f how outbreaks o f animal diseases can damage productivity and limit market opportunities. To mitigate this risk, mechanisms for surveillance, diagnosis and disease mitigation (including vaccination programs) need to be strengthened in Mongolia, as well as improved access to information by herders and firms on sanitary and phyto-sanitary standards in other countries on the basis o f which Mongolian products will be judged in it export markets. At the same time the country will also have to contend with some sources o f domestic policy risk, which could equally pose a risk to its growth prospects. Risk that emerge from the threats o f "Dutch Disease", fiscal policy and populist spending programs, and domestic policies that may influence the investment climate and the country's attractiveness to foreign direct investment and the perceptions o f corruption and weak governance that tend to raise the costs o f doing business. 7.8 Under these circumstances, the appropriate policy response is one which seeks to appraise each risk and implement a risk minimization strategy. Ingeneral, the optimal strategy would be to diversify the economy to reduce dependence on production and export o f a few key commodities, increase fiscal resilience and deepenreforms and to increase domestic value added (Chapter 3 discussed ways o f doing this). The present situation offers a unique opportunity for Mongolia to grow much more rapidly than it has inthe past decade and a half, a possibility to sustain the recent growth rates in the range o f 6-10 percent. This will be required too on account o f the enormous pressing needs, to lift 32 percent o f the population out o f poverty and to provide employment for the new school graduates entering the job market annually as well as the unemployed or under-employed. In 2006, 27 percent o f *In 2005, Mongolia's petroleum products imports (of US$326.5 million c.i.f.) accounted for 12.1 percent of GDP and almost a thirdof its total importbill. POLICIES TOMANAGE THEEXTERNAL AND INTERNALLY-GENERATED RISKS - 149- MONGOLIA: working age population was jobless and out o f scho01.~Although, these are enormous challenges the country has a unique opportunity to meet them successfully. The Risk of "Dutch Di~ease"~ 7.9 The strong balance-of-payments position has lessened depreciation pressures on the local currency (togrog). In 2005, the togrog depreciated by only 1.7 percent compared with about 3 percent over 2001-05, but in2006, the togrog appreciated innominal terms by about 4 percent compared with end-2005. In2005, the real effective exchange rate depreciated by 1.3 percent, compared to 10 percent in 2004.5 The absence o f real exchange appreciation up to 2005 suggests that so far the boom o f the mineral resource sector has not hurt Mongolia's competitiveness. However, the recent appreciation o f the nominal exchange rate, partly fueled by the massive foreign direct investment inflows inthe early 2000s, primarily into the mining sector, and the ongoing commodity price boom, raises concerns about `Dutch' diseaseq6 7.10 The `Dutch' disease could manifest itself through a spending effect and a resource movement effect. The resource boom has already resulted in increased fiscal spending on non- tradables (such as civil service wages and social transfer programs), shifting labor away from the lagging tradable sector (in this case, manufacturing and tradable services) and increasing the prices o f non-tradables. Such a shift i s called "indirect-deindustrialization" in the economic literature. Resource booms also tend to increase the demand for labor inthe mineral resource sector, thereby shifting it away from the lagging non-mining sectors. The longer the demand for minerals remains strong, the more likely it will be that `Dutch' disease will afflict the Mongolian economy, making it difficult for Mongolia to build up its non-resource tradable sectors. Drawing on international experiences, alternative strategies for diagnosing and reducing the threat o f "Dutch disease" are presented inBox 7.1. 7.11 Fiscal performance improved due to the high copper and gold prices that resulted in a jump in government revenues from taxes on profits of mining companies, but also due to improved budget management.7 However, the quality o f fiscal adjustment has deteriorated as the budget deficit has been kept in check by a reduction o f 1.4 percent o f GDP in the public capital spending and maintenance. This reduction was attributable to delays in the road fund financed by project loans. Given the planned changes to the tax code, there is a considerable This "jobless rate" measures the degree of underutilization of human capital in a country. Following international conventions, this includesthose looking for ajob (unemployed) andthose who are not looking for a job and are not inschool (idle). The term "Dutch Disease" originated in the Netherlands after the discovery of its North Sea Gas deposits. It refers to a situation when deindustrialization occurs in the economic structure of a country that has discovered large mineral deposits. This raised the value of the nations' currency (Le. an appreciation) thereby making the manufactured exports less competitive with its trading partners. As a result manufactured imports increase and exports fall. A similar situation occurred inBritain inthe 1970s with the exploration of its North Sea oil deposits. As the UK Pound appreciated, domestic workers demanded higher wages across the board in a situation where the country's manufacturedexports were becoming non-competitive in the international markets and a recession *followed.Fitch, (Source: UB Post, November 30, 2006.) Source: Mongolia Country Report, 2006. 6 Between 1990 and 1999, only 25 percent of the US$l 17 million of foreign investment went to mining, while between 2002 and 2005, almost half of the total foreign direct investment of US$419 million went into copper and gold mining investments alone. (Source: UB Post article entitled "The jlip side of the mining boom", November 30, 2006.) 7 Generalgovernment balanceturned from a deficit of2 percent in2004 to a surplus of 3.2 percent in2005. - 150- CHAPTER 7: COUNTRY ECONOMICMEMORANDUM level o f uncertainty as to fiscal and public debt developments. The international creditworthiness agency Fitch expects that fiscal pressures will remain significant in the run- upto the 2008 elections.8 Box 7.1: Strategies for Diagnosingand Fighting "Dutch Disease". "Dutch disease" i s an economic concept that tries to explain the seeming relationship between the exploitation o f natural resources and a decline in the manufacturing sector. The theory is that an increase in revenues from natural resources will de-industrialize a nation's economy by raising the exchange rate, which makes the manufacturing sector less competitive. Meanwhile, the appreciating localcurrency induces workers to lobby for higher wages, which cannot be undone when the commodity boom reverses (the so caIled "ratchet effect" on wages), thereby prolonginga recession that follows. Diagnosing Dutch disease Diagnosing Dutch Disease i s difficult because it is difficult to prove the relation between an increase inthe natural resource revenues, the real-exchange rate and a decline in the lagging sector. There are a number o f different factors that could be causing the appreciation o f the real exchange rate including the Balmsa- Samuelson efect, which occurs when productivity increases affect the real exchange rate, large capital inflows, associated with foreign direct investment or a country's debt, and terms o f trade changes. It is also difficult to identify the causes leading to a contraction o fthe lagging sector. Reducing the threat of `Dutch' disease The threat o f Dutch disease can be reduced by slowing the appreciation o f the real exchange rate and by boosting the competitiveness o f the manufacturing sector. The appreciation o f the real exchange rate can be slowed down by sterilizing the boom revenues, i.e. saving some o f the revenues abroad in special fimds (e.g. State Oil Fund of Azerbaijan and GovernmentPension Fund in Norway) andbringing them back into the country slowly. By saving the boom revenues the country is also saving for future generations. In developing countries pressures to spend the boom revenues immediately on poverty alleviation schemes are very strong. Measures to increase the competitiveness o f the manufacturing sector include, but are not limited to, investing in education and infrastructure. Risksto Fiscal and Debt Sustainability 7.12 Macroeconomic stability depends on the stability o f the terms o f trade. A negative terms-of-trade shock i s a threat to debt sustainability' and financial sector stability as Mongolia's domestic economy i s very much affected by any fluctuations in the world copper and gold prices. According to IMF (2005), in the period 1994-2004 the correlation between the change of the world copper price and Mongolia's GDP was 0.59. Highcredit growth and remaining weaknesses in supervision and enforcement o f prudential rules have heightened concerns about financial sector instability in recent years. The incidence o f non-performing loans increased from 8.3 percent at the end-2003 to more than 10 percent at mid-2005, while other indicators o f banking sector soundness were mixed." Although costly,' the recent collapse o f 50 SCCs i s considered healthy for the economy in the long run. Credit risk management, bank corporate governance, and enforcement o f applicable prudential rules remain weak, while deposit insurance i s still indraft. 8 Source: Fitch Mongolia Country Report, 2006. 9 Although Mongolia's external debt is sustainable for now and its debt service is manageable due to high concessionality and the large export share o f GDP (80 percent in 2004), external debt is high-much higher than the 40 percent threshold applied to countries at equivalent levels ofpolicy performance. lo Source: International Monetary Fund(2005). ` IThe total cost is estimated at MNT 60 billion. Political pressure may force the government to cover the losses. POLICIES TOMANAGE THEEXTERNAL AND INTERNALLY-GENERATED RISKS - 151- Box 7.2: Baseline ScenariosofJoint IMF/World Bank Debt Sustainability Analysis Assumes Continued High Output and Exports Growth. Real GDP: Assumed to grow by 7 percent in 2006 until 2009 (as the development of Oyu Tolgoi Mine continues) and is expectedto reach 11percent by 2010 when this mines starts production. Thereafter, with the start up of additional new mining sector and infrastructure projects and continued development o f the service sector over the medium term and beyond, the real GDP growth is assumedremain high, but at a lower rate of between 6 to 5.5 percent per annum between 2010 and 2014, before further slowing down to a steady-state growthrate of 5 percent after 2015. Fiscal Dolicv: In2007 the overall budget deficit is assumed to be 2 percent of GDP. (This is 3 percentage points lower than the 2007 budget proposal of the Government and assumes continued progress in the implementationofthe Government's ongoingreformagenda. Balance of payments: Export growth is expectedto slow down marginally in 2007-09 assuming copper prices revert to their long-term trend (in line with IMF WE0 assumptions). Exports would then pick up substantially in 2010 when the mining productionjumps (see above). Imports are also assumed to be higher, mainly consisting of mining-related equipment and construction materials/ machinery for infrastructure development.Beyond2015, export growthis assumedto be 6.5-7.5 percent, while imports are assumedto grow at about7 percent over the longterm. New borrowingassumptions: All external loans during the projectionperiodare contractedon concessional terms. New borrowingis projectedto remainat around US$l50 million annually over the mediumterm, and to increaseby about 2%percent annually over the longer term. The average concessionality level of new external borrowingis assumedto be slightly lower thanthe current level. Source: IMFMorld Bank, "Mongolia - Debt Sustainability"Annex I of Staff Reportfor 2006Article N Consultations. IMF Country Report No. 07/30. December 18,2006.pp. 29. www,imjorg 7.13 The most recent findings of a joint IMF/World Bank Debt Sustainability Analysis (DSA) for Mongolia (2006) found that its public debt would stay below their respective debt sustainability thresholds under a baseline scenario that assumed continued high GDP and export growth. Box 7.2 outlines the assumptions that were made in this DSA exercise. The NPV of the debt-to-GDP ratio (40 percent at end-2005), which is the only indicator initially above its threshold, is expected to decline to 32 percent in 2006, mostly as a result of the substantial nominal GDP growth. Alternative scenarios (Table 7.1) and "stress tests" that allowed for slower GDP growth rates and lower non-interest (primary) fiscal balances (back to historical average levels over the past decade), constant primary non-mineral fiscal balance at 2006 level'*, and a one-time permanentdrop in GDP growth (say, due to adverse weather) showed that the Net-Present-Value (NPV) of debt-to-GDP ratio exceeding its threshold under a number of shock scenarios (See figures 7.3 and 7.4 for the impact of the baseline scenario, no-reform scenario and stress test on the debt sustainability thresholds.13) The largest deterioration of debt indicators was observed with lower GDP growth rates. This analysis concluded that Mongolia remains vulnerable to severe terms of trade shocks and, therefore, fiscal and debt sustainability should be closely monitored while maintaining prudent debt management. ''The assumption of an unchanged primary balance, which is typically used in IMF/WB debt sustainability assessments to represent a scenario without policy reforms, is not considered relevant for Mongolia, because export prices are currently exceptionally high and the budget has a substantial surplus. Instead, the "no-reform scenario" assumesanunchangednon-mineralbalance. l3"Stress test" assumes that the adverse circumstances assumed in the alternative scenarios A and B all occur simultaneously.This yields the highestratios in2016. - 152- CHAPTER 7: COUNTRYECONOMICMEMORANDUM Table 7.1: AlternativeShock ScenariosHighlightRisks to Maintaining Debt Sustainability A. Fiscal DSA: Sensitivity Analysis on Public Debt, 2006-2026. Alternative scenarios A1. RealGDP growthandprimarybalanceare at historicalaverages A2. Primary non-mineralbalanceis unchangedfrom 2006 A3. Permanently lowerGDP growth-(assumesthat real GDP is at baseline minus onestandard deviation divided by the sq. root of 20years, which is the length of theprojectionperiod.) B. Sensitivity Analysis on External Public and Publicly Guaranteed Debt, 2006-2026. Alternative Scenarios B1. Key variablesat their historicalaverages in2007-26. B2.Newpublic sector loanson less favorableterms in2007-26 (assumes that the interest rate is two percentage points higher than in the baseline scenario, ceterisparibus.) 