71M 11 11 Em s I fic i o 47 IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Poverty Reduction and Economic Management Sector Unit East Asia and Pacific Region THE WORLD BANK January 2013 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank CPA Central Procurement Agency CSO Civil Society Organizations DBM Development Bank of Mongolia ETT Erdenes Tavan Tolgoi LLC FSL Fiscal Stability Law GDP Gross Domestic Product IAAC Independent Authority Against Corruption IBL Budget Law of Mongolia IMF International Monetary Fund MCC Millennium Challenge Corporation MED Ministry of Economic Development MDG Millennium Development Goals MNAO Mongolia National Audit Office MNT Mongolian Tugreg MoF Ministry of Finance MTBF Medium Term Budget Framework MTFF Medium Term Fiscal Framework NDIC National Development and Innovation Committee OECD Organization for Economic Cooperation and Development OT Oyu Tolgoi Copper Mine PIP Public Investment Program PPLM Public Procurement Law of Mongolia PPP Public Private Partnerships PSMFL Public Sector Management and Finance Law SEG Social and Economic Guidelines SPC State Property Committee TT Tavan Tolgoi Coal Mine WB World Bank WDR World Development Report 2 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE CONTENTS EXECUTIVE SUMMARY .................................................. 7 CHAPTER 1: THE CHALLENGE OF SCALING UP INFRASTRUCTURE .......... 20 Introduction: What this Report is about..................................... 20 The Needs....................................................... 21 The Plans and Financing......................... ................ 23 The Analytical Framework ....................... ................ 24 What this Report does not cover ........................................ 28 CHAPTER 2: KEY PROBLEMS THAT NEED TO BE ADDRESSED .......................... 29 Not Spending in the Right Areas ........................................ 29 The relative neglect of the "growth poles" .................................. 30 Poor prioritization in medium-term plans ................................... 35 Fragmented capital budget ...................... ................ 36 The neglect of maintenance....................... .............. 36 Public Investments not grounded in a Sound Macro-economic Strategy ..................... 37 "Build-Transfer" schemes ....................... ................ 38 The Development Bank of Mongolia ...................................... 38 Weak regulatory framework for PPPs ..................................... 41 Poorly Prepared Projects......................... ................ 42 Limited project appraisal ............................................. 42 Poor coordination between the Ministry of Finance and the Ministry of Economic Development ..... 43 Extensive insertions of projects by parliament................................ 44 Problems in Public Procurement and Contract Implementation ....... .............. 45 Capacity constraints ................................................ 45 Weaknesses in procurement planning ..................................... 46 Lack of transparency and political interference........................... 47 Poor monitoring ................................................... 48 The reforms underway............................................... 48 Inflexibilities in Budget Execution ......................................... 50 Capacity Limitations in the Construction Sector......................... 51 Restrictions on immigration............................................. 51 Restrictions on the import of equipment ................................... 53 Bottlenecks in the supply of construction materials ....................... 53 Non-competitive public procurement ..................................... 53 The Result: Low Value for Money........................................ 54 CHAPTER 3: POLICY RECOMMENDATIONS....................................... 55 Spending in the Right Areas........................................... 57 Achieving the Balance between Infrastructure Needs and Macro-fiscal Stability................... 58 Ensuring that the DBM is within the framework of the FSL....................... 59 Eliminating "build-transfer" schemes ..................................... 60 Strengthening the legal framework for public-private partnerships ........... ....... 60 Strong Corporate Governance for the Development Bank of Mongolia ..................... 61 Strengthening Project Preparation ....................................... 62 Ensuring a unified budget process........................................ 62 3 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Improving planning.................................................64 Implementing the IBL provisions on project appraisal. ..........................65 Ensuring that projects proposed by MPs abide by the IBL ...............................67 Greater Capacity, Transparency and Oversight in Public Procurement and Project Implementation ....................... ............... 67 The Central Procurement Agency........................................67 Civil society monitoring of procurement..................................... 69 Improving Budget Execution ............................................74 Addressing Human Resource Capacity Constraints ................... .... .......74 Conclusion......................................................77 REFERENCES .....................................................78 FIGURES Figure 1: Mongolia is more heavily dependent on mineral resources compared to other countries in East Asia ...... .................................................. 21 Figure 2: Government revenues are projected to increase rapidly over the medium to long term2l Figure 3: Road density in comparative perspective ..............................22 Figure 4: Transport performance .........................................22 Figure 5: Growth in government capital expenditures, 2003-2011 ...................23 Figure 6: Investments are rapidly increasing overall .............................24 Figure 7: Conceptual framework for infrastructure provision ..........................25 Figure 8: The Mongolian population has been rapidly migrating from the periphery to the growth pol es...........................................................32 Figure 9: Ulaanbaatar has been relatively neglected in central government spending on electricity and transport infrastructure (2011 percent distribution of ministry capital budget allocation) .... 33 Figure 10: The neglect of the growth poles is particularly evident for roads and bridges........33 Figure 11: Distance from Ulaanbaatar is not a good predictor of roads expenditures............34 Figure 12: Growth poles have also been under-prioritized in government electricity and heating expenditures (2011) ............................................ .....34 Figure 13: Education spending is spread throughout the country (2011) ............................... 35 Figure 14: M id-term plans also under-emphasize Ulaanbaatar............................................... 36 Figure 15: Distribution of investment projects by size, 2008 .................................................36 Figure 16: The under prioritization of capital repairs and maintenance..................................37 Figure 17: Alternative forms of infrastructure financing have been increasing in prominence.....39 Figure 18: Public procurement has increased seven-fold since 2006 ..................................... 46 Figure 19: Average time taken at each stage of the procurement cycle ..................47 Figure 20: Increasing costs of road construction ......................... ......47 Figure 21: Disbursements from the capital budget are highly skewed with half being done in the last quarter .......................................................50 Figure 22: Capacity limitations in the roads construction sector.....................52 Figure 23: Machinery and equipment import (percent year-on-year change) .............52 Figure 24: Number of registered construction vehicles.............................52 Figure 25: Increases in cement prices (percent year-on-year change) ...................53 Figure 26: Time and cost overruns are a common occurrence (based on a sample of 14 national roads projects) ..................................................... 54 Figure 27: While the civil service wage bill is increasing it is fiscally sustainable and the Government can afford to significantly increase the salaries of the administrative service ..... ........75 Figure 28: Oil production and migration in the United Arab Emirates .................77 4 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE TABLES Table 1: The three stages of urban development ................................31 Table 2: The Mongolian parliament significantly changes the capital budget, as for example in 2008...........................................................45 Table 3: Limited competition for road construction contracts .......................54 BOXES Box 1: Recent key new pieces of public expenditure legislation Mongolia ...... .......26 Box 2: Stages of project appraisal for large, complex projects ......................44 Box 3: Some Principles for the Sound Governance of Development Banks... ..............61 Box 4: The Relative Roles of the Ministry of Finance and the Ministry of Planning in Managing .. Public Investment: The Chilean System ....................... 63 Box 5: Formal Project Appraisal in Ireland .................................. 66 Box 6: Central Procurement Agencies in the OECD Countries.........................69 Box 7: CSO Self-regulation and Sustainable Funding ...........................72 5 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE ACKNOWLEDGEMENTS This report was written by a team consisting of of the Cabinet Secretariat; Mr. Sedvanchig, Zahid Hasnain (Senior Public Sector Specialist, Member of Parliament; Mr. Bat-Erdene, EASPR, TTL), Munkhnasan Narmandakh Member of Parliament; Mr Davaasuren, (Economist, EASPR), Audrey Sacks (Governance Member of Parliament; Mr. Batur, State Specialist WBI), and Marek Hanusch (Economist, Secretary, Ministry of Finance; Mr. Gantsogt, EASPR). It drew on inputs from Joel Turkewitz Director General, Procurement Policy and (Lead Governance Specialist, EASPR), Coordination Department, Ministry of Finance; Kathrin Frauscher (Operations Officer, WBI), Dr Khaschuluun, chairman NDIC; Mr. Batjargal, Paul Schapper (Consultant), Richard Allen Director General, Fiscal Policy and Coordination (Consultant), NorovjavOtgonjargal (Consultant), Department, Ministry of Finance;; Mr Batbayar, and Peter Trepte (Consultant). Lynn Yeargin, Director General of the Financial Policy Batzul Oxendine, and Otgonbayar Yadmaa Department, Ministry of Finance; Mr. Nyamaa, provided administrative support. The note was Director, Expenditure Division, Ministry of prepared under the overall guidance of Sudhir Finance; Mr. Batgerel, Director, Investment Shetty, Sector Director (EASPR), Rogier Van Den Division, Ministry of Finance; Mr. Zorigt, vice- Brink, Lead Economist (EASPR), and Coralie chairman NDIC; Mr. Bailikhuu, Advisor, State Gevers, Country Manager, Mongolia. Property Committee; Mr. Ganbaatar, Director Sector Policy and Investment Coordination The note draws on discussions with the