7.14 Inthis regard, it will be helpfulifthe authorities continue refraining from undertaking new non-concessional borrowing and issuance o f sovereign loan guarantees (which would increase the Government's contingent liabilities and generate fiscal risks) in the short- to medium-term. Focus should be on attracting non-debt creating flows such as foreign direct investment. In order to maintain high GDP growth its "binding constraints" need to be removed-which was discussed in Chapter 2 o f this report. This highlights the need to continue the Government's ongoing overall efforts to improve the investment climate for the private sector to operate in Mongolia and address impediments to doing business and trading activities within Mongoliaand with the rest of the world. FISCAL SPACE AND USE OF WINDFALL REVENUE 7.15 "Fiscal space" refers to a government's ability to undertake public spending without impairing its present and future ability to service its debt (i.e.' s~lvency).'~ It is measured as the gap between the current level o f public expenditure and the maximum level o f expenditures that a government can undertake without impairing its s~lvency.'~ A number of factors influence whether and how fiscal space can be created and sustained. These include: initial fiscal conditions, the track-record o f past fiscal management, the efficiency o f public spending and credibility of government policies. For aid-recipients like Mongolia, the predictability and flexibility o f aid also has an impact on its available fiscal space. Fiscal space can be created without the need for new borrowing through: (a) improvements in the efficiency o f public spending that will free up resources for reallocation; (b) efficient revenue enhancement measures including tax measures and user charges; and (c) through continued access to external grant aid. 7.16 Recent empirical economic literature finds that although macroeconomic stability i s necessary for growth, it is not sufficient. The transmission channels through which fiscal policy influences long-term growth need to be incorporated inthe design o f fiscal policy. This requires increased attention to the likely growth effects o f the level, composition and l4This implies that the present value of primary surpluses plus seignorage revenueshould at least add up to its outstandingdebt. See Agenor and Montiel(l996) andEasterlyand Serven(2003). 15Source: International Monetary Fund "Fiscal Policy for Growth and Development: An Interim Report", DevelopmentCommittee of the Board of Governors of the World Bank and the IMF, Report No. DC2006-003. April 6,2006. POLICIES TOMANAGE THEEXTERNALAND INTERNALLY-GENERATED RISKS - 153 - MONGOLIA: ~~~ efficiency o f public spendin and taxation. The record of stable macroeconomic management in Mongolia during the 20' century obscures the fact that, like many other countries that a stabilized their economies, it did so by cutting government spending on public capital formation and the maintenance o f existing infrastructure despite its negative impact on growth and poverty reduction (See Chapter 1). Figure 7.3. PublicDebt Sustainability Figure7.4. ExternalPPG Debt Sustainability Scenarios 1/ Scenarios 1/ 80 , 60 SO . 40 . 30 . i n1 + - -_-- ----___ _--- ._....---- - 20 . --_. Bar1,ne 10 . -Mossxlremc Hisorical senarm nrw Ion 0 """""""""" 1006 2008 2010 2012 2014 2016 2018 2020 2022 2024 201 140 ::I/ NPVofdebt-to-expons ratio ,--_--- ------ ---- --_ -..----_ 4n i n Debt service-to-expons ratio 1J 7 . 20 J - 15 I O I --8aui,ne - - --Hinorisal senam I Source: IMF,Annex I -Debt Sustainability Analysis, in Source: IMF,Annex 1-Debt Sustainability Analysis, in Staff StaffReport of 2006 Article IV Consultations.Dec. 2006. Report of 2006 Article IV Consultations. Dec. 2006. Note: ]/Most extreme stress test is test thatyields Note: I/fiternal public andpublicly guaranteeddebt highest ratio in 2016 sustainability thresholdsfor the three above indicators are 40 2/ Revenue includinggrants oercent, 150percent and 20percent, respectively. 2/ Revenue including grants 7.17 A growth-oriented approach to fiscal policy follows from the understanding o f the country's binding constraints to growth and to then ascertain whether fiscal considerations could be usedto address some o f these constraints. An increase infiscal spending may also be considered to address a growth constraint if possible fiscal savings from increased efficiency - 154- CHAPTER 7: COUNTRY ECONOMICMEMORANDUM or cuts inlow-value expenditure are inadequate.l6The "growth diagnostics" exercise that was conducted for Mongolia in the context of this Country Economic Memorandum (CEM) showed that private investment and growth have been constrained by distortionary taxes, infrastructure bottlenecks that translate itself into high transport costs, negative coordination externalities that have adversely impacted on Mongolia's ability to diversify its exports and markets abroad and discontent with decisions and administrative processes in Government. (See Chapter 2 and Annex 11). 7.18 While the issue of composition and efficiency of public investments in Mongolia will be examined in greater depth in the forthcoming World Bank Public Expenditure and Financial Management Review (PEFMR), this section of the chapter discusses a key issue that is currently being debated in Mongolia and among Mongolia-watchers abroad-namely , how should one use the windfall revenues and fiscal surpluses that the Government is accumulating in a manner that makes fiscal policy to become more forward looking towards achieving broad-basedgrowth for many years to come? 7.19 One aspect of this would be for Mongolia to run counter-cyclical fiscal policy by design.l7The evidence to date suggests that fiscal policy has been mostly pro-cyclical (Figure 7.5). With the recent surge in budgetary revenues arising from the global boom in gold and copper prices and the looming prospects of significant expansion of mining output through new operations, there is a need for policy makers to anticipate the inevitable spending - pressures that will arise with respect to windfall revenues. Figure 7.5: FiscalPolicy has been Largely Pro-cyclical Thus, it is critical that I?--- --3 Mongolia prepare for this and I I I carefully consider options to manage this, including through adoption of an appropriate 0 fiscal framework and with clear fiscal rules. Transparent, I I flexible and well designed I fiscal rules can help fiscal policy by restraining political pressures for an expansionary policy. Numerical targets, like the 3 percent deficit target of -*-'"`] Soum:NationalStalistffisOfTcw.MinishyofFinam andBank Staffestimates. the EMU Stability and Growth Pact provided incentives for the new member states to undertake fiscal consolidation in a responsible manner. In Australia, New Zealand and the U.K., for example, where fiscal consolidation was achieved, the fiscal rules emphasized transparency in fiscal reporting and allowed them to build fiscal credibility. Rules definedin cyclically-adjusted terms allow for automatic stabilizers but restrain pro-cyclical tendencies. Chile has been successful in using l6 In this regard, one must of course consider the costs of such financing compared to the benefits and be consistentwith maintaining macroeconomicstability. Detailed sectoral assessments, with data on unit costs and relatedefficiency measures, are requiredto estimatefiscal savingsalternatives. 17Fiscalpolicy could be less counter-cyclical ifthe economywere more financially developed. I8The U.K.adopted a "Golden Rule" in 1997 together with a 40 percent ceiling on the net public debt to GDP ratio. POLICIES TOWNAGE THEEXTERNAL AND INTERNALLY-GENERATEDRISKS - 155- MONGOLIA: such stabilizers since 2000 over the medium term." Similarly, Brazil and South Africa have used their respective Fiscal Responsibility Laws to improve sub-national fiscal discipline. 7.20 The establishment o f an earmarked Development Fund in 2006 is a welcome step in this direction but should only be considered as a transitional arrangement as much more needs to be done inthis area to safeguard savings and to ensure that they generate a positive return for the country when they are spent. To this end, having a budget management framework, fiscal rules, and accompanying institutional set-up, that formally and transparently links the Government's Public Investment Program (PIP) with the existing MTBF i s imperative. This task will require adequate time and preparation, but the fact the Mongolia has a fully- functioning GFMIS, it i s already a step ahead. 7.21 Meanwhile, the operational efficiency o f public spending depends on rules and incentives that motivate and guide the performance o f civil servants. Effective management i s critical in this regard, which entails putting in place effective internal controls and regular audits. A good ex-ante process o f vetting projects for costs and benefits and a system o f ex- post impact assessments will minimize resource waste. Hence, as questions o f fiscal space for productive government spending are considered, the issue o f efficiency and the quality o f budget systems and public sector management processes must be addressed to provide assurance to the citizens that such public expenditures are in fact productive. Linking the MTBF and the PIP of the Government through a formalized process of vetting costs and benefits is, therefore, imperative in Mongolia. Then determine what is essential in the PIP (Le., a "Core Productive Public Expenditure Program '7 andprotect these@om the vagaries offuture fiscal adjustment.2o 7.22 Given that all governments face an inter-temporal budget constraint when making fiscal policy decisions (Le. they need to maintain fiscal sustainability over time), it defines the limits o f the room for fiscal maneuver. One must consider thefuture spending implications of current spending programs (i.e. some expenditure programs, once started, in effect pre-empt future fiscal space). The availability o f significant aid inflows to Mongolia (in per capita terms one o f the highest in the developing world), has helped bridge the gap between the country's growth and development needs (including physical infrastructure, delivery o f critical health and education services, protection o f the poor and vulnerable) and its public financing capabilities (due to its narrow tax base, vulnerable existing public debt situation). Inevitably, one cannot ignore the fact that public expenditure and taxation policies are fundamentally political choices which reflect the political economy and institutional arrangements in Mongolia. Under these circumstances, fiscal policy decisions of the government need to be informed by ex-antepolicy analysis that clarij?es the likely growth and distributional consequences of alternative choices. In addition, planning and fiscal institutions in the country need to enable the political actors make informed fiscal policy decisions in Parliament by taking a longer term perspective and for them to support a contestableprocessfor determiningpolicy decisions. Itusesa structural surplustarget of 1percent of GDP. Source:IMF(2006), Box 1, pp.7. 20To ensure transparency in the design and monitoringof this core spending program, not only of the public accounts but also in communication with the public, an appropriate institutionalset-up in government may be needed(e.g. a FiscalPolicyCommittee). - 1.56- CHAPTER 7: COUNTRY ECONOMICMEMORANDUM GOVERNANCE ANTI-CORRUPTION AND 7.23 The efficiency o f resource use, and the growth impact o f fiscal policy, is intrinsically linked to the incentives and accountability for performance, and the quality o f institutions and governance in the public sector. Governance and corruption are related but are distinct from each other. Typically, "governance" i s defined as the traditions and institutions by which authority ina country is exercised for the common good.21This includes: The process by which those in authority are selected, monitored, and replaced (the political dimension); 0 the government's capacity to effectively manage its resources and implement sound policies (the economic dimension); and 0 the respect o f citizens and the state for the country's institutions (the institutional respect dimension). 7.24 On the other hand, corn tion is traditionally more narrowly defined as "the abuse o f public office for private gain"q2 It should be noted, however, that the responsibility o f corruption does not only lie on the public sector officials but on anyone (especially powerful private interests) who exerts undue influence, and those who are unduly influenced, in providing access to a public service (for example, favoritism toward particular firms in the awarding o f public procurement bids and contract^).^^ In this sense, corruption would be considered to have taken place even ifthe act was not strictly illegal. 7.25 Less than a dozen years ago, few comparable, worldwide measures o f governance or corruption existed. However, in recent years, through the efforts o f institutions such as the World Bank (the Governance Indicators), the World Economic Forum (the Executive Opinion Survey), Transparency International (Corruption Perception Index), Freedom House (political and civil liberties and freedom o f the press), and numerous other institutions, we have sought to counteract this widespread perception. In order to more closely define and measure Governance, the World Bank has constructed a set o f aggregate Governance Indicators. These now cover more than 200 countries and are based on more than 350 variables obtained from dozens o f institutions worldwide, including the survey data. The Governance Indicators capture six key dimensions o f institutional quality or governance, and measure, through two indicators each, the political, economic, and institutional dimensions o f governance. Box 7.3 provides a summary o f these dimensions. 2'Taken from Kaufinann(2006). 22Source:Kaufinann(2006). 23 Powerful private interests often exert undue influence in shaping public policy, institutions and state legislation. For instance, the public sector is not the sole decider of a country's investment climate, nor is the private sector a passive recipient of the investment climate. Reality involves a complex interplay of corporate and public governance and policymaking, whereby powerful segments of private sector also play a very important role in shaping public policy, legislationand regulations that define the rules of engagement in the private sector andthe business environment within which f m s operate. POLICIES TOMANAGE THEEXTERNALAND INTERNALLY-GENERATEDRISKS - 157- MONGOLIA Box 7.3. The World Bank's Worldwide GovernanceIndicators-A Way to Evaluatethe Quality of Governanceinand acrossCountries. The Worldwide GovernanceIndicators define governance as the set o f traditions and institutions by which authority in a country i s exercised. The political, economic, and institutional dimensions o f governance are captured by the following six aggregate indicators: 0 Voiceand Accountability the extent to which a country's citizens are able to participate inselecting - their government, as well as freedom ofexpression, freedom ofassociation, anda free media. PoliticalStabilityand theAbsence of Violence perceptions of the likelihood that the government will - be destabilized or overthrown by unconstitutional or violent means, including domestic violence and terrorism. Government effectiveness the quality o fpublic services, the quality o fthe civil service and the degree - o f its independence from political pressures, the quality o fpolicy formulation and implementation, and the credibility o f the government's commitment to such policies 0 Regulatory Quality the ability o fthe government to formulate and implement sound policies and - regulations that permit and promote private sector development. 0 Rule of Law the extent to which agentshave confidence inand abide by the rules o f society, andin - particular the quality o fcontract enforcement, the police, andthe courts, as well as the likelihood o f crime andviolence. 0 Controlof Corruption the extent to which public power is exercised for private gain, includingboth - petty and grand forms o f corruption, as well as "capture" o f the state by elites and private interests. Source: WorldBank. www.worldbank org/wbi/governance 7.26 Figure 7.6 presents the World Bank aggregate Governance Indicators for the period 1996-2006. It shows that, apart from the political dimension which has improved in some years, there has been a relative deterioration in governance inMongolia as definedby five of the six Governance Indicators. It should be noted that each bar in the table represents percentile ranks, i.e. the percentage of countries worldwide that rate below Mongolia (subject to margin of error). Thus, higher values indicate better governance ratings (and thus a larger number of countries that are worse off that the country in question). Percentile ranks have been adjusted to account for changes over time in the set of countries covered by the governance indicators. Clearly, margins of error in the use of these World Bank Governance indicators are not trivial, and caution ininterpreting the results is ~arranted.'~ 7.27 A more direct way to examine this issue is to conduct country-specific surveys of firms and households. Various studies and surveys have been recently undertaken in Mongolia in this regard (e.g., investment climate assessment, USAID corruption report, WBI indicators), which suggest that the perception of corruption in the public sector is on the rise in Mongolia. The World Bank Investment Climate Assessment (ICA) and Trade Integration Study (World Bank 2006e) found that corruption pervades every sphere o f business activity, be it urban firms or rural farm-based activities. In international trading-related business activities, the unpredictability of the time it will take to clear customs was a key concern. Paper-basedprocesses are the main source of delay in customs. Past automation efforts have not solved the problem. Within Customs it i s the customs valuation processes that appear to be a locus of corruption inMongolia. The ICA(2006) found that a quarter of firms that export andjust over a fifth of the firms that import reported having to pay a bribe inorder to expedite 24These indicators have beenavailable since 1996 and these margins of error have declined. (Source: Kauhann, 2006) - 158- CHAPTER 7: COUNTRY ECONOMICMEMORANDUM customs clearance or avoid excessive duties. Incentive structures and administrative processes within the Customs General Administration facilitate corrupt practices as well. The granting o f import duty exemptions also provides opportunities for rent-seeking. Figure7.6: The Qualityof GovernanceinMongolia,1996-2006 Compared MONGOLIFI Comparison b r t w r r n 2006, 2005, 2004, 2003, 2002, 2000, 1998, 1996 --bottom orde voice and Accountability Political Stability Gousrnnsnt Effcctiwsnsss RsKUlatOry Quality Rule o f Lau Control of Corruption e 25 a i 1 Country-s Percentile Rank Source: Kaufmann D.,A. Kraay, and M. Mastruzzi 2007: Governance Matters VI: Governance Indicatorsfor 1996-2006. Note: This chart depicts the percentile rank on each governance indicator. Percentile rank indicates the percentage of countries worldwide that rate below the selected country (subject to margin of error). Higher values indicate better governance ratings. Percentile ranb have been adjusted to accountfor changes over time in the set of countries covered by the governance indicators. In the Bar Chart, the statistically likely range of the governance indicator is shown as a thin black line. For instance, a bar of length 75 percent with the thin black lines extending from 60 percent to 85 percent has the following interpretation: an estimated 75 percent of the countries rate worse and an estimated 25 percent of the countries rate better than the country of choice. However, at the 90 percent confidence level, only 60 percent ofthe countries rate worse, while only 15percent of the countries rate better. 7.28 The I C A (2006) evidence indicates that the licensing and inspections regime in Mongolia suffers from red-tape and rent-seeking. This i s similar to the case with the other specialized agencies that deal with the private sector-the tax and customs administrations) do. There i s clearly a need for reform. But because licensing and inspections involve technical details that vary from activity to activity, and because they serve an underlying public purpose, which risks being undermined in a hasty attempt to eliminate red tape, the reform agenda needs to be elaborated more carefully. There are instances, such as in the case o f veterinary and hygienic inspections in the livestock sector, where the need i s for more and better inspections, not fewer. The same may be said for environmental inspections. The private-public governance challenge i s not only confined to the domestic players in a country. In Mongolia, this is particularly important due to the ongoing discussions between the Government and interested foreign mining companies on mining-sector investment agreements, taxation and licensing arrangements. The Government's stated commitment to POLICIES TOW N A G E THEEXTERNAL AND INTERNALLY-GENERATEDRISKS - 159- MONGOLIA: implement the Extractive Industries Transparency Initiative (EITI) is a welcome step in improvingthe transparency and corporate governance inthe Mongolianmining sector. 7.29 Public opinion surveys conducted since 1995 and recent discussions conducted inthe context of the World Bank's ICA (2006) and the 2007 Governance & Anti Corruption (GAC) stakeholder consultations indicate increasing public concern over corruption in Mongolia. There remains the need to tackle governance issues in Mongolia in the near-term from three perspectives, namely: (i)consolidating reforms to improve fiduciary controls in Government; (ii)implementing enhancedtransparency measures; and (iii)putting inplace direct anti- corruption reforms, such as asset and income declarations by senior public sector officials and Parliamentarians, tax, audit, conflict of interest disclosure programs. This approach allows for acting on both reducing the perceptions (by increasing transparency) and actual corruption (through fiduciary and anti-corruption program^).^' 7.30 Over the last 15 years, the Government has put in place the foundation for a robust public finance management framework. The elements of this foundation include: (i) a fully functional Treasury Single Account system; (ii)a government-wide Financial Management Information System with full financial commitment controls; (iii)a chart of accounts that fully comply with the International Public Sector Accounting Standards; (iv) a Debt Management Office within the Treasury Department where an effective debt recording and monitoring system is housed; and (v) an internally consistent and ambitious Public Finance Management Law. These elements have contributed to significantly improved fiduciary controls and aggregate budget outturns. However, reforms are needed to consolidate these into a results-basedpublicfinance managementframework that is linked to the Government's Action Plan, its medium term budget framework, annual budget and public investment program in any given year.26 7.31 Inan endeavor to improve public accountability and citizen monitoring, although the Government has made tangible gains in improving public sector systems and processes, there i s very little disclosure of budget, public debt, or procurement information to entities outside of parliament.Even data and analysis conducted to inform the design of public policy, such as raw poverty data from the Living Standard Measurement Survey, Environmental Impact Assessments, etc., are not effectively placed in the public domain. This lack of disclosure perpetuates a perception of mismanagement of public resources and fuels unsubstantiated rumors to become rampant. The Government is addressing the issue of transparency by instituting a policy of better information disclosure and by recently promulgating a more effective Anti-CorruptionLaw. The implementation of this Law hasjust begun and the World Bank, among Mongolia's other external partners, is supporting this effort through a technical assistancethrough grant funds. (Table 7.2). 25 The World Bank is continuing to support traditional core competencies; helping with capacity building, sharing knowledge, and focused reformsin key institutionssuch asjudiciary, customs, tax, procurementthrough its ongoing Governance Assistance Project (GAP) and other technical assistance in cooperation with the Government and Mongolia's other external development partners. It is also supporting initiatives for transparency, freedom of information, and an independentmedia, participatory anti-corruptionprogram. 26The World Bank Governance Assistance Project (2006) is supporting the government's ongoingefforts inthis regard. Fiscal TA from the InternationalMonetary Fund, especially in the area of improving fiscal reporting, is underwayas well. - 160- CHAPTER 7: da MONGOLIA: 7.32 Partly in response to the recent household and firm surveys and related studies, in October 2005 Mongolia ratified the United Nations Convention against Corruption (UNCAC). Parties to the convention must create a transparent procurement system; institute merit hiring for civil servants; toughen criminal penalties for bribery and other corrupt acts; permit law enforcement authorities to freeze, seize, and confiscate the proceedsof corruption; and take a host of other measures to combat corruption. It has enacted a new Law on Anti- Corruption in 2006, and immediately thereafter established a National Anti-Corruption Council-an informal Parliamentary body mandated with the responsibility for oversight on the corruption matters inMongolia. A formal Anti-Corruption Agency was also established in January 2007 which has been charged inthe first instance to collect and process the asset and income disclosure and declaration information expeditiously. Staffing for that office is currently being undertaken. Box 7.4: Reform Measures to Improve Transparencyin Government. Research shows that transparency helps improve governanceand reduce corruption--essentialingredients for better development and faster economic growth. Within a concerted, practical, and comprehensive pro- transparency strategy, a basic checklist of concretereforms, which countriesmayuse for self-assessmentmight includethe followingitems: public disclosure of assets and incomes of candidates running for public office, public officials, politicians,legislators,judges, andtheir dependents; public disclosure of political campaign contributions by individuals and f m s , and of campaign expenditures; 0 publicdisclosureofall parliamentaryvotes, draft legislation, andparliamentarydebates; effective implementationof conflict of interest laws, separatingbusiness, politics, legislation, and public service, and adoption of a law governing lobbying; publicly blacklisting f m s that have been shown to bribe inpublic procurement(as done by the WorldBank); and a requirementto "publish-what-you-pay" bymultinationalsworkinginextractive industries; 0 effective implementation of freedom of information laws, with easy access for all to government information; freedomofthe media(includingthe Internet); 0 fiscal and public financial transparency of central and local budgets, adoption of the IMF's Reports on StandardsandCodes frameworkoffiscal transparency, detailedgovernment 0 reporting of payments from multinationals in extractive industries, and open meetings involving the country's citizens; 0 disclosureofactual ownershipstructureandfinancial status ofdomesticbanks; transparent(Web-based)competitiveprocurement; 0 periodic implementation and publicizing of country governance, anti-corruption and public expenditure trackingsurveys, suchas those supportedbythe WorldBank; 0 Transparencyprogramsat the city level, includingbudgetdisclosureandopenmeetings. Source: Kaufman, Daniel (2006), "Myths and Realitiesof Governanceand Corruption The WorldEconomicForum 'I. Global CompetitivenessReport 2005-2006 Chapter 2.1,Box 1. WorldBank ~ 7.33 Effective implementation of the relevant policies and anti-corruption regulations should be the focus of the authorities in the coming year in order to reap the initial benefits/outcomes of fighting against corruption and improving governance inMongolia. Box 7.4 outlines reform measuresthat needto be adoptedto improve transparency inGovernment. Further efforts towards improving the efficiency and effectiveness of public sector management, upgrading professional skills and ethics of employees, should continue. Implementation of the approved Tax and Anti-Corruption codes is neededas is improvement of administrative processes to support the implementation of these key legislations. Public -162- CHAPTER 7: COUNTRY ECONOMICMEMORANDUM disclosure initiatives need to facilitate the administrative reforms; and foster partnership and participation o f civil society, professional groups, and private with the public sectors. This will also help citizen monitoring o f the progress of overall reform implementation and assist the government to credibly communicate its goals and outcomes toward implementation o f the MDG-based National Development Plan. EnvironmentalRisks 7.34 The rapid economic growth and changing structure o f the economy brings with it greater pressures that erode the quality and contribution o f natural resources to the Mongolian economy by the very nature in which they are being utilized. The sooner one begins to address these risks and put inplace mechanisms and institutional frameworks to manage them the better. Fruits o f these efforts will take time under any circumstances, so time is of the essence here. 7.35 Inthe agriculture and livestock sector, for instance, considerable environmental risks emerge due to the dependence o f the rural population on Mongolia's vast open pastureland for the nutritional intake o f the majority o f their animals. Given that the country is already prone to extreme climatic conditions that have in the past caused high rates o f livestock mortality these environmental risks on the land tend to further jeopardize rural livelihoods. In addition to exogenous factors (such as harsh weather) man-made factors (such as poor management o f livestock by inexperienced herders) were certainly a contributing factor to the high losses in the 1999/2000 and 2000/2001 dzuds. The overstocking o f livestock has led to accelerated pasture degradation and, consequently, to poor nutritional quality o f new livestock herds. This, inturn, also accentuates livestock mortality. 