Department, NDIC; Mr. Enkhtur, Director following officials during missions to Mongolia Department of Roads. in 2011 and 2012: Mr. Saikhenbileg, Chairman 6 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE EXECUTIVE SUMMARY 1. Mongolia today is at the cusp of a major achieve redistributive goals. Infrastructure needs economic transformation as it begins to exploit are considerable for a vast, scarcely populated, its vast copper, gold, coal, and other mineral and sub-arctic climate country such as Mongolia resources. The economy has been growing at with poor transport connectivity and high unit almost 9 percent on average in real terms since costs of service delivery. Financing will be less 2003 when the mining boom began with the of a constraint as government revenues are increase in global commodity prices; growth has projected to triple in the next seven years as accelerated to double-digits in 2011 and 2012 the mines go into full production, and increase with the construction of the Oyu Tolgoi copper steadily thereafter. The key challenge will be mine, one of the five largest in the world; and to effectively use these increasing revenues, will likely remain in the double digits as Oyu with the major responsibility falling on the Tolgoi and the similarly huge Tavan Tolgoi Government's public investment system for coal mine, with an estimated 100 years of coal planning and implementing capital projects. reserves, go into operation over the next few years thereby greatly increasing the volume of 4. The objective of this report is to analyze Mongolia's mineral production and exports. in depth the current public investment If the right institutions and policies are put in management system and to assess whether place, this resource boom can be used for the or not it is able to meet this challenge of sustained improvement in the lives of current delivering good quality projects in the priority and future generations of Mongolians. areas in a macro-economically sustainable manner; and to recommend what needs to be 2. Achieving this potential is far from automatic done to improve the system so that it is able to as there are numerous examples of commodity effectively transform natural resource revenues rich countries which have performed worse than into sustainable capital assets. those without such endowments, hence the frequent use of the phrase "resource curse". 5. Meetingthischallengewill requireadherence Natural resource production is an "enclave" to four broad principles. First, spending should activity with few linkages to other sectors of aim to achieve "allocative efficiency" by shifting the economy, which means that mining-driven resources from less productive sectors to more high GDP growth numbers by themselves do productive ones ("spending in the right areas"). not automatically imply broader development Despitethe hugeincreasesin revenues,the needs of the other sectors of the economy or large- willcontinuetooutweightheavailableresources, scale job creation. And, most importantly, at least in the near future, and therefore some mineral resource revenues significantly increase hard decisions about infrastructure prioritization opportunities for corruption, a risk that is will have to be made. Second, public particularly acute in Mongolia given the scale and expenditures should be grounded in a sound pace of the change, its very heavy dependence macro-fiscal framework to avoid the deleterious on natural resources, and the already close effects of commodity price volatility and to connections between political and construction prevent real exchange rate appreciation from an industry circles. investment spending boom not modulated to the absorptive capacity of the economy. Third, 3.One of the main mechanism for avoiding the public investment management system these problems and achieving sustained growth should be sound so that that capital projects are through a diversified economy will be public well prepared, implemented in a transparent investments in infrastructure, education, and and cost effective manner and well maintained health to provide public goods, address market ("technical efficiency"). Finally, the construction failures, crowd in private investments, and sector has to be able to effectively respond and 7 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE meet these increasing demands placed on it by KEY PROBLEMS THAT NEED TO BE the government, and the investment climate ADDRESSED should be such as to encourage the growth of the sector, thereby increasing the absorptive 8. Not spending in the right areas: Mongolian capacity of the economy. policy-makers are not making the best use of their budgetary resources and are under- 6. As of today, the Government is not meeting spending in high priority areas and over- any of these four principles and correcting spending on lower priority ones. The main these weaknesses is of paramount importance indicators of this allocative inefficiency is the given the Government's ambitious plans for relative neglect of the "growth poles", or scaling up infrastructure. Budget funded capital geographic areas that are the natural clusters expenditures have increased twenty-fold since of economic activity in Mongolia and which 2005, and the Government recently successfully produce the bulk of the economic growth; and issued a $1.5 sovereign bond - equivalent to the gross under-spending on infrastructure 15 percent of GDP - to finance road, rail, and maintenance with the result that capital assets energy infrastructure. Without concerted action have been deteriorating quickly and require there is a real risk that the citizens of Mongolia costly rehabilitation or replacement. will not rightfully benefit from the mining boom. 9. Mongolia's growth poles are the capital city of Ulaanbaatar, and the mining regions of 7. Before elaborating on these problems, it the south Gobi and the north. These have all should be noted that the Government recognizes seen a significant increase in population over this challenge and has recently undertaken some the past decade through migration from the major reforms in the regulatory framework rest of the country, a trend that will almost for public expenditure management. These certainly continue. Ulaanbaatar now accounts initiatives include a new Fiscal Stability Law for 45 percent of Mongolia's population, (FSL, 2010) to improve macroeconomic stability; and is continuing to grow rapidly. However, a new integrated Budget Law (IBL, 2011) to infrastructure spending does not reflect this strengthen budget formulation and execution; economic geography. While infrastructure in and an amended Public Procurement Law(PPLM, south Gobi is largely being developed by the 2011) to significantly change the institutional mining companies themselves, Ulaanbaatar is arrangements for public procurement with the heavily reliant on central government spending aim of increasing capacity and transparency. and currently receives only 30 percent of the These laws however, are yet to be effectively roads sector, and 20 percent of energy sector, implemented and face significant opposition central government capital budget allocations. from vested interests. One major difficulty The result is severe congestion on Ulaanbaatar's is that other laws, such as the Law on the roads - average traffic speeds have halved Development Bank of Mongolia (2011) and over the past decade in the city center - and the Concessions Law (2009), are undermining dangerous levels of pollution as the residents these legislative reforms. Corruption is a of the pen-urban ger areas have to burn coal major concern, particularly because of the during the severe winter months as they are close overlays between political, mining, and unconnected to the city's central heating construction industry circles. There is also a network. This poor prioritization is also evident significant lack of coordination between the intheGovernment'smedium-termdevelopment key agencies involved, and the Government will plans - Ulaanbaatar will only get 21 percent of need to significantly improve its human resource the planned road construction for 2011-2016. capacity while working around the relatively fixed constraint of labor scarcity. 1 0. 60 percent of the national paved road network is in poor condition and in need 8 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE of urgent capital repair and rehabilitation. 13. The FSL however, is not being implemented However, the Government spends only 20 in principle through off-budget financing of percent of what is required annually on routine infrastructure that bypasses these fiscal rules, maintenance in the roads sector. The growth in in particular the structural balance and the new investments is also significantly outpacing expenditure growth rule. Specifically, this off- that in capital repairs - expenditure on new budget financing is in the shape of "build- investments increased twenty-five fold since transfer" (BT) projects in the roads and energy 2005 as compared to a thirteen-fold increase sectors that were financed by construction for capital repairs - pointing to increasing companies themselves on the condition of problems in maintaining capital assets in the repayment from the budget at a later date; and future. Correcting this problem would only excessive lending by the Development Bank of require a modest reallocation of 20 percent Mongolia (DBM), in particular for non-revenue from new investments to maintenance, which generating public infrastructure projects. The can be easily achieved today if the political will value of off-budget BT and DBM-financed is there. schemes, in terms of total project cost, has increased from 3 percent of the total capital 11. Public investments not grounded in a sound budget in 2008 to over 41 percent in 2012, macro-economic strategy: The two particular which represents a significant fiscal liability for macro-economic challenges that mineral-rich the Government. It is anticipated that DBM countries need to effectively deal with are the project finance for non-revenue generating volatility of mineral prices and real-exchange projects is equivalent to 4 percent of GDP for rate appreciation (the "Dutch Disease") due 2012, and will likely be higher for 2013, thereby to over-spending. If investments increase at a violating the FSL structural balance rule. pace much higher than the absorptive capacity of the economy then this will result in inflation 14. The DBM is likely to be a major source of and an appreciation of the real exchange rate infrastructure financing in Mongolia going with its consequent negative macroeconomic forward and, under a sound macroeconomic effects. In Mongolia, this effect is clearly visible and corporate governance framework, can play today with the soaring prices of construction an important role in the country's development. materials as the construction sector is unable to However, the DBM's current legal framework expand capacity adequately to meet the rapidly has a number of weaknesses which means increasing government demand. An optimal that there is a risk that it is funding the wrong strategy would therefore, be to spread the projects, and is doing so under excessive political investments over time by limiting the growth in influence. These weaknesses include: insufficient annual investment spending to avoid such over- clarity of its mandate, in particular no explicit heating of the economy. reference to cost-recovery implying that the DBM can, and is, funding projects that should be funded from the government budget; excessive 12. The FSL, which went into effect on January authority of the parliament to instruct the DBM 1, 2013, recognizes this problem and puts in to finance specific projects, which compromises place fiscal rules to smooth volatility by using its independence; lack of clarity on who the long-term prices to estimate mineral revenues government shareholder is; lack of sufficient and requires budgets to comply to a structural independence of the DBM board; lack of a clear deficit of less than 2 percent of GDP; to control supervision function; and excessive authority expenditure growth to less than nominal GDP to lend funds (50 times equity) which can growth and therefore avoid over-heating of create substantial future fiscal liabilities for the the economy; and to ensure long-term fiscal Government. Unless urgently addressed, these solvency through caps on public debt. problems imply that Mongolia risks repeating the failures of many development banks in 9 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Africa, Latin America, and Asia that were used most vulnerable part of the public investment to finance bad, politically motivated projects system as procurement requires government and became loss-making enterprises requiring officialsto exercise discretion and makedecisions frequent bailouts from the government. overlargesumsof moneyatspecific points in time which often invites influence from "interested" 15. Poorly prepared projects: A major problem parties. These problems are particularly evident in Mongolia is that most projects that enter in Mongolia given the small size of the formal the budget are poorly prepared. They have sector and the close connections between inaccurate cost estimations that require frequent ministers and members of parliament and the additional financing in supplementary budgets, construction industry. Approximately 10 percent there is little justification of the projects based of parliamentarians in the 2008-2012 parliament on national and sectoral priorities, and the owned shares in construction companies, and future maintenance needsof the projectsare not the top ten local construction companies, calculated. The precise roles and responsibilities which combined received 30 percent of road of the Ministry of Economic Development (MED) construction contracts in the past five years, and the Ministry of Finance (MoF) remain unclear were either owned by members of parliament in practice, even though these are reasonably or by individuals who had close ties to them. well laid out dejure in the IBL. And members of Mongolia also has the more common technical parliament insert a number of projects during problems of poor procurement planning and the budget debate session that bypass the limited human resources in public procurement, normal planning and budgeting process and which combined with the political interference have even more inaccurate cost estimations. results in a low value for money of infrastructure projects as measured by time and cost over- 16. The IBL attempts to address some of these runs. weaknesses. It mandates that only projects that have gone through a proper appraisal process will be considered for financing, with the MED 18. Line ministries, which to date have been responsible for reviewing and evaluating the responsible for a bulk of the public procurement, appraisal (pre-feasibility and feasibility studies) of have few specialized procurement staff to large, strategically important projects. Effective handle the seven-fold increase in procurement implementation of the IBL however, will pose a since 2006. This lack of capacity combined with challenge given capacity constraints as well as the short duration of the construction season in poor coordination between the line ministries, Mongolia - from April to October - implies the MED, and the MoF. In particular, the new that any delay in tendering in the relatively government structure of 2012 indicates that short window of time between the December responsibility for evaluating all projects has approval of the budget and the start of the been transferred to the MED. Such separate construction season could delay a project by institutional processes for the capital and at least six months to the next construction recurrent budgets, with the MED responsible season. Poor cost estimation has been a major for the former and the MoF the latter (a dual problem in procurement planning, in part due budget), will likely fragment policy-making. MED to the use of outdated cost normatives, and will also not have sufficient capacity to properly in part by the tendency to award contracts to evaluate the over a thousand project proposals the lowest priced bidder which has encouraged that it will receive each year from line ministries, companies to submit unrealistically low bids and with the result that project preparation will to then to seek price increases during contract continue to be poor. implementation. 17. Lack of transparency and capacity in public 19. The extensive use of direct contractinge procurement: Public procurement is usually the 43 percent of all contracts, and 75 percent of 10 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE roads contracts in 2007 - is the most obvious both responsibilities in line ministries given indicator of political interference in the award the close links between political and business of contracts. Such large-scale direct contracting circles. The reasons are both the lower cost of is now prohibited by the amendments to the monitoring the procurement process in one PPLM approved by parliament in 2011. However, agency as opposed to several ministries; and the DBM is not subject to the PPLM and has the increased cost to those who would wish to been, on the instructions of the parliament, influence contract award for their own personal implementing a number of roads projects and political interest since they would now through direct contracting. need to effect the CPA as well as concerned line ministry staff since both will be involved 20. The amended PPLM has substantially altered in the bid evaluation committees. Retaining the procurement system in the country. Two procurement authority with line ministries and important changes are the creation of a new increasing specialized procurement staff in central procurement agency (CPA) that will be them would not address this political economy responsible for all major procurements from the problem since these staff would continue to be central government budget, taking procurement susceptible to the influence of their minister. authority away from the line ministries (line ministries will continue to be responsible for 23. The authority given to CSOs in the PPLM is contract implementation); and a new formal very extensive when compared to similar pieces role for civil society organizations (CSOs) in bid of legislation in other countries, and if effectively evaluation and contract monitoring. implemented will make Mongolia quite unique in institutionalizing citizen oversight over public 21. The rationale for the creation of the CPA procurement. This change is in keeping with a is to both increase procurement capacity and trendseeninmanycountriesoverthepastseveral to increase transparency and reduce the risks years for a greater push for transparency and of corruption. The aim is to establish an entity CSOoversightofpublicexpenditures.Concerned that specializes in procurement and which CSOs in Mongolia have recently come together would be staffed by professionals dedicated full to form a procurement monitoring network time to this purpose, as opposed to the current called the Public Procurement Partnership. arrangements where regular officials from line ministries conduct procurement in addition 24. Inflexibilities in budget execution: Between to their normal duties. This separation of the 50to60percentofthecapitalbudgetisdisbursed procurement function from line ministries is in the fourth quarter of the financial year, with also meant to allow the latter to focus on their approximately 30 percent in the final month. main responsibilities of policy-making, planning, Part of the reason for this skewed pattern is the implementation and monitoring. incentive for line ministries to disburse given that the capital budget is annually appropriated and 22. A priori, it is difficult to predict whether any unspent funds are re-appropriated by the the centralization of procurement increases MoF at the end of the fiscal year. This pressure or reduces the risks of corruption and political to disburse undermines financial controls as interference. On the one hand, under the money is being given to construction companies wrong leadership, the CPA will have much for work that is yet to be completed. The capital greater ability than multiple line ministries to budget has to date not provide any flexibility compromise the procurement process given the to deal with project cost adjustments or to scale of the procurement that will be conducted allow for virements between projects without by it. On the other, the centralization and the approval of parliament. An additional separation of procurement from the contract inefficiency is the excessive involvement of the implementation function may also reduce the budget department of the MoF in authorizing risk of political capture as compared to retaining payments for projects, a responsibility that 11 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE ideally should be delegated to line ministries together with the limited capacity of the in keeping with their authority for project construction sector, all translate into low value management. The IBL has introduced reforms for money of public investments. Time and cost to address some of these problems, although overruns are ubiquitous; a sample of roads some, such as allowing carry-over financing for projects had an average time overrun of 120 3 months, do not go far enough. percent and an average cost overrun of 35 percent. 