7.36 Coping with these risks requires a multi-dimensional approach. Lower level risks can be mitigated by improved pasture and livestock management practices. These include: the increased use o f alternative sources o f nutrition for animal, protecting seasonal pastures, preserving pastures by limiting stocking levels, and strengthening veterinary services. The government i s currently implementing a program for the rehabilitation o f wells through the Ministry of Food and Agriculture, which can also have a significant impact on the sector and its ability to withstand and mitigate environmental risks. Water i s a critical factor in the management o f pasture land, and the careful identification o f sites can help to open up new pastureland for herders. Pastureland management, therefore, needs to recognize the linkages between land, water and the livestock sector. The establishment o f the National Council for Pastureland Management i s an important first step in this regard. To become effective, this Council will require permanent staffing, analytical capacity, and the authority to link to local authorities, so as to advise them effectively on pasture planning and management issues. In addition, the government is supporting the development o f livestock insurance for more extreme climatic impacts, and this has the potential to become a market-based tool for mitigating environmental risk. Given the potential scale o f liabilities, the key to the sustainable availability o f livestock insurance i s likely to be the extent to which the risk can be transferred out o f the country and into the international re-insurance market. The opportunities for this may be limiteduntilthe regulation o f the sector is improved. 7.37 Environmental impacts from mining operations have the potential to be a significant risk for the sustainability o f the mining sector and the Mongolian economy. As indicated in the World Bank report (2006) Mongolia -A Review of Environmental and Social Impacts in POLICIES TOMANAGE THEEXTERNAL AND INTERNALLY-GENERATEDRISKS - 163- MONGOLIA: the Mining Sector, the environmental record for the Mongolia mining sector i s mixed at best with many of the ongoing operations managed in a sub-optimal way leading to a significant environmental damage and production losses. The Government is working to address these challenges by enacting and updating a series of environmental laws, preparing regional economic developments plans, strengthening its monitoring and compliance systems as well as the technical skills of its personnel in MNE and other relevant government agencies, and ability to back up Government's plans by better and systematic environmental impact and projection analysis. 7.38 Finally, air pollution represents an additional risk, particularly in urban areas Winter air pollution inUlaabaatarhas increasedsignificantly over the last decade primarily due to the large increase in the use of heating stoves and small heat-only boilers. The rapid growth of motor vehicles also have increased air pollution burden. Based on the emissions data, it is estimated that the annual average ambient concentration of fine particulates (PMlo) in UB is about 210 pg/m3, compared to the maximum threshold of 100 pg/m3 adopted by the World Bank and other countries. The public health impact of such high level pollution is significant and range from additional child asthma cases per year (2,530) and restricted activity days per year (6,325,000). These damages could double in the next ten years if the current trends in population growth, heating modes selection, and urban transport continue. The Government has recognized that the air pollutionproblem has become a critical development issue because of its multi-dimensional aspects, not only in terms of direct causes, such as heating modes, dwelling patterns, and urban traffic but also with underlying linkages to income levels, land use policy, and urban infrastructure planning and execution. Thus, the solution must be programmatic - using a combination of various measures to achieve short-to-medium term improvements and long term clean air objectives. Also, to most effectively allocate resources and achieve results, there is a need to improve the alignment of government and donor programs to address the variety of issues which contribute to air pollution, as well as for better monitoring and evaluation of the progress made and adjustmentsneeded. -164- CHAPTER 7: COUNTRYECONOMICMEMORANDUM REFERENCES Agenor, Pierre and Peter Montiel (1996), Development Macroeconomics. Princeton: Princeton UniversityPress. Asian Development Bank and Ministry of Education, Culture and Science (2005). "Technical and Vocational Education and Training Sector Analysis," Ulaabataar, Mongolia. Barro, R. and J. Lee (1996) "International Measures of Schooling Years and Schooling Quality," American Economic Review 86 (2): 218-23. BatboldJ. (2002) "The problem of management o f Marmots inMongolia." inK. Armitage and V.Y. Rumiantsev (eds.) 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"Universities/Research Institutes and Regional Innovation Systems: The Case of Beijing and Shenzhen." Berkeley,C.A.: Universities as Drivers of the Urban Economies in Asia 168. Available on line at http://brie.berkeley.edu/publications/wp 168revised.pdf. Cheng, Kevin (2003), Growth and Recovery in Mongolia During Transition, IMF Working Paper 03/217, November 2003. Chessa, Antonio, and Marije Schouwstra(2005), TotalFactor Productivity and the Mongolian Transition, Tinbergen InstituteDiscussion Paper 05-087/2, September2005. Crisp, N,Dick, J., and Mullins, M.(2004) Mongolia Forestry Sector Review, Washington, D.C.: World Bank. Cuddington, John T., Rodney Ludema and Shamila A. Jayasuriya (2007). "Prebisch- Singer Redux." inLederman, Daniel and William Maloney (eds.). Natural Resources: Neither Curse nor Destiny, World Bank and Stanford UniversityPress: Washington, DC. 2007. pp. 103-140. DeFerranti, D.,G.Perry, D. Lederman,and W. Maloney (2002), From Natural Resources to the Knowledge Economy: Trade and Job Quality, World Bank Latin America and Caribbean Studies, Viewpoints, World Bank. Doggett, Michael (1996), "TheEnvironmental Impact of Small and Medium-Scale Mining inBolivia, Chile, and Peru: CanadianResearchComponent," mimeo, Centre for ResourceStudies, Queen's University, Kingston, Canada. Easterly, William and Luis Sewen (2003), The Limits of Stabilization: Infrastructure, Public Dejcits, and Growth in Latin America. Stanford University Press and World Bank. Education and Evaluation Center. 2006. Report on the National Assessment of Students Achievements within the "Educational Quality Assessment",draft, Ulaabataar, Mongolia. - 166- REFERENCES COUNTRYECONOMICMEMORANDUM Enoch Charles, and A.M.Gulde, D.Hardy(2002), Banking Crises and Bank Resolution: Experiences in Some TransitionEconomies, IMF Working Paper 02/56, March 2002. Erdenechuluun, T. (2006) WoodSupply in Mongolia: TheLegal and Illegal Economies. Mongolia Discussion Papers, East Asia and Pacific Environment and Social Development Department. Washington, D.C.: World Bank. Evia, Jose Luisand Molina, Ramiro (1997), Estudio Medio-ambiental de la Mineria Mediana, PequeJiay Artesanal en Bolivia,mimeo, Universidad Cat6lica Boliviana, La Paz, Bolivia. Favaro, E. (2005) "A Guideto Economic Growth Analysis," World Bank, Economic Policy and Debt Department, PREM, manuscript, March. Fisher, I., (1906). The Nature of Capital and Income, New York: Macmillan. Ghosh, S. and A. Kraay (2000) "Measuring growth intotal factor productivity," PREM NoteNo. 42, Economic Policy Unit, September. Gehlhar, M.(1998) "Bilateral transportation margins," inMcDougall et al. (ed.) Global TradeAssistance and Protection: The GTAP 4 DataBase, Center for Global Trade Analysis, PurdueUniversity. Hamilton, K. 1994. "Green Adjustments to GDP." ResourcesPolicy 20 (3): 155-68. Hamilton, K.,and J.M. Hartwick. 2005. "Investing Exhaustible ResourceRentsandthe Path of Consumption." Canadian Journal of Economics 38 (2): 615-21. Hausmann, Ricardo, Dani Rodrik and Andres Velasco (2005), Growth Diagnostics. John F. Kennedy School of Government, Harvard University, Cambridge, MA: Dani Rodrik, March2005. Hausmann, R. and D. Rodrik (2003) "Economic Development as Self-Discovery," Journal of Development Economics 72, December. Ianchovichina (2006) "Are Duty Drawbacks on Exports Worth the Hassle?" Canadian Journal of Economics (forthcoming). IENIM(1996), A Mining Strategyfor LatinAmerica and the Caribbean, World Bank Technical PaperNo. 345, Industry and Mining Division, Industryand Energy Department,World Bank, Washington, D.C. International Monetary Fund(2006a), Mongolia: StaffReport for the 2006Article I V Consultations, January 2007, IMF Country ReportNo. 07/30. www.imf.org REFERENCES -167- MONGOLIA: International Monetary Fund (2006b), "Fiscal Policy for Growth and Development: An InterimReport", Development Committee of the Board of Governors of the World Bank anthe IMF, ReportNo. DC2006-003. April 6,2006. International Monetary Fund (2005) Mongolia: 2005 Article IV Consultation-Staff Report, IMF Country Report No. 05/396, November 2005. Jorge Katz, Salmon Farming in Chile. Kaufmann, Daniel, Aart Kraay, and Massimo Mastruzzi (2007), The Worldwide Governance Indicators Project: Answering the Critics. World Bank Policy Research Working Paper 4149, March2007. Kaufmann, Daniel (2006), Myths and Realities of Governance and Corruption. The World Economic Forum Global Competitiveness Report 2005-2006 Chapter 2.1, Box 1. World Bank. Kemple, James J., and Judith Scott-Clayton. 2004. Career Academies: Impacts on Labor Market Outcomes and Educational Attainment. New York: MDRC. Kharas, Homi and IndermitGill (2006). An East Asian Renaissance: Ideasfor Economic Growth. World Bank, Washington DC. Knack, S., and P. Keefer (1995) "Institutions and Economic Performance: Cross-Country Tests Using Alternative Institutional Measures." Economic and Politics 7(3): 207-27. Krugman, Paul (1991) (cited inChap 4, Box 4.2) Lecraw, DonaldJ., Philip Eddleston, Alene M c Mahon (2005), A Value ChainAnalysis of the Mongolian Cashmere Industry, U SAID Study under the MongoliaEconomic Policy Reform and Competitiveness Project (EPRC), May 2005. Lederman, Danieland William Maloney (eds.) (2007). "Natural Resources:Neither Curse nor Destiny", World Bank and Stanford University Press: Washington, DC. Lederman, Danieland William Maloney (2007). Neither Curse nor Destiny: Introduction to Natural Resourcesand Development, inLederman,Daniel and William Maloney (eds.). "Natural Resources:Neither Curse nor Destiny", World Bank and Stanford University Press: Washington, DC. 2007. pp. 1-14. Maloney, William (2007). Missed Opportunities: Innovation and Resource-based Growth in Latin America, in Lederman, Danieland William Maloney (eds.). Natural Resources: Neither Curse nor Destiny, World Bank and Stanford University Press: Washington, DC. 2007. pp. 141-182. - 168- REFERENCES COUNTRYECONOMICMEMORANDUM McMahon, Gary, Jose Luis Evia, Albert0 Pascb-Font, and Josk Miguel Sanchez. (1999). An Environemntal Study of Artisanal, Small, and Medium Mining in Bolivia, Chile and Peru. World Bank Technical PaperNo. 429. Mongolian Information Development Association (2005), The Mongolian Information and Communications Technology (ICT) Worltforce Demand Survey, 2005, July 2005. MongolianPopulation and Development Association. (2006). Status and Consequences of Mongolian Citizens WorkingAbroad, The Mongolian Population and Development Association, Ulaabataar, Mongolia. Ministry of Industry and Trade (2006), Mongolia Industrial Sector Development Strategy: Priority Sector Policy, 2006; and supporting exhibits (processed). Ministry of Social Welfare and Labor. 2006. Status of the Labor and Social Welfare Assistance in 2005, Ministry of Social Welfare and Labor, Ulaabataar, Mongolia. Nathan Associates, Mongolia Meats and Hides Industries CompetitivenessStudy - InternationalMarket Review, July 2005, pp. 22, 38. National Statistical Office of Mongolia (2003). Internal Migration and Urbanization in Mongolia: Analysis based on the 2000 Census,NSO, Ulaanbaatar, Mongolia, 2003 Otsuka, K.(2006) "Development of Industrial Clusters: East Asia Experience andNew Development Strategy for Africa," paper presentedat the World Bank, November. Otto, James, Craig Andrews, FredCawood, Michael Doggett, Pietro Guj, Frank Stermole, John Stermole and John Tilton (eds.), (2006). Mining Royalties: A Global Study on their Impact on Investors, Government and Civil Society, World Bank: Washington, DC. Pearce, D.W., and G. Atkinson. (1993). "Capital Theory andthe Measurement of SustainableDevelopment: An Indicator of Weak Sustainability." Ecological Economics 8 (2): 103-108. Rodrik, Dani(2004), GrowthStrategies. John F. Kennedy School of Government, Harvard University, Cambridge, MA: Dani Rodrik, August 2004. pp. 1-57. Rodrik, Dani (2005), why We Learn Nothingfrom RegressingEconomic Growth on Policies. John F. Kennedy School of Government, Harvard University, Cambridge, MA: Dani Rodrik, March 2005. Rodrik, D. (2004) "Industrial Policy for the Twenty-first Century," manuscript, Harvard University. REFERENCES - 169- SamuelsonP. 