25. Capacity limitations in the construction sector: Improving government systems for POLICY RECOMMENDATIONS planning, budgeting, procurement, contract implementation, and monitoring have to be 27. Political economy factors underlie many matched with ensuring that there are no of these technical problems in the public regulatory hurdles that prevent the growth of expenditure system. For example, the need the construction industry to meet the rapidly for members of parliament to appeal to rural growing demand, and addressing capacity constituencies plays a big role in the skewed constraints. The Mongolian roads construction infrastructure spending towards the growth industry is currently incapable of meeting the peripheries; and the links between political and huge construction demands of the medium business circles explains many of the problems term plan. These capacity constraints are evident in public procurement as well as the extensive in the soaring prices of construction materials. use of off-budget financing. The rapid socio- While the industry has been growing steadily, of economic transformation underway however, the 186 registered road construction companies, is also changing the political landscape and only 59 are currently active, and of these 59 only part of the Government's motivation for the 10 have the capacity to build roads above 50 km host of public expenditure reforms underway in length. Restrictions on the hiring of foreign _ the FSL, the IBL, and the PPLM - as well as workers are the main regulatory constraint to a new Conflict of Interest Law and a Freedom the construction sector. Due to the labor force of Information Law, is to put in place regulatory shortage -approximately 500 engineers and shorage-aproxmatly 50 eginersand safeguards that will prevent these new resource 5,000 skilled laborers are employed in the rents from being "captured" by relatively roads construction sector, about half of what is currently needed -it is essential for companies piily doit the n e to obtain laborers and specialists from abroad. However, the Labor Law requires a specific political influence of the majority of members quota to be kept between the number of local of parliament. There are also several positive and foreign workers. The law also requires a features of Mongolia's political economy high premium (monthly fees) per foreign worker an ethnically homogenous and relatively well which approximately equals the average salary of educated populace, and relatively (compared a local construction worker. There are also some to other developing countries) well-disciplined restrictions in the Customs Law on the import political parties with a clear corporate identity of equipment that negatively impact the sector. - that give a degree of optimism that some Non-competitive procurement practices - both of the reforms being proposed below have a de jure, such as the use of direct contracting reasonable chance of being implemented. and the recent raising of the threshold for international competitive bidding, and de facto 28. In making its recommendations, this report through politically motivated award of contracts focuses on some of the details that need to be - also hurts the growth of the construction laid out in implementing regulations in order industry by creating barriers to entry. to make the FSL, 11L, and PPLM work. The report also suggests amendments to some of 26. The result: low value for money: These the existing laws that pose a risk to meeting weaknesses in the public investment system, the four objectives. In proposing policy options, 12 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE the report is conscious of the political economy on the main national and local unpaved roads of reform and, wherever possible, analyzes the to make these roads all-season, and regular compatibility of the technical solutions with the maintenance, thereby improving connectivity political interests of policy-makers. for rural communities. 29. Higher spending on the growth poles and 32. The government needs to increase its on capital maintenance: the Government's annual roads maintenance spending from the current and medium-term infrastructure current 15 billion MNT to 75 to 90 billion MNT spending priorities need to be reoriented to to meet network maintenance needs and to emphasize the growth poles, in particular clear the backlog. This can achieved through Ulaanbaatar, and to focus on the maintenance a modest reallocation from new investments of capital assets to move away from the current to maintenance as it represents only 20 to 30 'build-neglect-rebuild' syndrome. 60 percent percent of the 330 billion MNT earmarked in the of Ulaanbaatar's population lives in peri-urban 2012 capital budget for new road and bridge settlements that are not fully integrated into construction. Clearly this is a "low hanging the city's infrastructure, a problem that will fruit" that can show immediate results if the get worse if not urgently addressed with the political will is there to implement it. continuing migration into the city. Rather than 33. Ensuring that the DBM is within the discouraging migration to Ulaanbaatar and framework of the FSL: Sensible phasing of artificially creating alternative urban centers, as outlined in the draft medium term National capial e ies ipie th te Development Strategy, the Government needs fisclires set out cin he ude fund to accept that this migration is driven by the on alternative forms of financing, most notably forces of economic agglomeration that, if from the DBM. It is imperative that there be well managed, can encourage broader-based a clear policy from the government that: (a) economic growth. that the DBM only funds revenue-generating 30. mprvin thelivs o theresdens ofthegerprojects; (b) if it is to fund social benefit projects 30. Improving the lives of the residents of the ger(e.g. areas will require construction of access roads; the $150 million lent for rural roads in 2012) better heating systems to improve efficiency and be reflected in the state budget and therefore reduce air pollution; investments in solid waste be capped by the structural balance and management and community infrastructure; expenditures rules of the FSL; and (c) that there affordable collective housing for mid-tier areas; are some limits on the aggregate lending of the and expansion of the city's electricity, heating, DBM to prevent overheating of the economy and water utilities. In the roads sector, new and to ensure macroeconomic sustainability. construction should concentrate on where These provisions would require an amendment demand is the highest: Ulaanbaatar's city to the DBM Law. trunk and feeder roads the international transit corridors, and roads serving mining areas. 34. Eliminating BTschemes: BT schemes involve very little transfer of risk from the government 31. This is not say that equity considerations are to the private sector partner and increase the not important. In fact low cost improvements financing costs of projects. The advice on this in rural transport connectivity are feasible given is simple: the government should discontinue that Mongolia's terrain allows for relatively these BT schemes as they are a bad practice and good driving conditions on natural tracks should instead finance such projects from the and gravel roads. These natural tracks can be budget. made all-weather through a focused program of spot improvements that would entail the 35. Strengthening the legal framework for construction of some new bridges or culverts public-private partnerships: More generally, the 13 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE legal framework for public-private partnerships 38. This report recommends that the division in Mongolia, which is set out in the Law on of responsibilities between the MED and the Concessions (2010), is quite weak. Under the MoF proposed in the IBL be implemented, with IBL, the MoF has now been correctly given the perhaps the threshold of large projects to be sole authority on evaluating fiscal risks of PPPs evaluated by the MED lowered from 30 billion and issuing guarantees, addressing a major MNT to 10 billion MNT. The exact amount of the weakness in the Concessions Law. However, this threshold is a judgment call, and should be such provision could be strengthened further given so as to ensure that only large, complex projects the particular risks that Mongolia faces. Some of a number that can be realistically evaluated countries have established in law a quantitative by the MED given its current staff capacity are limit on the government's aggregate exposure above it. On project appraisal methodology, the to fiscal risks through PPP contracts. This would report suggests that initially the Government for limit the government's exposure to fiscal risk most projects focus more on ensuring accurate during the period when the PPP policy is being cost estimates rather than a full socio-economic developed and piloted, and the government is cost-benefit analysis, with cost-benefit analysis building its capacity to assess risk, and design limited to large, complex projects. Parliament and implement contracts. proposed projects should be subjected to the same project appraisal process specified for 36. Improving corporate governance in the DBM: line ministry projects in the IBL and supporting The vast majority of development banks across regulations. In terms of the budget cycle, this the world are either 100 percent or majority may imply that projects proposed during the government-owned and therefore government parliamentary budget session, if they pass ownership in itself is not a determinant of MED's or Mo's appraisal, could be considered success or failure. Rather, the better performing for funding and inclusion in the capital budget development banks have been characterized for the following fiscal year. Alternatively, for by a sound regulatory environment and projects to be included in the same fiscal year corporate governance principles, which include there needs to be a formal mechanism by which a clear mandate, clear ownership structure, parliament can propose projects early during independence of the board, checks against the budget preparation process. political interference, strong supervision, and regular performance assessment. It is critical 39. Improving pub/ic procurement and project that these principles be incorporated in the implementation: The three key challenges regulatory framework of the DBM, and the that the CPA will face are how to ensure that report provides some suggestions to this effect. the centralization of procurement reduces corruption and increases transparency; how to 37. Strengthening project preparation: The IBL properly coordinate with the line ministries that represents a significant step in strengthening are still responsible for preparing the technical the regulatory framework for project specifications and to clarify that they remain preparation and appraisal, and in improving accountable for contract implementation; and the coordination between planning and capital how to scale up capacity quickly. budgeting. However, operationalization of the IBL is very much a work in progress. There is a 40. On the first challenge, the extensive use of risk that responsibilities for capital and recurrent e-procurement will be important, though this budgets will be split between the MED and would not entirely solve the problem of political the MoF; that the methodology for the more influence in bid evaluation. The Procurement rigorous project appraisal required in the IBL will Inspectorate under the MoE will also clearly not be sufficiently calibrated to current capacity have an important role to play in supervising the in the MED and MoF; and that parliament will procurement process. The Government is also continue to insert projects that bypass the ThL. considering the establishment of an Oversight 14 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Council under the Prime Minister. These 43. The report provides some detailed sugges- are all important measures. However, given tions to both the Government and the Mongolia's small size and the fact that conflict emerging CSO procurement network that has interests abound, it would also be advisable recently formed on the modalities for CSO to subject some of the CPA's operations to participation in bid evaluation and contract international oversight. For high profile, and/ monitoring, on the nature of the self-regulatory or particularly sensitive contracting, the CPA regime for the Public Procurement Partnership, should consider the use of "probity advisors", and on long term funding arrangements so typically an international audit firm, on bid that CSOs are not reliant on unpredictable evaluation committees in order to provide international donor resources. in order to independent procurement expertise in the event preserve their independence, it is suggested of disagreement and to ensure a transparent that CSO participants in bid evaluations should and robust process. be observers, and not voting members, with their observations documented in standardized 41. Success of the CPA will be conditional observers' reportthat can be publically available. on proper coordination with line ministries The criteria that are used to select contracts for that will continue to provide all the technical CSO monitoring should be transparent, with the specifications for the bidding, and will continue annual monitoring authorized by the Cabinet in to be responsible for contract implementation, order to guarantee CSO access to all relevant and clarity on roles and responsibilities so that all documents. With regards to the CSO network, stakeholders know what they are accountable to encourage its growth it is recommended that for. The PPLM's implementing regulations need the network enact loose entry requirements to clearly state that the CPA takes responsibility such as prior experience with monitoring for facilitating the administrative processes, i.e. government processes, compulsory training for advertising, disseminating tender documents, affiliates, and agreement to a code of ethics, receiving and opening bids, organizing the violation of which would result in black- evaluation committees etc. At the same time, it listing. Finally, on sustainable funding in the should be clearly stated in the regulations that medium to long run, an independent national the line ministry/implementing agency takes foundation can be established to fund different responsibility for the technical aspects of the types of CSO activities including procurement procurement, i.e. (a) preparation of technical specifications and related requirements in monitrin T udain ould ndia the tender documents and (b) the technical prite and stan loure ofrfnding evaluation. Without this ownership from the m fompthesudget, dee ent par implementing agencies accountabilities will be mi co maind andinden bor diluted and line ministries may even have an ncil fo in fun e ciisf incentive for the CPA to fail.pros sm ti ies 42. The CPA will also need to quickly ramp 44. Improving budget execution: Mongolia's up capacity. Currently there is no transition capital budget execution faces two particular arrangement in place - as per the PPLM, the challenges: an extreme climate that reduces CPA will have to take over from line ministries the construction season to 6 months; and high starting January 1, 2013 - which creates a volatility in the prices of construction materials big risk that sufficient capacity will not be in that makes it difficult to fully anticipate costs place in time to have contracts finalized before during budget preparation. Greater flexibility in next year's construction season commences. It budget execution is required to meet these two would be advisable for the CPA to begin slowly challenges. The two usual methods are carry- with some selective contracts to give it sufficient over funding or multi-year appropriations, and time; this provision however, would require an giving spending agencies more authority for amendment to the PPoLM. virements between projects. On the latter, the 15 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE IBL has made significant progress. On the former, salary premiums to staff working in jobs in high the IBL only allows carry-over for three months demand. The Government will also need to rely of up to 3 percent of the capital appropriation, more on contracting-in and contracting-out the which implies that any spending in the next necessary capacity, such as for project appraisal fiscal year would have to be completed before and procurement of large, complex contracts. the new construction season commences in April. Therefore, this provision does not do 47. The problem of skills scarcity is obviously not enough to solve the problem. Instead, the carry- limited to the government, as the discussion of over provision should be increased to one year, the construction sector highlighted, and over while sticking to the 3 percent limit, to provide the medium to long term additional investments sufficient time for the completion of works in the education system, including tertiary while minimizing fiscal risks. and vocational training to ensure that the economy can draw on a highly qualified pool 45.Addressing human resource capacity of technicians, operators, engineers, and other constraints: Limited number of skilled personnel professionals will be necessary. Realistically is a persistent theme in many of the problems however, these measures will not completely identified in this report. Key ministries and ameliorate the fundamental constraint of labor agencies in Mongolia are generally small and scarcity in Mongolia, and the Government will the potential for significantly recruiting staff need to learn from the experience of other labor with the necessary technical expertise for scarce natural resource rich countries which planning, budgeting, procurement, and project relied extensively on importing both skilled implementation in the near term is limited. and unskilled labor from overseas. Currently, Worryingly, the booming wages in the mining international migration flows to Mongolia are sector are attracting some of the best staff in low with migrants accounting for only 0.4 the civil service, a part of the general movement percent of the country's population. As noted, of factors of production from the non-mining to the policy for migrant workers is restrictive, the mining sectorthat is a common characteristic which in particular is hurting the growth of the of natural resource-rich economies. construction sector. Opening the borders to highly qualified immigrants can plug the skills 46. In order to combat this "brain drain" from shortfall and produce knowledge spillovers that the civil service, and to maintain its attraction accelerate human capital formation. for new recruits, the Government may need to be more flexible in its approach to civil service 48. These policy recommendations, with a pay by moving beyond across-the-board salary suggested prioritization for implementation are increases and giving additional market-based summarized in the table below: aapndrhetraf in the ini ngregins. 2. In the rural areas, the government should focus on low-cost spot improvements (e.g., construction of bridges or culverts, maintenance of natural tracks) on theactin te main national and local unpaved roads to make these roads all-season, thereby Immedial improving connectivity for rural communities. 16 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 3. The Government should be annually spending five times as much as it currently does on road maintenance to cover routine maintenance needs and to clear the backlog of roads requiring rehabilitation. This would only require a 20 percent Immediate reallocation from new investments to maintenance and repair and can be easily achieved. Achieving the Balance between Infrastructure needs and Macro-fiscal Sustainability 4. The Government should have a clear policy that (a) that the DBM only funds revenue-generating projects,; (b) if it is to fund socially beneficial projects then the amount of lending to such projects be reflected in the state budget and therefore be capped by the structural balance and expenditures rules of the IFSL; and (c) that I there arsome limits on the aggregate lending of the DBM, through adequate capital adequacy ratios and MoF oversight, to prevent overheating of the economy and to ensure macroeconomic sustainability. Such a policywill require amendments to the Law of the Development Bank. 5. The government should discontinue "build-transfer" (BT) schemes in the roads and energy sectors as they increas the cost of projects and involve very little transfer of risk from the government to the private sector, and should instead finance such projects from the budget. 6. The government should consider imposing a cap on its aggregate exposure to Medium- fiscal risks through PPPs, perhaps initially at 2 percent of government revenues, a Mem figure which could be increased as experience of implementing PPPs grows. Strong Corporate Governance for the DBM 7. The Law on the Development Bank needs to be strengthened to reduce the risk of macroeconomic instability and poor quality of capital expenditures. This will require amendments to ensure clarity of mandate a higher capital adequacy Immediate ratio; greater oversight by the MoFj independence for the board; supervision by the iank of Mongolia and performance contracts to balance accountabiity with independence. Strengthening Project Preparation 8. The Government should not create a dual budget with the MED and MoF responsible for preparing the capital and recurrent budgets respectively. Instead, the IBL provisions on planning and capital budgeting should be implemented with the MED responsible for reviewing large projects only. The Government however, could consider lowering the threshold for these large projects from 30 billion MVNT. 9. The draft planning law needs to specify the consultative mechanisms, such as sectoral inter-ministerial groups, and a Southern Gobi Infrastructure Council, to Medium- mandate the collaborative process needed in developing the medium and long term term planning documents and scenarios. 10. The implementation of IBL provisions on project appraisal need to be calibrated to local capacity. The Government could start by focusing more on the cost sideImeit of cost-benefit analysis for most projects, with the more sophisticated full socio- economic cost-benefit analysis limited to large, complex projects. 11. Parliament proposed projects should be subjected to the same project appraisal process specified for line ministry projects in the IBIL and supporting regulations. In terms of the budget cycle, this may imply that projects proposed during the parliamentary budget session, if they pass MED's or MoF's appraisal, could be Medium- considered for funding and inclusion in the capital budget for the following fiscal term year. Alternatively, for projects to be included in the same fiscal year there needs to be a formal mechanism by which parliament can propose projects early during the budget preparation process. 17 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Improving Budget Execution 12. The IBL should be amended to increase the carry-over funding provision for capital Medium- projects from three months to one year, while sticking to the 3 percent limit, to term provide sufficient time for the completion of works while minimizing fiscal risks. 