1961. "The Evaluation of "Social Income"" Capital Formation and Wealth", inF. A. Lutz and D. C. Hague (eds.), The Theory of Capital,New York: St. Martin's Press. Shagdarsuren O., D. Sumya, E. Gombobaatar, E. Potapov, andN.Fox. (2001) "Saker Falcon inMongolia, Numbersand Distribution." inBanzragch, S., E. Potapov, N.C. Fox, andN.W.H. Barton (eds.) Proceedings of the 11International Conference on the Saker Falcon and Houbara Bustard, Ulaanbaatar, Mongolia. Sommer, Y. (2003) Urban Land ManagementAssessment: Ulaanbaatar.Mongolia: SecondUlanbaatar Services Improvement Project (UBSIP 11). State Street Global Advisors, WhoHolds the Wealth of Nations? August 2005. Tarr, D., 0.Shepotylo, T. Koudoyarov (2005) "The structure of import tariffs inRussia: 2001-2003," working paper. Townsend S. and P. Zahler (2006) "Siberian marmot survey inthe Eastern Steppe of Mongolia: Evidence of a severe decline." inSymposium of the Fifth International Conference on GenusMarmota, Instituteof Zoology, Uzbekistan Academy of Sciences. UNCTADIWTO (2006) Export Potential Assessment in Mongolia, Project MONIA1/O 1A Creation of Geographical Indications inMongolia, International Trade Centre, UNCTAD/WTO. UNDP (2004). Report on UrbanPoverty and Migration in Mongolia, 2004. UNIDO (2002) Mongolia: Industrial and Trade Development Policy Review, United National Industrial Development Organization, November. USAID(2005), Economic Policy Reformand Competitiveness Project (EPRC), A Value Chain Analysis of the Mongolian CashmereIndustry, May 2005 USAID(2006), Economic Policy Reformand Competitiveness Project newsletter, various issues. Venables, 2003. (cited in Chap 4, Box 4.2) Wingard J.R. and P. Zahler. 2006. Silent Steppe: The Illegal Wildlife Trade Crisis in Mongolia. Discussion Papers, East Asia and Pacific Environment and Social Development Department.Washington D.C.: World Bank. Woetzel, JonathanR., Capitalist China: Strategiesfor a Revolutionized Economy, (Wiley, 2003), p. 85 -170- REFERENCES COUNTRYECONOMICMEMORANDUM World Bank (1997) Mongolia: Country Economic Memorandum, Policiesfor Faster Growth, Reportno. 16749-MOGYAugust 1997. World Bank (2006a), Mongolia: Macroeconomic BrieJ Preparedfor the Annual DevelopmentPartnersMeeting, February2006. World Bank (2006b), Mongolia: Poverty Assessment, Reportno. 35666O-MNyApril 2006. World Bank (2006~)~ Mongolia: Government Financial Sector Reform Program, 2000- IO, draft Mid-termReviewReport,June 2006. World Bank (2006d), Bank Lending Rates in Mongolia, Backgroundpaper for CEM, preparedby Hiroshi Akama, August 2006. World Bank (2006e). Mongolia: Promoting investment andjob creation: An investment climate assessment and trade integration study, World Bank, WashingtonDC. World Bank. (20060. Development and Next Generation, World Bank, WashingtonDC. World Bank. (2006g). Doing Business in 2007: How to Reform, World Bank, WashingtonDC. World Bank (2006h), Governance, Investment Climate, and Harmonious Society: CompetitivenessEnhancementsfor I20 Cities in China, October 2006. World Bank.(2006i). Where is the Wealthof Nations? Measuring Capital in the 21'` Century. WashingtonDC: The World Bank. World Bank (2006j). Mongolia: A Review of Environmental and Social Impacts in the Mining Sector. World Bank, Washington, D.C. World Bank (2005). Equity and Development. World DevelopmentReport, World Bank: Washington, DC. World Bank (2004). Mongolia Environment Monitor, World Bank, Washington DC, 2004. World Bank (2003), From Goats to Coats: Institutional Reform in Mongolia's Cashmere Sector, report26240-MOGY19December2003. World Bank (2002), From Natural Resourcesto the Knowledge Economy: Trade and Job Equality, Latin American and CaribbeanStudies, 2002, pp. 38-44. Wright, GavinandJesse Czelusta(2007), "Resource-based GrowthPast and Present," in REFERENCES - 171- MONGOLIA: Lederman,Danieland William Maloney(eds.). Natural Resources; Neither Curse nor Destiny, World Bank and StanfordUniversity Press: Washington, DC. 2007. pp. 183- 212. -172- REFERENCES ANNEX I Mongolia at a glance 517107 1 Easl Key Development Indicators Asia 8 Low Mongolia Pacific income Age distribution, 2005 (2006) Mala Female Population, mid-year (millions) 2.6 1,885 2,352 Surfacearea (thousand sq. km) 1,567 16,300 29,262 Population growth (%) 1.2 0 9 1 8 tirban population (% of total population) 57 41 30 GNI (Atlas method. US$billions) 1.9 3,073 1,377 GNI per capita (Atlas melhod,US$) 720 1,630 585 GNI per capita (PPP, international$) 2,190 6,060 2,470 GDP growth (70) 8.4 8 9 8 0 15 10 5 0 5 10 I 5 GDP per capita growth (%) 7.1 8 0 6 1 percent (most recent esiirnaie, 20&2006) I Poverty headcounl ratio at $1 a day (PPP, %: 11 9 Poverty headcount ratio at $2 a day (PPP, %) 45 37 Under4 mortality rate (per 1,000) Life expectancy at birth (years: 67 71 59 Infant mortality (per 1,000live births) 39 26 75 '*$l Child malnutrition (70of children under 5) 13 15 Adult literacy, male (% of ages 15 and older) 98 Adult literacy. female (% of ages 15 and older) 98 Gross primary enrdlment. male (% of age group) 117 115 106 Gross primary enrollment,female (% of age group! 119 113 96 1I Access to an improvedwater source ( O hof population) 62 79 75 Access to improved sanitation facilities (Oh of population) 59 51 33 1330 1335 2000 2005 OMongoiia East Asia d Pacific I Net Aid Flows 1980 1990 2000 2006# I (USS millions) Net ODA and oficial aid 2 13 217 212 Growth of GDP and GDP per capita 1%) Top 3 donon (in 2005) Japan 2 105 56 Germany 4 19 28 ' 5 T United States 13 18 10 5 Aid (% of GNI) 0 1 0.7 23 2 10 4 0 Aid per capita (US$) 1 6 91 83 5 .10 Long-Term EconomicTrends 90 35 00 05 Consumer prices (annualYOchange) 325 5 8 1 5 9 GDP implicit deflator (annual % change) 2 0 0 0 9 0 15 9 --9-GOP -GOP p0rcapila Exchangerate(annual average, local per US%) 3 0 5 0 1.0767 1,1796 Terms of trade index (2000= 100) 100 110 1980-90 1990-2000 2000-06 (average annualgrowthX) Population, mid-year(millions) 1 7 2 1 2 4 2 6 2.4 1.3 1 2 GDP (US%millions) 2,310 2 093 941 2689 5.4 1.o 6 6 (IGDP) of Agriculture 16 7 15 2 338 21 1 1 4 2 5 2 6 Industry 25 0 40 6 243 439 6 6 -2 5 7 6 Manufactunng 35 6 5 4 5 3 -9 7 5 8 Services 58 3 44 2 42 1 34 9 8 4 0 7 7 9 Household final consumptionexpenditure 52 3 61 6 546 450 General goVt final consumptionexpenditure 24 9 29 8 18 1 14 7 Gross capital formation 70 0 35 6 44 1 36 0 Expods of gwds and services 23 9 22 4 652 736 Imports of goods and services 71 0 49 4 823 695 Gross savings 22 3 6 3 367 492 Note Figures in italics are for years other than those specified 2006 data are prelirninar/ Group data are for 2005 indicates data are not availablf a Aid data are for 2005 Development Economics. DevelopmentData Group (DECDG) Mongolia Balance of Payments and Trade 2000 2006 Governance indicators, 2000 and 2005 (US%millions) Total merchandiseexports (fob) 536 1,543 Total merchandiseimports(uf) 676 1.486 Voice and accountability Net trade in goods and services -158 193 Poiiticai stability Workers'remittancesand compensationof employees(receipts) 12 202 Regulatoryquality Current account balance -69 459 Ruleof law as a % of GDP -7.3 17.1 Controlof mnuption Reserves,induding gold 141 718 0 25 50 75 100 Central Government Finance 2000 2005 a2005 Counlryr percentilerank p1W) 02000 hrgher VaIYW mply bsmr Wmg8 (UofGOP) Revenue 39.0 Sourw KauhnanwKraay-Ma8tru~1World Bank Tax revenue 22.3 Expense 30.4 Technology and Infrastructure 2000 2005 Cash surpluddefiut -0.5 Paved roads (% of total) 3.5 Highest marginaltax rate (%) Fixedline and mobile phone Individual subscnbers(per 1,000 people) 113 279 Corporate Hightechnology exports (% of manufacturedexports) 0.5 0.1 External Debt and Resource Flows Environment (US%millionsj Total debt outstanding and disbursed 896 1,327 Agriculturalland (% of landarea) 83 83 Total deM semce 39 45 Forest area (% of land area, 2000 and 2005) 6.8 6.5 HlPC and MDRl debt relief (expected flow: - - Nationally protectedareas (% of landarea) .. 13.9 Total debt (% of GDP) 95.2 63.3 Freshwaterresources per capita (cu. meters) .. 13,626 Total debt ServIW (%Of exports) 6.2 2.8 Freshwaterwithdrawal (% of internalresources: 1.3 Foreign direct investment (net inflows) 54 182 C02 emissions per capita (mt) 3.1 3.2 Portfolioequity (net inflows) 0 0 GDP per unit of energy use (2000 PPP $ per kg of oil equivalent) Composition of total external debt, 2005 Energy use per capita (kg of oil equivalent) 006 (US%millions) IBRD Total debt outstandingand disbursed - Disbursements -- -- -- - Principalrepayments Interestpayments US$ millions IDA Totaldebt outstandingand disbursed 137 277 Disbursements 14 14 Private Sector Development 2000 2006 Total debt service 1 4 Time required to start a business (days) - - 20 IFC (fiscalpar) Cost to start a business(% of GNI per capita) 5.1 Totaldisbursed and outstandingportfolio 1 6 Time requiredto register property(days: - 11 of which IFC own account 1 6 Disbursementsfor IFC own account 0 6 Ranked as a major constraintto business Portfoliosales, prepayments and (% of managerssurveyedwho agreed) repaymentsfor IFC own accouni 0 0 Tax rates 64.9 Access to/cost of financing .... 64.4 MlGA Grossexposure 0 20 Stock market capitalizalion(% of GDP) 3.9 1.5 New guarantees 0 20 Bank branches(per 100,000 people) Note:Figures in italicsare for years other than those specified. 2006 data are preliminary 5/7/07 .,indicates data are not available. -indicates observationis not applicable DevelopmentEconomics,DevelopmentData Group (DECDG) Millennium Development Goals Mongolia With selected targets to achieve between 1990and 2015 (estimate closest to date shown, +/- 2years) Goal 1: halve the rates for S I a day poverty and malnutrltior 1990 1995 2000 2005 Povertyheadcount ratio at $1 a day (PPP, %of population) 13.9 10.8 Povertyheadcountratio at national povertyline (% of population) 36.3 43.1 36.1 Share of incomeor consumptionto the poorestqunitile (%) 7.3 7.5 Prevalence of malnutrition(% of children under 5) 12 13 Goal 2: ensure that children are able to complete primary schooling Primaryschool enrollment (net.%) 90 91 89 Primarycompletionrate (% of relevant age group) 76 87 97 Secondaryschool enrollment (gross,%) 82 63 94 Youth literacy rate (% of peopleages 15-24: 98 Goal 3: eliminate gender disparity in education and empower womer Ratio of airlsto bow in Drimarvand SeCOndaNeducation(%) 113 119 116 Women employed.in the nonagriculturalsectdr (% of nonaghculturalemployment) 44 47 49 50 Proportionof seats held by women in nationalparliament(%) 25 8 8 7 Goal 4: reduce under-5 mortality by two-thirds Under-5 mortalityrate (per 1,000) 108 07 65 49 Infant mortalityrate(per 1,000 live births) 78 64 50 39 Measlesimmunization (proportionof one-year olds immunized,%: 92 85 94 99 Goal 5: reduce maternal mortality by three-fourths Maternalmortalityratio(modeledestimate,per 100,000 live births) 110 Births attendedby skilledhealthstaff (% of total) 97 97 Goal 6: halt and beginto reverse the spread of HlViAlDS and other major diseases Prevalence of HIV (% of populationages 15-49) 0.1 Contraceptiveprevalence(%of women ages 15-49) 67 69 Incidenceof tuberculosis(per 100,000people) 219 209 200 191 Tuberculosis cases detectedunder DOTS (%) 7 62 82 Goal 7: halve the proportion of people withoutsustainable access to basic needr Access to an improvedwater source (% of population) 63 62 Accessto improvedsanitation facilities (% of population) 59 Forest area (% of total land area) 7.3 6.8 6.5 Nationallyprotectedareas (% of total landarea) 13.9 C02 emissions(metrictons per capita) 4.7 3.5 3.1 3.2 GDP per unit of energy use (constant 2000 PPP $ per kg of oil equivalent) Goal 8: develop a global partnership for development Fixedline and mobilephone subscribers(per 1,000 people) 32 34 113 279 Internetusers (per 1,000people) 0 0 13 105 Personalcomputers(per 1,000 people) 3 13 133 Youth unemployment(% of total laborforce ages 15-24) 22.8 Education indicators (%) Measles immunization (% of I-year olds) ICT Indicators (per 1,000 people) 3001 n 200 100 1998 2000 2002 2004 0 2000 2002 2005 +Primarynetenrnllmenl ratio +Ratio of pirh to boys in pnmary 8 0Mongolia 0EastAsia 8 Paufic DFlxed + mobile subswbers secondary education mlntemet users Note:Figures in italicsare for years other than those specified. .. indicatesdata are not available 5/7/07 DevelopmentEconomics,DevelopmentData Group (DECDG). MONGOLIA: ANNEX I1 Mongolia Growth Diagnostics This annex provides details of the "Growth Diagnostics" approach that was applied to Mongoliato highlight the key areas that need immediate policy intervention by the Government in order to have the largest total positive impact (including hard-to- measure indirect effects) on economic growth over the next decade. LOOKINGTHECONSTRAINTS AT The recent economic growth literature suggests that developing economies exhibit significant slack once relevant constraints are relaxed and can respond very vigorously to small-scale (and strategic) interventions in the economic environment to unleash this growth potential. To design appropriate strategies, however, one needs to undertake continuous diagnosis, experimentation and evaluation. Therefore, if one's objective is to promote high, sustained, private sector-oriented growth with efficient use of all resources (public and private), as is the intention in Mongolia, one will need to address several inter-related questions, including whether the level of private investment inthe country is low? Investment could be low because returns to capital are low or because the cost of finance is high. In turn, returns to capital may be low due to insufficient investment in complementary factors o f production (such as infrastructure and human capital), low land productivity (perhaps, due to poor natural resource management), or low private returns to capital (perhaps, due to hightaxes or high appropriability so that even ifone invested it would not be translated into adequate cash flows), poor property rights, corruption, macro instability, and market failures (such as coordination externalities and adverse learning externalities that adversely effect the ability to adopt new technologies), and the like. Alternatively, the cost of finance may be high because the country has limited access to external capital markets or because of problems in the domestic financial market. A country may have difficulties accessing external capital markets for a variety of reasons including high country risk, unattractive FDI conditions, vulnerabilities in the debt maturity structure, and excessive regulations of the capital account. Inadequate or inappropriately priced local finance may be due to low domestic saving and/or poor domestic financial intermediation. Figure A2.1 summarizes this kind of "growth diagnostics" approachthat we use inthis report