13. The budget department of the MoF should not be authorizing payments for capital Medium- projects as this is a treasury function and it takes precious time away from the vital term task of budget planning and project appraisal. Greater Capacity, Transparency, and Oversight in Procurement and Project Implementation 14. In order to ensure transparency and adequate oversight over the Central Procurement Agency the Government should: establish an Oversight Council; use e-procurement; and for high profile contracts, use "probity advisors", typically an international audit firm, on bid evaluation committees to both advise on technical issues and to be an independent observer to ensure transparency and robustness of the process. 15. In order to clarify roles and responsibilities between the CPA and line ministries, the line Ministry/ Implementing Agency should have the majority vote in respect of the technical issues during bid evaluation (either when it comes to voting on technical Immediate issues or by way of a separate technical evaluation sub-committee, whatever is most efficient). To provide a guarantee of probity, the CPA would be able to veto that technical decision whenever it considers the decision not to be genuine. 16. Transition arrangements need to be in place as the CPA builds capacity to ensure that procurements are not delayed. It would be advisable for the CPA to begin Immediate slowly with some selective contracts to give it sufficient time; this provision however, would require an amendment to the PPLM. 17. It is recommended that the non-government participants on bid evaluation committees should be observers and not voting members, and should not comment Immediate on the technical evaluations but restrict their role to observing and commenting on the transparency of the process and compliance to rules and regulations. 18. There should be a standardized reporting template - an "observers report" -for bid observers. The template should include a space to include detailed comments. Immediate The reports should be submitted electronically and channeled to procuring entities and to the Ministry of Finance. 19. To be effective in contract monitoring, CSOs will likely need to partner with engineers or other technical specialists. The engineers would bring the necessary Medium- technical skills to the table, while the CSOs would help ensure that these engineers remain independent and that their technical assessments are effectively used for advocacy purposes to ensure transparency and accountability. 20. A CSO network has an important roleto play to ensure standards in CSO monitoring. This is particularly important given that CSOs can suffer from the same conflicts of interest as policy-makers. The network should be an umbrella organization with affiliates across Mongolia. In the short-term, the network should have very loose Medium- entry requirements: prior experience with monitoring government processes (e.g. term EITI, budgets, and elections); compulsory training for affiliates; and, agreement to its Code of Ethics. The network should monitor its members' participation in procurement monitoring and have the right to blacklist members for violating the network's Code of Ethics or government regulations and laws. 18 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 21. In the short run the World Bank and other donors can fund the CSO procurement network. The Government could also provide a budget line to the MoF to fund contract monitoring and bid evaluations. In the long run, an independent IMediate foundation can be established to fund different types of CSO activities, including Medm procurement monitoring, which could be funded by the government, donors, and mining companies. 22. In order to combat the "brain drain" from the civil service, and to maintain its attraction for new recruits, the Government may need to be more flexible in its approach to civil service pay by moving beyond across-the-board salary increases Medm and giving additional market-based salary premiums to staff working in jobs in high demand. 23. The Government can also learn from the experience of other labor scarce natural resource rich countries which relied extensively on importing both skilled and unskilled labor from overseas. Opening the borders to immigrants can plug the Medium- skills shortfall and produce knowledge spillovers that accelerate human capital term formation. This would require relaxing some of the restrictions on migrant workers in the Labor Law. 19 THE CHALLENGE OF SCALING UP INFRASTRUCTURE INTRODUCTION: 15,000 workers during the construction phase, WHAT THIS REPORT IS ABOUT or roughly 0.14 percent of Mongolia's labor force, and will employ only about 3500 during 1. Mongolia today is at the cusp of a major production. Such low employment generation economic transformation as it begins to exploit is a common feature of such large mining its vast copper, gold, coal, and other mineral projects. The non-renewable nature also implies resources. The economy has been growing at that care must be taken to avoid the "Dutch almost 9 percent on average in real terms since Disease", the phenomenon in which the rise 2003 when the mining boom began with the in value of natural resource exports results increase in global commodity prices; growth has in an appreciation in the real exchange rate, accelerated to double-digits in 2011 and 2012 reducing international competiveness that hurts with the construction of the Oyu Tolgoi copper the tradable sectors, such as manufacturing or mine, one of the five largest in the world; and agriculture, that are viewed as the sources of will likely remain in the double digits as Oyu sustainable growth. And, most importantly, Tolgoi and the similarly huge Tavan Tolgoi mineral resource revenues significantly increase coal mine go into operation over the next few opportunities for corruption, a risk that is years thereby greatly increasing the volume of particularly acute in Mongolia given the scale Mongolia's mineral production and exports. The and pace of the change, and the already close scale and pace of this change will be staggering connections between political and construction given the roughly trillion dollar estimated industry circles. reserves in these fifty to hundred year mines, making Mongolia one of the, if not the, fastest 3. Mongolia is very vulnerable given its heavy growing economies of the world. If the right dependence on natural resources. As Figure 1 institutions and policies are put in place, this shows, mining directly accounts for 20 percent resource boom can be used for the sustained of the economy and approximately 85 percent improvement in the lives of current and future of exports, by far the largest share in East generations of Mongolians. Asia and the Pacific, and more in line with the proportions of the oil-producing Gulf states. This 2. Achieving this potential is far from automatic dependence will only increase once Oyu Tolgoi as there are numerous examples of natural and Tavan Tolgoi go into full production over resource rich countries which have performed the next decade and Mongolia's annual copper worse than those without such endowments, and coal output increases four-fold in terms of hence the frequent use of the phrase "resource volume as compared to today. By 2016, mining curse".Natural resourcesaredifferentfrom other is expected to contribute to more than half of assets because they need to be extracted and GDP and 95 percent of exports. not produced, and they are non-renewable. The former implies that natural resource production 4. The main mechanism for avoiding these is an "enclave" activity with few linkages to problems and achieving sustained growth other sectors of the economy, and therefore through a diversified economy will be public mining-driven high GDP growth numbers by investments in infrastructure, education, themselves do not automatically imply broader and health to provide public goods, address development of the other sectors of the economy market failures, crowd in private investments, or large-scale job creation. For example, the and achieve redistributive goals.' Tax revenue Oyu Tolgoi project currently employs about 1 MF (2012) suggests a rethinking of standard MF policy advice for resource rich developing countries, It notes that given that such countries are capital scarce and are likely to have high returns to domestic investment, an optimal resource allocation strategy should have a significant domestic investment com- ponent. Therefore, straight savings in foreign assets, as for example in Chile and 20 Normay, may not be as advisable. MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE collections are high in Mongolia at around 35 THE NEEDS percent of GDP, and with mineral revenues accounting for a third of government revenues. 6. Mongolia's infrastructure needs are con- These revenues are projected to triple in the siderable. Its population of 2.8 million people next seven years as Oyu Tolgoi and Tavan Togoi is spread out over an area of 1.5 million go into full production, and increase steadily square kilometers (the 19th largest country in thereafter with the growth of the mining the world by area) making it the least densely economy (Figure 2). populated country in the world, at 1.8 persons per square kilometer. Given that the capital city 5. The key challenge will be to effectively use of Ulaanbaatar has over 1.2 million inhabitants these increasing revenues, with the major most of the country has less than 1 person responsibility falling on the Government's per square kilometer. The scarce population public investment system for planning and scattered over a large land area, combined with implementing capital projects. The objective the extreme climate, implies that the unit cost of this report is to analyze in depth the current of providing infrastructure such as roads, water, public investment management system and to and electricity, as well as services, for much of assess whether or not it is able to meet this the country is very high. challenge of delivering good quality projects in the priority areas in a macro-economically Figure 2: Government revenues are projected to sustainable manner; and to recommend what increaserapidlyoverthemediumtolongterm needs to be done to improve the system so that it is able to effectively transform natural resource revenues into sustainable capital assets. Figure 1: Mongolia is more heavily dependent on mineral resources compared to other countries in 10000 Mineral revenue East Asia 800 e eEducaion GDP by Sector Agriculture, Real Estate 1% Frsr 5% Fishing 2,00 Other 17% 11% 0 Finance, 2008 2011 2014 2017 2020 Insurance 4% As percent of GDP 30 - Wholesale, %...Manufactur. 25 -4$-Total revenue Retail Construction 20 Mineral revenue 14% 2% 15 90 Mineral exports (as percent of total) 10 80 60 0 5n 2008 2010 2012 2014 2016 2018 2020 40 30 Source: World Bank staff projections 20 10 ~J A 7.Given these challenges of geography, it is C0 ar hT itMlm N .LoMn not surprising that Mongolia's infrastructure is Chn Camb Ph Th Viet Mal Ind PING E. Lao Mong Timorrelatively under-developed. Its current network of 49,000 km of roads implies a road density Source: National Statistical Office (NSO); Bank staff of 0.03 km per square kilometers of area, calculations considerably lower than other Asian countries, 21 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE though similar to other scarcely populated Figure 3: Road density in comparative perspective countries such as Botswana, Kazakhstan, Australia, and Canada (Figure 3). Only 6500 km Roaddensity:Kofroadspersq. km of this network however, are engineered roads 0.80 0.7 (paved, gravel, or improved earth) with the rest 0,7 Asian countries being natural tracks formed through repeated 050 0.4 0.4 countries use. Because of Mongolia's terrain, these tracks 040 03 can offer reasonable driving conditions, but 03' 0.2 0.1 014 are prone to closures during winter and clearly 0 04* . are not as efficient as paved roads. Although 000 Mongolia lies at the border of East Asia and :2 Central Europe, from an analytical perspective 0 U it has much in common with Pacific island _o states. Apart from having a small population, Mongolia also faces high transport costs. It is Figure 4: Transport performance not as remote from major markets as these (x-axis: GDPper capita; y-axis: World Bank Logistics Performance Index) island countries, yet transport across land tends to be more costly than maritime shipments, increasing the cost associated with distance.2 Mongolia's regional ranking on the World Bank's Logistics Performance Index' places it close to the Solomon Islands, Papua New Guinea, and 2.5 Timor Leste and distinctively below all other East Asian countries (Figure 4). 1.5- 8. The power sector faces similar problems, =0.7896 with 92 percent of the country's power being supplied by socialist era coal-fired power plants which are inefficient and unreliable. Since 2000 Soure: World Development Indicators Mongolia's energy demand has been increasing Note: Mongolia (MNG); Solomon Islands (SLB); Papua New faster than economic growth and losses in the transmission and distribution systems are high 9.The infrastructure that exists is of poor (technical losses were about 12.5 percent in quality. The 2011-12 Global Competitiveness distribution and about 3 percent in transmission report ranked Mongolia 11181 of 142 countries on average). Peak demand of Mongolia's on infrastructure quality. Currently 60% of electricity systems is estimated to double from the national engineered roads are in "poor" 570 MW in 2005 to 1,099 MW in 2014. condition requiring significant repair or complete rehabilitation (this classification is based on standard criteria developed by the Department of Roads, the implementing unit of the Ministry of Roads and Transportation). The number of annual power outages has increased forty-fold ____________over the past five years, from 6 in 2006 to 238 2 Lam5o and Venables 120011 estimate that ground transport is about seven times more expensive than sea transport. i 00 3 The index is based on surveys conducted by the World Bank in partnership with academic and international institutions and private companies and individuals en- -oglas eeomn gaged in international logistics. Respondents evaluate eight markets on six core 1 0. Moglasinfrastructure dvlpethas dimensions (e.g. the quality of infrastructure and competitive transport pricing). The markets are chosen based on the most important export and import markets been unable to keep pace with the burgeoning of the respondent's country, random selection, and, for landlocked countries, demand and is aproachin a breakin oint neighboring countries that connect them with international markets. Respondents evaluated the quality of trade and transport related infrastructure on a scale from in the capital city of Ulaanbaatar. The number 1 (worst) to 5 (best0. See Arvis at al. 120101 for more details. 22 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE of vehicles has been growing at 12 percent Figure 5: Growth in government capital annually since the transition from socialism expenditures, 2003-2011 in 1990, with the pace accelerating since the NominalCapitalExpenditures,inBillionsofMNT mining boom, resulting in severe congestion 2,500 in Ulaanbaatar - the average recorded speed in the city center fell by half between 1998 2,000 and 2008 (from 45 km/h to 23 km/h), and has almost certainly fallen further since then.4 The 1,500 peri-urban informal settlements, or "ger areas", are home to about 60 percent of Ulaanbaatar's residents and are virtually not served by the city's 500 heating, water supply, and sanitation network. In the winter months, residents are forced to burn coal for heating, and the resulting smog has given Ulaanbaatar the dubious distinction of being the world's most polluted city in the p e winter to add to its rank as the coldest capital city. The poor condition of unplanned and 25 unstructured earthen roads in the ger areas is a 20 major problem for the residents as many portions 15 of these roads are impassable for vehicles, have 10 drainage problems, pose traffic safety hazards and are the source of a substantial amount of 5 dust. Solid waste collection from the ger areas 0, is unreliable and infrequent - once a month 2003 2004 2005 2006 2007 2008 2010 2011 2012 2013 or even once in three months - with obvious NAs percent of total expenditures As percent ofGDP unpleasant consequences and health hazards.' Source: MoF and NSO data THE PLANS AND FINANCING 12. To take the example of the road sector, 11. The Government has ambitious plans to "Mitr o oStrengTenstapity meet these infrastructure needs. Mongolia's "MdemPormt teghnteCpct medium term infrastructure investment plan's of Road Transport Sector", includes the specified in sectoral master plans and the draft ofs212akmoofonew5 pave roads an7ridg National Medium Term Development Strategy crossings in Ulaanbaatar. Outside the capital, amount to approximately $45 billion over the the program will create 5,572 km of new paved period 2011-2016, or over five times the 2011 roads linking aimag (province) centers to the GDP, with major investments anticipated in capital and nearest check points and 990 km of roads, railways, electricity, and an industrial park. highways along the international trade corridors. While there is little doubt about the overall scale If successfully implemented, 95 percent of of the infrastructure development requirements, estimating these with some degree of precision pae byn2016.nThtoal inet plne is not easy as it is unclear whether all the frhed w orks ivestme t $ lin, investments specified in these plans need t or 50 percent of 2011 GDP. Clearly, not all of should be the prioritization and sequencing ofplans can be implemented in the expected theoudvet e pt in time frame, and as this report will argue, some the ivestmnts.logical prioritization of the infrastructure based ____________on its contribution to national economic growth 4 ADB (2011) 5 World Bank (201 2a) to 23 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 13. In 2010, the parliament approved a new Figure 6: Investments are rapidly increasing overall policy on railways that outlines the construction of 5600km of new railways in three phases, with ra an anticipated cost of $6 billion, connecting the main strategic copper and coal deposits in 50 OTAgreement Southern Gobi to border crossings to China in 40 the South and Russia in the Northeast. Phase 1, of 1800km, connecting Dalanzadgad, Tavan 30 Tolgoi, Sainshand, and Choibalsan is currently 20 at the feasibility stage. 10 14. The Government is also in the feasibility 2004 2005 2006 2007 2008 2009 2010 2011 stage of developing a large industrial park in EPublic nPrivate the south Gobi town of Sainshand. The project objective is to construct coking coal, metallurgy, Soure: NSO data coal gasification, copper smelting, construction materials and petroleum refinery industries 16. The Government also plans to finance the through private investment. These projects will ambitious development agenda through other form an industrial complex and are aimed to be sources such as public-private partnerships (PPPs) developed in parallel with the railroad project, and loans from the newly formed Development at an anticipated cost of $9 billion. Again, the Bank of Mongolia (DBM). For example, the feasibility of the industrial park, both in terms Sainshand Industrial Complex Project is expected of its current proposed location as well as the to be implemented through PPPs, and there are choice of industries, will need to be carefully a number of "Build-Transfer" (BT) roads and evaluated before any public funds are spent. power schemes currently under implementation. The legal environment of PPP investment 15. Before the mining boom, Mongolia relied consists of Government policy on Public-Private largely on overseas development assistance to Partnership (2009), the Concessions Law finance capital expenditures. Budget funded (2010), and the Integrated Budget Law (2011). capital expenditures have ballooned since 2005, in 2011, the Government established the DBM increasing twenty-fold in nominal terms, or an to provide financing for long-term infrastructure average annual increase of 53 percent, and rising projects. The DBM is governed by the Law of from 11 percent of government expenditures the Development Bank of Mongolia (2011), and 4 percent of GDP to a budgeted 35 percent which specifies that it has a mandate to finance of expenditures and 14 percent of GDP (Figure 5) "large-scale development projects" approved for 2013. Almost all of these expenditures are by by the parliament based on borrowings from the central government, although this situation domestic and international capital markets. To is changing with the significant decentralization date, the DBM has raised $600 million from a introduced with the new Integrated Budget government guaranteed international bond Law of 2011. Investments are rapidly increasing flotation, and will use these resources to finance in general, particularly after the construction the above-mentioned railway project, roads, of the Oyu Tolgoi mine commenced in 2010 power supply, low-cost housing, and potentially following the investment agreement, with gross the Sainshand industrial complex. fixed capital formation rising from 27 percent of GDP in 2005 to 49 percent of GDP in 2011 THE ANALYTICAL FRAMEWORK (Figure 6). 