to examine the situation inMongolia.2 In theory, this economic growth literature suggests that when constraints are "binding", they result in activities that are designed to get around them. Symptoms that one sees under these circumstances include: high taxes; high degree of informality in ' See Dani Rodrik (2004) and Dani Rodrik (2005) for a summary of the recent thinking in the Economic *Growthcalled literature. Also a "growth diagnostic tree diagram" a la Hausmann, Rodrik and Velasco (2005) that is typically usedto organize the thinking aboutthe "binding constraints" to private sector growth in a country. An exercise in growth diagnostics consists of reviewing and analyzingthe factors found alongthe branches of the growth diagnostic tree in order to ascertain which of these factors are most binding constraints to growth. Although, all factors are likely to matter for growth and welfare, the ones that are most binding are those that are likely to provide the largest positive direct effect, so that even after taking into account second-bestinteractions, the net impact of a policy change remains positiveandsizable. - 176- Annex II: COUNTRYECONOMICMEMORANDUM economic activities; poor legal institutions; high demand for informal mechanisms of conflict resolution and enforcement; poor financial intermediation; and internationalization of finance through business groupskonnected lending operations; among others. Therefore, in applying the growth diagnostics method to the case of Mongolia we rely on direct and indirect evidence to identify "bottlenecks" to economic growth, andbecause the aggregate picturetypically hides important details at the industry level, we use aggregate as well as industry and firm-level data.3 I s private investment in Mongolia low? Gross domestic investment in Mongolia has been high by international standards. In the past ten years gross domestic investment in Mongolia averaged 34.5 percent of GDP (Table A2.1). This average investment-to-GDP ratio was comparable to the average investment ratio in the East Asia regionfor this period. It was also much higher than the investment ratio one saw in the low income countries, on average, as well as, in the averagefor the group of land-locked, resource-rich countries in CentralAsia. However, the majority of investment in Mongolia was funded by foreign financing, primarily foreign aid. In fact, the share of foreign aid in gross investment has averaged 60 percent over the past ten years (Table A2.1). In 2004 this share was approximately four times the share in low income countries. Domestic investment has grown slightly, but is a minor share intotal investment (Figure A2.2). The small share of domestic investment implies that the economy is dependent on foreign funds which are uncertain by nature, and may decline substantially if global demand for commodities slumps. The bulk of private investment inMongoliawent into a limited numberof sectors -mining and construction, and into a very small number of firms operating in these sector^.^ In 2004 investment in the construction and mining sectors accounted for nearly 60 percent of gross investment in Mongolia (Table A2.1). Investment in the mining sector alone accounted for 15 percent of total investment, 33 percent of investment in machinery, equipment and tools, 59 percent of private investment, and a large share of foreign investment. It should be noted that, with the exception of livestock herding, the official GDP statistics that are used here do not capture the activities of Mongolia's large and growing informal sector. In 2005, the informal sector allegedly producedoutput equivalent to 18 percent of GDP and employed as much as 35 percent of Mongolia's working age population (comparedto 20 percent inthe early nineties). Official export data also understate the importance of cashmere exports, since a large share of raw cashmere gets smuggled every year. In 2002, over 38% of the raw cashmere produced was allegedly smuggled to China (Source: World Bank, From Goatsto Coats,2003a) 4 In2004 private f m s operating inminingand construction were 0.7 percent and2.7 percentof all private f m s , respectively. A large number of Mongolian private f m s provided wholesaleand retail trade services (40 percent), and utilities, social sector services, and public administration services (32.9 percent). Manufacturing firms represented only 5.7 percent of all private f m s , private agricultural firms - 5.1 percent, hospitality f m s - 3.2 percent, transport - 2.1 percent, financial real estate and business - 7.5 percent. Mongolia GrowthDiagnostics - 177- COUNTRYECONOMICMEMORANDUM Foreign direct investment (FDI) grew at a rapid pace in the past ten years. As a share of GDP FDI rose from 1.4 percent in 1996 to 10.4 percent in 2003 before it fell down to 5.8 percent in 2004, but recovered to 9.8 percent in 2005. The average share of FDI for the ten year period was 5.2 percent of GDP and was higher than the average of East Asia and more than three times the average of low income countries (Table A2.1). Most of foreign direct investment however was attracted by a single sector-mining.5 The share of FDI attracted by mining rose from 46 percent of total FDI in 2001 to 68 percent of total FDIin2005.6 Domestic private investment has increased in importance, but in 2004 its share in total investment was still relatively small. Only one third of the total private domestic investment was financed by bank loans (Table A2.3). Although domestic credit to the private sector has been growing at high rates,7 the vast majority o f bank loans has been short term and has financed mainly wholesale and retail trading activities, rather than investment projectse8 Some FDI went into the service sectors, but a large portion of it was low quality investment made by individuals rather than companies (Source: Mr. Otgonbat, Vice Chairman of Foreign Investment and ForeignTrade Agency.) 6 Foreign direct investment in mineral and petroleum exploration and development activities expanded from US$148million in 2004 to US$191million in 2005. 7Accordingto the IMF (2005) private credit grew at a rate of more than 200 percent in 2002 and 2003, and 33 percent in 2005. In 2005 domestic credit to the private sector was close to 40 percent of GDP- higher than domestic credit to the private sector in low income countries, but lower than domestic credit in *Vietnam, World andthe average for the middleand high income countries. Source: Bank(2006b) and FitchRatings(2006). Mongolia Growth Diagnostics - 179- MONGOLIA: Table A2.1: Cross-country Comparisonof Saving and InvestmentIndicators,1996-2005 1996-2000 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average Foreign savings in Mongolia 3.1 -9.8 7.7 5.7 7.4 6.1 9.4 7.2 -3.9 0.3 3.3 National Savings in Mongolia 26.8 37.9 27.5 31.3 28.8 30.0 22.8 30.8 40.4 35.2 31.1 Gross capital formation (% of GDP) Mongolia 29.9 28.1 35.2 37.0 36.2 36.1 32.2 38.0 36.5 35.5 34.5 Cambodia 14.5 14.8 11.7 17.4 16.9 18.7 20.1 25.2 25.8 18.3 Vietnam 28.1 28.3 29.0 27.6 29.6 31.2 33.2 35.4 35.6 30.9 Azerbaijan 29.0 34.2 33.4 26.5 20.7 20.7 34.6 53.2 53.5 34.0 Kazakhstan 16.1 15.6 15.8 17.8 18.1 26.9 27.3 25.7 26.3 27.5 21.7 KyrgyzRep. 25.2 21.7 15.4 18.0 20.0 18.0 17.6 11.8 13.8 20.4 18.2 Uzbekistan 29.2 21.7 20.2 17.5 16.3 19.6 20.3 20.2 24.5 25.1 21.5 Ghana 21.2 24.8 23.1 20.9 24.0 26.6 19.8 22.9 27.9 29.6 24.1 Uruguay 15.2 15.2 15.9 15.1 14.0 13.8 11.5 13.1 13.3 14.1 East Asia and Pacific 36.5 34.8 30.8 29.5 29.9 30.8 31.5 33.1 34.4 32.4 Low Income Countries 20.9 21.1 20.8 21.9 21.3 21.5 21.9 22.3 23.0 21.6 Foreignaid (YOof gross capital formation) Mongolia 56.9 84.9 59.5 66.4 63.5 57.8 57.1 51.4 44.3 60.2 Cambodia 82.9 65.8 92.4 45.2 64.6 59.3 59.2 46.5 38.0 61.5 Vietnam 13.6 13.1 14.9 18.0 18.2 14.2 11.0 12.6 11.4 14.1 Azerbaijan 10.5 13.6 8.1 14.0 12.8 19.7 16.2 7.8 3.8 11.8 Kazakhstan 3.7 4.1 6.4 5.8 5.7 2.5 2.8 3.4 2.3 4.1 Kyrgyz Rep. 50.1 62.5 94.2 125.8 78.4 69.0 65.8 88.1 84.9 79.9 Uzbekistan 2.2 4.4 5.2 5.2 8.3 6.9 9.6 9.5 8.3 6.6 Ghana 44.3 28.9 40.7 37.9 50.3 45.6 53.3 54.7 54.9 45.6 Uruguay 1.1 1.0 0.7 0.7 0.6 0.6 0.9 1.1 1.3 0.9 East Asia and Pacific 1.5 1.3 1.9 2.1 1.7 1.3 1.1 0.9 0.7 1.4 Low Income Countries 14.6 12.1 12.8 10.9 11.0 11.9 13.4 13.3 11.9 12.4 FDI(%of GDP) Mongolia 1.4 2.4 2.0 3.3 5.7 4.2 7.0 10.4 5.8 9.8 5.2 Cambodia 8.4 5.9 7.8 6.6 4.0 3.9 3.6 1.9 2.7 5.0 Vietnam 9.7 8.3 6.1 4.9 4.2 4.0 4.0 3.7 3.6 5.4 Azerbaijan 19.7 28.1 23.0 11.1 2.5 4.0 22.3 45.1 41.0 21.9 Kazakhstan 5.4 6.0 5.2 9.4 7.0 12.8 10.5 6.8 9.5 8.1 Kyrgyz Rep. 2.6 4.7 6.6 3.6 -0.2 0.3 0.3 2.4 3.5 2.6 Uzbekistan 0.6 1 . 1 0.9 0.7 0.5 0.7 0.7 0.7 1.2 0.8 Ghana 1.7 1.2 2.2 3.2 3.3 1.7 1.0 1.8 1.6 2.0 Uruguay 0.7 0.6 0.7 1.1 1.3 1.5 1.4 3.7 2.4 1.5 East Asia and Pacific 3.9 4.0 4.1 3.3 2.6 2.7 2.9 2.6 2.5 3.2 Low Income Countries 1.3 1.5 1.3 1.2 1.3 1.5 1.6 1.4 1.4 1.4 Source: WorldBank (SIM) - 180- COUNTRYECONOMICMEMORANDUM Table A2.2: Compositionof Total Investment,2001-04 (percentageshare oftotal investment) 2001 2002 2003 2004 Construction 29.3 34.9 40.6 41.9 Machinery,equipment andtools 44.9 50.6 49.1 46.3 o/w mining 14.8 11.2 9.1 15.4 Others 25.8 14.5 10.3 11.8 Source: Mongolian Statistical Yearbook (2004). Table A2.3: Domestic Investment in Mongolia,2001-2004 Investment 2001 2002 2003 2004 Government (% of domestic investment) 38.0 37.2 36.1 35.5 Privatedomestic (% of domestic investment) 62.0 62.8 63.9 64.5 Privatedomestic (% of investment) 21.6 22.7 23-3 26.4 Bank loans (% of private domestic investment) 16.5 30.3 30.6 31.9 Own funds (% of privatedomestic investment) 83.5 69.7 69.4 68.1 Bank loans (YOof investment) 3.6 6.9 7.1 8.4 Source: Mongolian Statistical Yearbook (2004). Hence, the question that follows from this is whether private investment outside the miningand construction sectors has beenlow because of highcost of capital or due to low rates of return. This is critical if one needs to ensure that Mongolia's future growth and employment generation is broad-based. I s the cost of capital in Mongolia high? Real interest rates in Mongolia are high, but they have come down substantially since the late nineties (Figure A2.3). Although nominal deposit rates remained stable and high in the period 2001-2005, real lending rates came down from 30 percent in 2001 to 11 percent in 2005.' This drop inthe real cost of capital was due mostly to a rise in the inflation rate, rather than a decline in the risk premium (Figure A2.4). Inthe absence of any changes to the deposit rate and the risk premium, a drop in inflation from 13 percent in2005" to 4.5 percent in2006 is likely to reversethe decline inthe real lending rate and result in an increase in the real cost of capital above 15 percent. Indeed, real deposit and lending rates have risen significantly even when inflation has declined recently. (Figure A2.5). 9 The real lendingrateis definedas the ratechargedon loansto primecustomers on loansofany maturity. loIn2005 inflationary pressures in Mongoliawere muchhigher than those incomparatorcountries such as Vietnam, Cambodia, Kazakhstan,Kyrgyz Rep.,andUruguay. Mongolia Growth Diagnostics - 181 - Figure A2.2: Domestic investment is on the rise in - Mongolia ... Figure A2.3: as the cost of capital declines. 700 70 A ea , ,,x, l9W 1887 1898 1- 2wO 2W1 2W2 2W7 2W4 2005 2001 2002 2003 2004 I +-Mongoha --Cambodia +Vietnam *KyrgyrRepublic Source: Mongolian Statistical Yearbook (2004). Source: WorldBank (SIMA)). Figure A2.4: Real cost of capital has declined Figure A2.5: Cost of capital is high because of primarily due to increaseinthe inflation rate high deposit interest rates and risk premiums. rather than declinesin the risk premium. 251 20 10 15 / 10 5 0 Mongolia Arerbai)an Cambodie Kyrgyz Vietnam Urnway Republic mtmposn interest rate mkterest rate spread llendngrate minus depDsit rate) Table A2.4: Interest Rate Spreads (lending minus deposit rate), 1996-2005 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Mongolia 43.2 45.7 19.3 15.9 15.9 15.9 15.2 12.3 11.2 10.6 Cambodia 10.0 10.4 10.5 10.2 10.5 12.1 13.7 16.5 15.8 15.4 Vietnam 20.1 5.9 5.2 5.3 6.9 4.1 2.6 2.9 .. 3.9 Azerbaijan .. 7.4 6.8 11.2 8.7 5.9 6.5 8.5 Kyrgyz republic 28.3 9.8 37.7 25.3 33.5 24.8 18.9 14.1 22.6 20.8 Uruguay 43.5 37.6 31.6 28.5 27.8 27.0 55.8 29.3 17.5 10.8 East Asia & Pacific 6.1 6.2 5.6 5.9 6.9 5.9 5.9 5.9 6.3 5.5 Low income countries 11.5 10.6 12.7 12.7 12.9 13.7 13.0 12.4 11.9 11.0 Low & middle income 8.7 8.4 9.3 8.3 8.4 8.3 8.6 8.2 7.4 7.3 Middle income countries 7.6 7.4 7.7 7.5 7.6 7.6 7.2 7.1 6.5 6.5 Highincome countries 3.9 3.5 3.8 3.9 4.1 4.1 4.1 World 7.2 7.0 7.6 7.1 7.4 7.1 7.2 7.1 6.5 6.5 Source: WorldBank Note: Datafor Kazakhstan, Uzbekistan and Ghana were not available. The reasons for the high cost of capital in Mongolia cannot be traced to inadequate or expensive international finance. Mongolia's official debt is primarily - 182- Annex II: COUNTRYECONOMICMEMORANDUM concessional, long-term debt. The share of concessional debt in total external debt averaged 85 percent over the past ten years, and i s much higher than the average for low income countries (51 percent) and East Asia (20 percent) (Table A2.5). Mongolia continues to have little trouble obtaining concessional finance as the levels of these external inflows have remained relatively stable over the past decade. InDecember 2005, concessional loan agreements have been entered into with China (US$300 million), and South Korea, among others. Significant additional grant financing over the next few years from the U.S.MillenniumChallenge Corporation (MCC) is also being negotiated. Table A2.5: ExternalFinance in Mongolia is not Costly 1996 1997 1998 1999 2000 2001 2002 2003 2004 Period Average External debt (% of GNI) Mongolia 45.8 58.3 74.7 102.4 96.0 87.2 93.1 116.6 94.7 85.4 Cambodia 68.9 70.2 80.5 73.5 74.4 73.9 74.1 75.3 72.5 73.7 Vietnam 108.2 82.6 84.1 82.0 41.7 39.0 38.7 40.6 40.1 61.9 Azerbaijan 14.1 12.9 16.0 23.7 27.2 24.2 25.6 25.5 25.4 21.6 Kazakhstan 14.0 18.7 27.9 37.5 72.5 70.8 73.3 78.2 85.1 53.1 Kyrgyz republic 63.6 78.7 96.1 147.7 142.1 117.5 119.5 109.2 99.3 108.2 Uzbekistan 17.1 19.9 22.5 29.1 34.1 43.4 50.1 50.1 42.0 34.3 Ghana 85.3 84.6 86.2 85.1 126.6 121.9 115.4 101.2 80.0 98.5 Uruguay 29.4 31.1 34.8 35.8 40.0 53.2 87.3 106.4 97.7 57.3 East Asia & Pacific 33.4 34.3 38.4 35.3 29.7 28.9 25.9 24.0 22.5 30.3 Low income countries 53.2 48.8 51.1 48.0 44.8 41.7 41.4 39.4 35.6 44.9 Concessionaldebt (% oftotal external debt) Mongolia 76.2 81.7 87.0 89.6 91.2 91.5 90.3 76.3 85.2 85.4 Cambodia 90.8 90.5 90.5 90.2 88.2 88.4 88.9 89.3 89.0 89.5 Vietnam 75.8 15.3 20.0 24.0 61.3 66.4 72.4 73.9 71.4 53.4 Azerbaijan 14.7 23.2 23.3 28.3 29.4 35.4 46.1 53.8 57.7 34.7 Kazakhstan 4.4 4.1 4.4 6.5 3.3 2.6 2.9 3.3 3.0 3.8 Kyrgyz republic 32.3 34.6 41.9 46.1 48.2 56.6 62.5 68.0 74.5 51.6 Uzbekistan 25.9 27.1 28.7 26.6 30.4 30.1 32.7 35.6 37.6 30.5 Ghana 62.9 65.7 68.1 70.7 73.3 70.4 71.7 75.0 74.3 70.2 Uruguay 3.6 3.5 3.2 3.3 2.6 2.1 1.7 1.5 1.4 2.6 East Asia & Pacific 19.2 14.1 17.7 20.0 20.9 19.3 21.2 22.3 22.1 19.6 Low income countries 49.4 45.8 47.5 49.4 49.0 50.2 52.9 56.9 56.4 50.8 Short-termdebt (%oftotal external debt) Mongolia 0.9 4.2 3.9 2.4 1.4 1.6 4.3 19.4 11.0 5.4 Cambodia 4.5 5.2 5.5 6.0 8.6 8.3 7.5 7.1 7.8 6.7 Vietnam 14.3 10.8 9.8 10.2 7.2 6.2 5.9 8.1 12.0 9.4 Azerbaijan 3.5 0.8 0.2 2.7 11.6 7.9 5.5 5.9 6.9 5.0 Kazakhstan 7.6 8.6 7.0 7.7 7.7 9.0 10.7 12.5 11.1 9.1 Kyrgyz republic 0.8 2.5 1.9 3.5 7.1 2.8 1.0 1.9 0.4 2.4 Uzbekistan 3.8 14.5 4.4 12.7 6.1 10.4 6.9 4.4 3.6 7.4 Ghana 11.2 11.7 11.3 11.0 9.4 8.7 8.5 9.2 10.0 10.1 Uruguay 28.2 28.5 26.5 24.0 23.5 30.3 15.1 12.6 16.0 22.7 East Asia & Pacific 26.1 25.1 15.9 13.5 12.6 20.5 22.7 26.0 29.7 21.3 Low income countries 11.8 10.7 10.0 10.0 8.0 7.8 7.5 7.6 8.5 9.1 Source: WorldBank (SIMA));Datafor 2005were not available. Mongolia Growth Diagnostics -183- MONGOLIA: Inward FDI was high in Mongolia (at 9.8 percent of GDP, compared with the medianof only 1.7 percent for Fitch's `B' rated countries)." Rising official reserves and commercial bank assets helpedpushthe 2006 liquidity ratio to over 600 percent (notably higher thanthe comparable Fitch's `Bycountry group medianof 170 percent). It explains why Mongolia is rated more favorably than its `Bypeer group. Looking at the cost and access to domestic financing, domestic savings have fluctuated a lot during the past decade, but on a trend basis has increased substantially in the past few years. As a share of GDP, domestic saving fell from 19percent in2001to 11 percent a year later,I2 but increased to 25 percent in 2004, and rose again slightly thereafter (Table A2.6). Although low compared to saving in East Asian countries, the average ratio of domestic saving to GDP in Mongolia for the period 1996-2005 (22 percent) is higher than the average for low income countries with comparable interest spreads between deposit and lending rates (Tables A2.4 and A2.6). Table A2.6: Gross DomesticSavings (% of GDP) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Period Average Mongolia 22 34 22 23 21 19 11 18 25 26 22 Cambodia -4 3 -1 4 5 1 1 12 16 15 7 Vietnam 17 20 22 25 27 29 29 27 28 25 Azerbaijan 3 I O 2 13 21 24 27 30 30 .. 18 Kazakhstan 15 13 11 20 26 26 27 31 35 37 24 Kyrgyz republic -1 14 -6 3 14 18 14 5 4 0 7 Uzbekistan 23 19 20 17 19 20 22 27 32 33 23 Ghana 13 4 10 3 5 7 8 11 8 11 8 Uruguay 15 15 15 14 12 12 13 15 15 .. 14 East Asia & Pacific 37 37 36 34 34 34 35 37 38 36 Low income countries 18 18 17 18 20 20 20 20 20 .. 19 Source: WorldBank This increase in domestic saving has been due to the strong GDP growth and balance of paymentsposition of Mongolia over the past few years. This, inturn, has been due to favorable terms of trade, new mining operations, strong tourism revenues, remittances from abroad, and robust capital flows inthe mining sector.13Indeed, receipts from remittances have grown significantly since 1997 (when no remittance receipts were recorded) to a peak of US$195 million in 2004. But in 2005 remittances' growth was negative for the first time since 1997. This was allegedly due to the closure of illegal representative offices o f Mongolian banks in South Korea.14 The sharp drop in I]Insurersinthe Fitch's `B' peer group are viewedas weak with a poor capacity to meet policyholderand contract obligations. The fall in domestic saving in 2002 reflectedthe shock of bad weather to agriculture. 13Remittances and proceeds from businesses contributed 30-40 percent of growth in deposits in 2005, accordingto data from BOM. I4 GoM has approached the South Korean government for banking licenses to enable the Mongolian commercial banksto operate branches in S. Korea, and discussionsare underway. - 184- Annex II: COUNTRY ECONOMIC MEMORANDUM Mongolia's exports o f textiles and apparel has a modest net external effect due to the fact that garments were manufactured mostly using imported inputs." Meanwhile, in 2005, there was excess liquidity inthe bankingsystem. 16 The analysis suggests that it i s not low domestic saving, but poor financial intermediation that has been primarily responsible for the hi h cost o f capital in Mongolia. The Work Bank's recent investment climate report1$ provides compelling evidence that, with the possible exception o f the wholesale and retail trade sector,18 the degree of bank-based financial intermediation in business activity, even though improving i s still very low inMongolia.l9 Bank deposit rates remain high compared to other emerging countries due to intensive competition among financial institutions in Mongolia. Such competition has exerted an upward pressure on bank deposit rates, and in turn, commercial bank lending rates. In spite of ample liquidity in the banking system, banks-motivated, by the desire to expand their market shares-remain aggressive in attracting depositors by offering highdeposit rates, and compressing their interest margins.2o Infact, the average returns on commercial bank assets have declined from around 4 percent in 2002 to only 1.4 percent in 2005. In an attempt to consolidate the banking sector, the Bank o f Mongolia stipulated an increase in the minimumpaid-up capital requirement for commercial banks inMongolia (from MNT 4 billionto MNT 8 billion). This attempt seemedto have failed since the vast majority o f existing banks (16 out o f 17) met this new threshold quickly without having to close down or merge with other banks. The spreads between deposit and lending rates are also high compared to other countries. This is largely due to the difficulty banks have in assessing credit risk. In addition, the profitability o f bank's non-lending assets remains low since their operating costs and required reserve ratio are high by international standards. According to firm findings o f the Mongolia's Investment Climate Report (World Bank 2006b), the difficulty in assessing credit risk derives from a number o f sources. The most important being poor corporate governance, and the lack o f transparency in business operations, which makes it difficult for potential lenders to assess borrowers' creditworthiness. 21 The weakness o f the bankruptcy and debt recovery framework in Mongolia has translated 15 The lifting of quotas on exports of textiles and apparel from China in 2005 had a negative effect on Mongolia's textile industryas many foreign-owned companiesleft Mongolia andrelocatedin China. I6 Donor assistance and foreign direct investment flows helped to build up again Mongolia's official reserves which were depleted by the large payments related to the Russian debt settlement at the end of 2003. "WorldBank(2006b) l8 The wholesale and retail sector was not covered by the Productivity and Investment Climate Survey (2004), which was the basis for the investmentclimate report. Also not coveredby the survey are f m s that failed and startups that did not make it. l9The degree of bank-basedfinancial intermediation has increasedin2005 as the M2/GDP ratio rose to 52 ercent from 47 percent in 2004 and credit expanded at the highest pace since 1996. In 2005 the Central Bank reducedthe coupon rate on its bonds and augmentedliquidity in the banking system (World Bank 2006d). 21Mongolia was not rated in the Doing Business database on the three dimensions of investor protection, namely: transparency of transactions (extent of disclosure index), liability for self-dealing (extent of director liability index), shareholders' ability to sue officers and directors for misconduct. Mongolia GrowthDiagnostics - 185- MONGOLIA: itself to increased risks and costs o f banking business. Data shows that bankruptcy claimants recover only 17 percent of total claims from insolvent firms in Mongolia, on average, compared to 24 percent for East Asia as a group, and 73.8 percent for OECD countries. In response, banks in Mongolia have been forced to rely entirely on collateralized lending and need to change high risk premiums on their loans to small businesses and individuals.22Cheap financing i s only made available to a very few prime customers-typically big companies. For instance, whereas large firms can obtain financing for as little as 9.6 percent per year, the annual nominal cost of micro finance can be as high as 72 percent on short term loans to individuals or small firms (Table A2.7). Table A2.7: BanksProvideFavorableLendingInterestRatesto a Handful of its Best Customers (annual percentagerate on loans extendedby banks in Mongolia) 2003-111 2004-111 2005-111 Average Low, Average Low, Average Low, high high high Upto 1year 41.5 11.O-72.0 39.0 6.0-72.0 42.0 12.0-72.0 1to 5 years 37.8 9.6-66.0 37.8 9.6-60.0 57.6 9-6-48.O 5 and more years 33.3 7.8-58.8 17.8 12.0-23.5 17.8 12.0-23.5 Industrial use 39.9 7.8-72.0 36.0 18.0-54.0 29.5 11.O-48.0 Non-industrial use 40.8 9.6-72.0 24.0 6.0-42.0 27.0 6.0-48.O Source: Bank of Mongolia Access to capital in Mongolia has been limited for the majority ofjrms. Ca ita1 markets are underdeveloped and banks offer a limited range of products to firms B so bank loans are the primary option for raising capital from domestic sources.24Unlike firms in China and Malaysia, most Mongolian firms have relied largely on finance from informal sources for their investment and working capital needs. In 2004, only 6 percent of new investment was financed by commercial bank loans, compared to the average for East Asia (17 percent). Inthe same year, less than a third of the firms in Mongolia had a commercial bank loan, and of those only 3 percent had loans with maturities of more than 5 years (Figure 2.6).25Without such credit, potential productivity-enhancing investments in plants, machinery, technology upgrading of processes are difficult to undertake on a sustained basis, thereby inhibiting a firm's capabilities to scale up existing operations or improve product quality. 22 According to the Doing Business database, the degree to which collateral and bankruptcy laws in Mongolia facilitate lending are comparable to those in East Asia and Central Asia. Mongolia scores higher than East Asia and Central Asia in terms of rules affecting the scope, access and quality of credit information andthe public credit registry coverage. 23Financingthrough leasingarrangementsis practicallynon-existent inMongolia. 24Mongolia's financial system is dominated by commercial banks. The stock market is small and illiquid, insurance companies and pension funds are small, and a commercial bond market has yet to be developed (World Bank 1997). 25World Bank (2006b) - 186- Annex 11: COUNTRYECONOMICMEMORANDUM FigureA2.6: While the cost of capitalis high, it is not the primary reasonfor the small numberof firmswith accessto credit inMongolia 1year 27% I Loan I Maturltv > I5yeak 0 9% I High cost of Collateral Low return Capital To capital? 22.0% 18.7% 42.2% Source: Mongolia Productivity and Investment Climate Survey (PICS) 2004. The high collateral requirements have also limited access to credit. Collateral-to- loan values are higher in Mongolia than in any other country in East and Central Asia. The ratio of collateral requiredto loan value i s 224 percent in Mongolia compared to the average for East Asia (78 percent), and Europe and Central Asia (154 percent). Moreover, many people, especially in rural areas, do not have access to the collateral required by banks in the form of immovable assets (land or buildings) since the pastureland is not privately-owned.26Land ownership in urban and peri-urban (or "Ger areas" as they are called around Ulaanbataar) areas is allowed inMongoliainthe form of long-term possessionrights (up to 60 years with a possible one time extension of up to 40 years). However, transfer of possessionrights is constrained by the need for permission from the relevant authorities. The rules and regulations for this are, however, not yet well establishedor published.This leads to lack of transparency inland allocation decisions in the urbanandperi-urban (Ger) areas.27 While the cost of capital i s high and access to capital, especially long term financing, is limited, most of the firms that needed a loan got it. According to the 2004 Productivity and Investment Survey (PICS) 56 percent of the firms inthe complained that the cost of capital was a severe obstacle to business growth, but only 22 percent of the firms inthe survey were discouraged and did not apply for a loan because of the high cost of capital (Figure A2.6).28 Similarly, the survey results on access to capital suggest that 26World Bank (2003a) 27Source: Sommer (2003). 28Of those that were discouraged the main reason they gave for not applying was the high cost of capital (82.8 percent or 22 percent o f all survey respondents), but they also gave additional reasons which included Mongolia Growth Diagnostics - 187- MONGOLIA: while 42 percent o f firms claimed that access to credit was a severe obstacle, 70 percent o f the firms either obtained a loan (28 percent o f firms) or did not needa loan (42 percent o f the firms) (Figure A2.6). (See also Table A2.8). Table A2.8: Selected Parameters on the Quality of the Business Environment, 2006 Min. capital Recovery rate in the Documents Time for Cost to to start a firm case of bankruptcy for export export export (Yo of GNI (cents on the $) Number Days (US%per per capita) container) Mongolia 140.2 17.0 11 66 3007 Cambodia 66.2 0.0 8 36 736 Vietnam 0.0 18.0 6 35 701 Azerbaijan 0.0 32.5 7 69 2275 Kazakhstan 26.6 20.0 14 24 720 Kyrgyzrepublic 0.6 19.8 Uzbekistan 24.7 18.7 10 44 2550 Ghana 23.2 24.7 5 21 822 Uruguay 183.3 43.2 9 22 552 East Asia & Pacific 109.2 24.0 6.9 23.9 885 Europe& Central 49.1 29.8 7.4 29.2 1450 Asia L.America & 24.1 28.2 7.3 22.2 1068 Caribbean MiddleEast & N. 859.3 28.8 7.1 27.1 923 Africa OECD 41.0 73.8 4.8 10.5 811 South Asia 0.8 19.7 8.1 34.4 1236 Sub-SaharanAfrica 297.2 16.1 8.2 40.0 1561 Source: Doing BusinessSurvey, WorldBank (2006a) The question then is: what i s the reason for few investments in the non-mining- related sectors in Mongolia along with a large number of firms not wanting to borrow from the commercial banks to finance such investment? One avenue that was examined inthis study was to see whether it was a lack o fprofitable investmentopportunities inthe non-mining related sectors inMongolia, rather than highcost o f capital. Are returnsto private sector investmentin non-mining-relatedactivities low? One way to assess overall return to economic activity in Mongolia is to estimate rates o f growth o f totalfactor productivity (TFP) in the past few years.29Data suggests '' stringent collateral requirements (72 percent), cumbersome application procedures (59 percents), and erceivedcorruption inthe allocation of credit (15 percent). Notice that TFP growth is difficult to estimate. Small differences in assumptions can lead to very different estimate of TFP growth andgrowth in TFP reflect factors other than puretechnical change such as increasingreturns to scale, markups due to imperfect competition, and sectoral reallocations. The growth accounting method for estimating TFP growth is discussed in Ghosh and Kraay (2000) and was used in -188- Annex 11: COUNTRY ECONOMICMEMORANDUM that, despite the sharp decline inincomes inthe first years after transition, trend growth in per capita real incomes has beenpositive (Figure A2.7) and real, annual per capita GDP growth averaged 3.9 percent in the period 1993-2004.30Also, TFP growth has improved in recent years, and in 2004 productivity rose by nearly 5 percent (Figure A2.7). The result that productivity growth was positive in 2004 holds under all plausible sensitivity scenarios examined here (Table A2.9).31 Table A2.9: SensitivityAnalysis on TFP Growth in2004 TFP Growth Estimates in 2004 (YO)(Cobb-Douglas) a=O.3 a=0.4 A=0.5 y=l (CRTS) 5.8 5.2 4.5 y=l.2 (IRTS) 5.0 4.2 3.4 y=0.8 (DRTS) 6.7 6.2 5.7 TFP Growth Estimates in 2004 (YO)(CRTS CES) a=0.8 CY=1 c=1.2 A=0.5 7.1 4.5 2.6 Source: World Bank Staff estimates Note: Growth rates are in logform. I I Figure A2.7: Real Per Capita GDP (in PPP I Figure A2.8: Growth Accounting: Mongolia Terms) has been Growing over the Past Decade since Transition Hodrick-Preswtt Filter (lambda=6.25) I 2000 I O wr 5 wr o cor 5 m I .iown ' I -150 JO 91 92 93 94 95 96 97 98 99 00 01 02 03 d4 I d Data source: WorldBank,SIMA. assumptions:Cobb-Douglasproductionjiinction with CRTS (y=I) Note: Duerenee between per capita GNI and GDP are and capital share a=0.5. negligible, therefore we show analysis based on GDP data. Although the aggregate indicators suggest that Mongolia used capital efficiently, not all sectors enjoyed high returns to capital. A number of sectors seemed to lag behind the better performing ones in the past 2 years, and in two sectors-manufacturing and transport-returns to capital were not only low, they were negative (Table A2.10). KoreaEconomic Report (World Bank 1999). The methodrelies on data from the Governmentof Mongolia, the World Bank and IMF. Appendix 2 presentsdetails on the data andthe methodology. 30The transitionalrecessioncoveredthe period 1991 1994.The slowdown in2001and 2002 was related to - badweather conditions which ledto severe decline of farm output. 31See also Favaro (2005) where the author uses cross-country growthregressionsto show that countries with higher investment shares tend to grow at higherper capita growthrates. Mongolia Growth Diagnostics - 189- MONGOLIA: Table A2.10: Industries' Contributionto RealGrowth in Mongolia (percentagepoints) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Agriculture 1.2 1.6 2.5 1.7 -6.2 -6.2 -3.5 1.1 4.1 1.9 Industry -1.7 -0.9 0.9 0.0 -0.2 3.7 0.4 1.6 4.0 -0.1 Manufacturing -2.4 -1.4 0.3 -0.5 -0.4 2.2 1.2 0.7 -0.1 -2.2 Mining 0.6 0.6 0.6 0.5 0.6 1.2 -1.2 -0.3 4.1 1.7 Construction 0.1 -0.1 0.0 0.0 -0.4 0.3 0.4 1.2 0.0 0.4 Services 1.6 3.2 -0.1 -0.1 3.4 1.5 6.0 3.1 1.5 4.3 Utilities -0.8 -0.1 0.1 0.1 0.2 0.4 0.2 0.0 0.1 0.1 Transport 0.5 0.0 0.6 0.0 1.2 1.4 2.0 1.5 1.8 -0.3 Trade 0.3 3.2 -1.2 -1.6 1.3 0.1 2.7 1.4 -0.7 4.3 Other services 1.6 0.1 0.4 1.4 0.7 -0.3 1.1 0.2 0.3 0.3 Source: Staff estimates based on datafrom WorldBank (LDB) Mongolia's structure of production has evolved in a way that has increased its dependence on ores and metals (Table A2.1l).32 of primary commodities in The share total merchandiseexports grew from 75 percent in 1991to 87 percent in 2005, while the share of manufactured exports dropped from 25 percent to 13 percent (Table A2.11). At the same time the nonmetal manufacturing base has narrowed considerably, and consists mainly of textiles and apparel. Table A2.11: IndustryCompositionof Total Value Added in Mongoliaat Constant, ProducerPrices (factor cost) Shares 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Agriculture 36.4 36.6 37.8 38.8 33.6 27.7 23.6 23.4 25.1 25.5 Industry 22.1 20.4 20.6 20.3 20.8 24.7 24.3 24.5 26.1 24.4 Manufacturing 7.8 6.1 6.3 5.6 5.4 7.7 8.6 8.8 8.0 5.4 Mining 11.5 11.7 11.9 12.2 13.2 14.5 12.9 11.9 14.6 15.3 Construction 2.8 2.6 2.5 2.5 2.2 2.5 2.8 3.8 3.5 3.6 Services 41.5 43.1 41.6 40.9 45.6 47.6 52.1 52.1 48.9 50.1 Utilities 2.8 2.6 2.6 2.7 3.0 3.4 3.5 3.2 3.1 2.9 Transport 8.2 7.8 8.1 8.0 9.5 11.0 12.6 13.4 13.9 12.8 Trade 12.9 15.5 13.8 12.1 13.7 13.9 16.1 16.6 14.4 17.7 Other services 17.7 17.1 17.0 18.1 19.4 19.3 19.8 18.9 17.5 16.7 Source: WorldBank, LDB Note: Agriculture is dominated by livestock herding. These trends reflect favorable commodity prices and declining prices of manufactured goods, and suggest that Mongolia has grown successfully by increasing its specialization in products in which it has comparative advantage.33But they also tell us that: (i)Mongolia's economy has become more vulnerable to terms-of-trade shocks, natural disasters and environmental degradation; (ii) Mongolian manufacturing firms are not competitive in world markets, and (ii)Mongolia uses its scare resource-labor- 32The miningshare intotal value addedunderestimatesthe contribution of the sector as it doesnot reflect the output ofthe artisinal miningsector. 33Mongolia's vast mineralwealth includesover 6000 knownmineraldeposits o f 80 different minerals. - 190- AnnexII: COUNTRYECONOMICMEMORANDUM ineffi~iently.~~Indeed, Mongolia's share inworld manufactured exports has declined, and except for mining, its value added per worker is low (Figure Mongolia's agricultural sector employs 40 percent of the country's labor force, while it contributes only 25 percent of the total value added. 1 FigureA2.9: Value Added per Worker in Mongolia36 7000 ?------ 10Agriculture ka Manufacturing 0 Mining I Sehces ITotal Source: Staffestimates based on datafrom Mongolian Statistical Yearbook (2004) and Government of Mongolia. Economic diversification is, therefore, going to be imperative in order for Mongolia's growth path going forward to be broad-based. This report, especially, chapter 3 onwards, discusses how this can be done and provides specific policy measures that the government may want to implementinthe short-to-medium-term inthis regard. 34 Mongolia is one of the largest landlocked countries inthe world with a population ofjust 2.5 million. 35 Labor productivity inthe mining sector would be considerably lower ifwe include the output of artisanal miners. 36 Economy-wide labor productivity growth estimated, as the value added at constant prices per worker, stagnated over the past ten years. Labor productivity in agriculture, which employs a sizable share of Mongolia's working age population, was lower than other sectors' labor productivity, and declined substantially after 2000, while in services labor productivity was only slightly higher than the average. Mongolia Growth Diagnostics - 191- s x U c c c Yl c c c m (r c c c 2cc zcc c c c (4 Q s Q a 0 f t- Q f v e Q F I c w 2 5 c N O N 2 2 f8 ac " 9 W W N 2 s - 4 s N y?z N O N W P-Io- E " r ? " N $ 8 2 a m - c e " 9 5 N rW-Pm- o o 01 E 2 u. I- 2 01 \o 2 h h c c U w c w -l c CI C c. z h c w g L oc a 9 t t Y - 1 Y " N ? w 9 m Y - m l 9 m L m w mm m- o m o o md0 0 - 0 0 0 0 0 - mVI m m = z t- L bc E 0 t2 2 w Icl 0 -r: Y v) C 8 Y Y - Y m d N O .I m - N 3 - N .I c R & .. W a2 Table 7: Merchandise Imports by Origin (US$million, customs basis) 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total Imports 450.9 468.3 503.3 512.8 614 5 637.7 690.8 801.0 1,021.I 1,184.3 Australia 2.0 0.8 2.5 0.5 1 3 1.4 11.3 19.6 15.5 14.1 Austria 0.5 1.5 15.9 0.4 1 9 0.7 0.8 5.5 4.7 0.9 United States 11.1 36.6 36.4 31.5 28 4 14.9 23.4 23.5 46.5 40.1 Belgium 2.4 1.3 2.1 2.0 2 4 6.4 4.3 5.9 3.4 4.7 Bulgaria 2.1 3.3 4.1 3.2 3 6 1.7 0.9 1.5 1,7 1.6 Belarus 9.1 0.9 1.4 2.4 4 2 7.8 5.6 3.0 5.5 5.1 Viet Nam 2.5 2.7 3.0 1.7 1 6 2.5 2.0 I.7 2.2 2.6 South Korea 18.0 21.0 37.7 36.2 55 6 58.3 86.3 67.7 61.2 63.7 Germany 21.5 20.4 25.9 23.6 29 7 30.3 30.4 38.0 33.5 37.6 Denmark 2.3 13.4 0.8 3.0 4 4 7.8 3.0 3.9 5.0 3.3 Israel 0.0 0.4 0.0 0.1 1 5 0.7 0.4 0.8 4.3 8.1 Indonesia 0.0 0.4 0.7 1.9 2 5 2.6 2.8 2.8 3.0 3.2 Spain 0.1 0.0 0.5 0.2 0 2 0.1 0.1 8.2 4.3 0.9 Italy 23.8 29.7 3.4 4.5 3 0 3.4 2.8 3.3 3.0 3.4 United Kindom 3.1 5.1 3.6 3.9 6 0 3.8 2.8 3.9 4.0 8.7 Kazakhstan 0 7 1.8 3.3 0.7 6 8 21.3 7.2 4.9 26.3 40.5 Canada 0.3 1.o 0.4 2.5 0 9 1.1 2.5 3.8 6.2 17.3 Kyrgyzstan 1.o 0.9 1.0 1.3 1.1 Netherlands 1.3 1.2 1.7 1.o 2 7 2.9 2.2 2.1 1.4 3.1 Malaysia 1.4 0.9 1.5 1.9 2 4 2.7 3.0 4.1 5.5 7.0 RussianFederation 154.9 165.9 150.2 149.8 206 2 226.0 237.6 265.4 341.9 417.9 Poland 3.5 5.0 6.8 4.5 4 9 5.3 5.7 8.0 8.7 10.0 Singapore 13.4 17.6 17.3 9.1 10 6 10.4 11.2 10.4 15.0 16.3 Taiwan, China 0.5 3.1 4.0 4.2 2 5 2.0 4.4 1.9 5.0 2.5 Thailand 0.2 0.4 0.6 0.5 1 4 0.4 0.6 I.4 4.7 0.9 Turkey 0.0 0.3 0.4 0.3 1 1 1.2 1.2 1.2 1.5 2.3 Ukraine 2.8 1.5 1.5 1.6 1 1 2.3 3.5 9.2 14.8 19.6 Hww 2.1 1.7 2.0 1.4 1 7 1.4 1.5 3.8 7.2 3.4 Finland 0.8 1.9 6.2 5.7 4 1 3.9 3.4 2.7 2.5 2.8 France 1.3 10.8 26.5 8.5 8 3 6.2 4.8 10.8 14.9 29.4 Mainland, China 66.0 63.3 66.6 77.6 125 8 136.2 167.7 196.3 257.2 307.3 CzechRepublic 8.0 7.3 6.7 4.9 3 5 7.I 3.6 5.8 4.5 5.1 Sweden 0.2 0.9 1.3 6.2 2.1 Switzerland 5.I 1.4 1.2 2.3 3 2 4 5 3 7 4.4 4.4 1.1 India 0.4 0.7 1.5 1.8 1 8 1.4 1.o 0.9 0.6 1.5 Japan 77.8 34.8 59 3 115.0 73 3 56.0 42.8 63.4 75.0 75.5 Others 11.9 10.2 7.6 4.4 5 3 1.8 4.5 8.3 18.5 19.6 Source NarronalSlatistrcalOfice of Mongolia Stalisrical Appendix - 199- Table 8: Major import Commodities 1996 1997 1998 1999 ZOO0 2001 2002 2003 2004 2005 Consumer goods Food commodities Wheat thous toni 0 0 173 46 5 182 922 29 9 1393 61 5 1149 97 5 FlOUI thous toni 1002 66 4 45 3 382 992 92 8 96 9 75 2 79 3 103 9 Vegetable oil thous toni 17 0 8 03 01 I1 03 0 1 01 0 6 0 2 Margarin thous ton< 14 1 3 1 4 15 21 2 0 2 7 3 0 3 6 4 6 Buner tons 1049 96 7 183 8 809 550 62 4 186 55 I 5 0 8 4 Cranuiated sugar thous tons I O 8 II6 17 0 16 I 22 I 23 9 27 0 190 33 7 26 8 Candy thous tons 2 0 2 8 21 1 9 3 1 4 4 4 5 5 1 5 6 6 0 Flavoured flow product thous tons 18 18 1 7 2 0 3 6 5 0 5 7 5 2 58 6 1 Canned fruits, nuts thous tons 0 5 0 4 01 0 0 0 1 Rice thous tons 7 9 7 7 7 3 7 8 136 103 36 0 I4 8 26 7 I3 8 Millet thous tons 0 7 0 9 1 3 6 4 7 3 4 4 38 6 2 7 8 8 4 Green tea thous tons 0 9 0 9 1 3 0 9 1 7 2 2 2 2 1 9 2 2 15 Cigarene mlnpiece 671 7 1,013 3 1.247 I 1.263 0 1,746 2 971 7 703 7 673 0 764 7 629 3 Tobacco tons 603 4 575 4 548 4 671 5 581 9 497 0 440 3 474 2 1,035 3 1,383 3 Potato thous tons 7 8 122 11 8 8 9 132 21 9 35 6 40 2 38 4 41 0 Onion, garlic thous tons 13 0 8 23 2 0 2 9 5 1 5 8 7 1 9 5 5 5 Fresh fruit thous tons 4 5 7 2 8 2 8 4 114 12 1 18 7 23 3 22 9 22 6 Soft drinks mln litres 0 5 4 3 3 8 5 8 8 9 9 2 5 0 5 0 4 9 4 2 Alcohol drinks mlnlitres 3 1 107 I7 3 100 189 I 4 3 15 6 I 7 2 195 9 4 Oh which Beer mln litres 0 5 93 165 93 178 I3 3 14 I 15 7 12 9 7 8 Soap tons 3.5864 4,366 5 5,194 I 5,477 6 5,717 4 6,567 6 6,248 3 6,000 5 6,075 9 6,261 5 Detergent tons 558 7 592 6 979 4 1,048 6 1,326 8 1,413 I 1,579 I 2,283 I 2,1970 2,751 I Paqket medicine tons 698 4 650 4 970 7 784 8 790 7 Plash bottle, box mln piece 60 5 87 7 94 5 97 2 1153 Synthetic paper fabric min ma 9 4 5 9 9 4 I18 10 7 Cotton fabrics mlnm' 3 0 5 2 6 0 107 154 I t 6 15 7 8 8 4 9 8 7 Leather footwear thous pairs 124 5 35 8 31 6 39 3 34 I Refrigerator. freezer thous piece 23 2 9 4 4 4 1 6 1 6 7 14 8 25 9 39 4 29 9 Electric domestic appliances thous piece 80 9 86 3 70 0 158 I 93 5 Vacuum cleaner thous piece 6 0 102 9 9 87 125 I6 7 149 I1 I 25 5 26 0 W ,video monitors 8 video projectors thous piece 15 2 184 165 168 25 I 22 5 34 3 36 7 49 5 41 4 Line telephone sets with cordless handsels thous piece 39 5 43 8 82 3 I4 0 14 8 Data processing equipment, its spare parts thous piece 49 3 174 12 7 11 9 257 43 9 60 6 64 6 75 6 1140 For production and technical purposes Window glass thous m' 287 5 305 7 328 0 183 4 2892 4869 653 7 710 I 743 3 8185 Nitrogen thous tons 6 1 8 5 12 6 9 0 104 133 144 124 184 13 3 Cement thous tons 1 9 1 5 7 5 3 3 127 274 52 6 85 9 131 8 175 1 Paper thous tons 1 1 I O I O 0 7 1 4 1 1 1 2 17 2 2 2 2 New tyre thous piece 45 8 60 2 75 6 IO9 3 113 I 1167 1500 1304 148 I 1212 Steel tubes, steel parts tons 4,040 6 3,223 5 5.806 2 3.1899 5,999 4 Other tubes, pipes 8 bollow profiles tons 1,551 2 3,575 0 4,1023 5,l 14 2 4.91 8 0 Liquid pump thous piece 35 2 24 0 179 39 5 23 2 Printing machinery, machines 8 their auxiliary parts piece 777 0 276 0 572 0 605 0 932 0 Cars piece 2,996 0 1,737 0 5,690 0 4.862 0 11,509 0 8,374 0 7.1870 10,320 0 12,933 0 14,366 0 Trucks piece 297 0 299 0 1,193 0 2,769 0 3,061 0 1,878 0 1,868 0 2,870 0 4,926 0 6,237 0 Spare parts for vehicles thous piece 296 5 388 4 304 I 408 4 305 I Fuel, energy Petrol thous tons 193 2 1789 212 2 193 2 233 7 2472 243 7 259 I 270 I 254 8 Diesel thoustons 1204 1282 130 I 1594 1617 I97 I 1906 214 8 258 2 270 9 Jet fuel thous tons 27 5 24 7 20 8 I5 9 184 228 20 5 23 9 22 8 189 Mazut thous tons 33 6 34 5 31 8 22 7 146 175 9 5 124 I1 I 4 9 Lubricant thous tons 0 4 0 5 0 4 25 15 2 9 63 2 7 17 18 Electricity mln kwt h 374 8 344 4 367 8 223 I 181 5 1514 1580 173 I 240 9 175 5 Source Narronal SiarrsNcal O@ce Annex Ill: 0 0 0 4 o o o t # o o o a o o o t # h 0 x IC c w 2 I c N rr; wc wc N -s N c c c N c E a 5 t- c m m m c u r m o f N r r c \5 f 8,M m m - o m w w d m w o 0 0 0 0 ~ ? t = - - r ? o m N 8 d 8 0 8 r - m w O N w r - t @ ? = ? o i c ! ? t-8 ' 0 0 0 0 0 0 0 d m N 0 8 -8 8 w IloelCIEQ 9 9 - 9 9 m o = r ? o 8 1 B2 6 0 3 PY m m w c o o r - c o m m m N - b Y 0 Y N - m w w 959 -.-. m m m m -- b- r r 9 0 - w w w Pe p: N m o w m w b m w w m r - r - r - m - - m m N w m m w v o - r - r - w m l n r - m m - w w m r n r - r w hl I m 00 m n 3 rr a 33 N 3 33 :: m Y 3 e 6 3 2 Y 2m D3 2 fi9 00 o! 00 a 3 9 . 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N VI m VI -, 0 VI e % m I- I- 0 N W -* m W W 0 m * W 3 * - m m W W m d W m 0 VI W d :" 0" W m - W N 3 d I- 2 W N W * 0 W -I- I- 2 % I- m W 5: I- * W N m I- W m I- W m W W c;- i? N e VI I- m W x * m W I? I- W W W x VI I- W W W m Fr- R I- mN I- 3 I- m 2 d WI- W W m W z m ."* i? a 9 .- a 9 3 e Y I w o o - g 2 5 z N m m o - g z s z N x I- N % W N z W ol M W x m Y N W 10 u, 0, W 2 z N m m d -3 c1 I 7 7 "$5 (v I I 8 z. 9 wr. F 9 W 0 F. % - 9 F 0 CI m W 2 z W W vi 9 9 P vi W W x m 9 W 00 2 - 9 9 W 0 F. W vi 9 8 2 W vi x% 8 W 9 vi P 3 10 W .- B a CI .C CI B w -m m * N m - 00m ri m 2 % z o m m w m w m mmz m m m P-m N NF. - 5 -wwm8 P-00 mu, P- N * -3 0 0 - .-M CI 3 E P I 3??gs - m - 0 rn z=s ??? m - - m W b N w - r - Z?ZZ 9 9 9 - m - mm s g 2 d W m o m 9 9 9 9 9 - m - mm x 9- ' 9 0 . N vm, I 3