1 7. The challenge for Mongolian policy-makers will be to ensure that these rapidly increasing financial resources - from tax revenues, from 24 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE the DBM, and from private financing - are and to ensure that the absorptive capacity of effectively utilized to meet the considerable the economy is sufficient. Third, the public infrastructure needs. Irrespective of these investment management system should be financing sources, much of this infrastructure sound so that that capital projects are well spending will be publicly funded and prepared, and implemented in a transparent and implemented, and publicly guaranteed, placing cost effective manner ("technical efficiency"). great demands on the Government's systems Finally, the construction sector has to be able to for fiscal policy, public investment planning, effectively respond and meet these increasing capital budgeting, project implementation, and demands placed on it by the government, and project monitoring. therefore the investment climate should be such as to encourage the growth of the sector, Figure 7: Conceptual framework for infrastructure thereby increasing the absorptive capacity of provision the economy. Spndingn 19.Asthe next chapterwill argue, Mongolia faces arigt problems in each of these areas that need to be cotefetiemanra"ecncaiffceny) urgently addressed if it is to effectively meet this .0 challenge of scaling up infrastructure. Chapter 4W 3 then presents some suggestions on the main reforms needed in public investment planning oversigt,anre the investment climate ulob thsua the rowth of grthe ofntru scton the economy sesector p e n edi n 2 0.nT h e n c i n i n s e t h a t k e the righte t e r w h f t e o sru to "Asnca efficiencystakeholders in both the executive and legislative branches of government are well 18. Figure 7 illustrates a conceptual framework forthikig aoutths callng. Frst sendng enacted some ground-breaking reforms that if od ing about thisv challlenge fienin effectively implemented could go a long way should aim to achieve "allocative efficiency"towards addressing these challenges (Box 1). by shifting resources from less productive These include the passage of fiscal responsibility sectors to more productive ones ("spending in(FSL, the right areas"). While financing will be less 2010) - to reduce the risks of macroeconomic of a constraint in Mongolia than many other instability; an integrated Budget Law (IBL, developing countries, the needs will clearly 2011) to improve the comprehensiveness of outweigh the available resources, at least in the the budget, and strengthen public investment near future, and therefore some hard decisions planning and capital budgeting; and the revised about infrastructure prioritization will have to be Public Procurement Law of Mongolia (PPLM, made. Second, public expenditures will need to 2011) to improve the capacity and transparency be grounded in a sound macro-fiscal framework of public procurement. for long term fiscal sustainability, which is particularly important for natural resource rich economies characterized by commodity price volatility. In particular the government will have to carefully modulate its investment spending decisions so as to avoid Dutch disease effects from an investment spending boom 25 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE BOX 1: RECENT KEY NEW PIECES OF PUBLIC EXPENDITURE LEGISLATION IN MONGOLIA The Fiscal Stability law (FSL, 2010): The Fiscal Stability Law (FSL) introduces four fiscal rules to deal with mineral price volatility and Dutch disease effects. First, it mandates that structural or long term mineral prices will be used to calculate budget revenues. Second, every year the budget will have to be below a maximum allowable structural deficit (expenditures minus structural revenues) of 2 percent of GDP. Third, given that the volume of mineral production will be rapidly increasing, the annual growth of government expenditure shall not exceed non-mineral GDP growth so as to reduce the risks of real exchange rate appreciation from a spending boom. And fourth, to maintain long-term fiscal solvency, the debt-to-GDP ratio will be maintained at below 40 percent. All revenues above structural revenues are saved in a Fiscal Stability Fund, which shall be not less than 5 percent of GDP in any given year. The law goes into effect January 2013. The Budget Law (IBL, 2011): The Budget Law of Mongolia (IBL), which went into effect January 2012, is a comprehensive law that replaces the Public Sector Management and Finance Law (PSMFL) as the primary budget legislation for the country. The main objectives of the IBL are to: strengthen the medium term fiscal framework (MTFF) and ensure fiscal stability; improve the comprehensiveness of the budget; strengthen the public investment planning and capital budgeting process; ensure efficient financial management; significantly increase the authorities and financial resources of local governments; strengthen accountability through participatory budgeting. The law explicitly states that the budget consists of the state (central government) budget, the Human Development Fund, and the Social Insurance Fund, that the budget should list projects to be executed through concessions contracts, and includes information on government guarantees and contingent liabilities, thereby improving the budget's comprehensiveness. The budget calendar is laid out in detail with the process commencing with the approval of the MTFF by the parliament by June 1, together with the Socio-economic Guidelines, and which forms the basis for the line ministries ceilings (for recurrent and capital expenditures). Line ministry proposals, and those of the National Development and Innovation Committee (NDIC) for large projects, as discussed below, are meant to comply within the limits imposed by these ceilings. This provision should significantly improve the credibility of the budget process. The IBL significantly strengthens public investment planning and capital budgeting, thereby redressing a major weakness in the PSMFL. It mandates that only projects that have gone through a proper appraisal process will be considered for financing, and introduces the concept of a rolling four-year Public Investment Program (PIP) for large projects (greater than 30 billion MNT) as a stock of potentially financeable projects that have passed a pre-feasibility study. The NDIC has the responsibility to conduct these pre-feasibility studies on line ministry proposals and to determine which projects enter the PIP, with the approval of the PIP resting with the Cabinet. All financing decisions - whether to fund projects from the budget, loans, concessions, or the Development Bank of Mongolia - are then made by the Ministry of Finance (MoF), abiding by the good principle of the MoF as a single point of control on such matters. Importantly, the recurrent cost implications of the capital projects also need to be included in line ministry proposals and are an integral part of the capital budgeting process. The IBL also introduces the provision of carry-over funding - i.e. the authorization to spend unused funds in the subsequent fiscal year - for multi-year capital projects thereby potentially improving project execution. The authorities of local governments have been significantly enhanced, with the capital city and aimag governments responsible for basic education, primary healthcare, urban planning and construction, social welfare services, water supply and sewerage, public transport, urban roads and bridges, and municipal services such as street lighting and garbage removal. These functions 26 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE will be financed through local taxes and fiscal transfers (an equalization grant) from shared taxes from the central government, with the transfer formula based on population, population density, remoteness and size of the local government, and level of local development. There is also a conditional performance element to the transfers that are linked to local tax effort. Only the capital city government is allowed, with the approval of the MoF, to borrow from capital markets to finance public investment projects, with the debt limited to the previous year's revenue and debt service limited to 15% of the previous year's revenue. The Public Procurement Law of Mongolia (PPLM, 2011): The PPLM, which will go into effect January 2013, introduces radical changes in the system for public procurement in Mongolia. It takes away procurement responsibility from line ministries and gives it to a new Central Procurement Agency (CPA) for national level projects and to local governments for local level projects. The CPA will be responsible for all procurements of large projects - inter-regional roads, power plants etc - as well as for establishing framework agreements for common use items (such as office supplies) that will then be purchased by line ministries. Local governments will be responsible for all procurements of works, goods, and services to be financed from the local budget, as well as for local projects (e.g. schools and hospitals) financed from the national budget. The most novel aspect of the revised law, the new role for civil society organizations in both bid evaluation and the monitoring of contracts, with the latter potentially covering both monitoring the implementation of on-going contracts as well as gauging end-users' satisfaction with completed contracts. If implemented effectively, these provisions will make Mongolia unique among developing countries in institutionalizing civil society oversight over government public expenditure management. 21. These laws are still in the process of going effective implementation of the PPLM. And the into effect and the challenges of implementation Government will need to significantly improve its will be many. For example, there are several human resource capacity while working around nuances to the laws that need to be clearly the relatively fixed constraint of labor scarcity. spelled out in the implementing regulations in order to ensure that all stakeholders have a clear 22. Mongolia's underlying political economy understanding of the new modalities. Other is also suggestive of risks as well as reform laws, such as the Law on the Development Bank possibilities. Mongolia, a multi-party of Mongolia and the Concessions Law, may parliamentary democracy, shares some of the undermine these legislative reforms, in particular common problems of patronage-based politics given the countervailing pressures for significant - commonly referred to as "clientelism" or off-budget financing of infrastructure that if "neo-patrimonialism" in the academic literature gone unchecked will render the FSL in effect - problems that the resource-curse literature toothless. Corruption is a significant concern, has emphasized are likely to become worse particularly because of the close overlays once natural resource rents start flowing in.6 between political, mining, and construction However, unlike many of the sub-Saharan industry circles that reformers are trying to also African countries, there are a number of positive boldly address through the recent passage of features of Mongolia's political institutions that the Law on Conflict of Interest (2012) and the are a source of hope. First, compared to other Right to Information Law (2011). There is also young democracies, Mongolia has a relatively a significant lack of coordination between the stable party system with two large parties, key agencies involved, namely the infrastructure and one or two other smaller parties, and this ministries, the Ministry of Finance, and the existence of at least two parties that are capable Ministry of Economic Development that will of winning office greatly enhances electoral compromise the IBL if not addressed. Similarly accountability. Second, although Mongolia's coordination between line ministries, local political parties are factionalized they are more governments, and the recently established programmatic-i.e. havesomeshared corporate central procurement agency will be critical for policy objectives - and disciplined than is the 6 Humphreys, Sachs, and Stiglitz (2007) Collier (2010). 27 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE case in many other developing countries. Third, to one infrastructure sector, namely roads. It is there is little prospect of an extra-constitutional therefore a deliberately incomplete analysis of intervention (e.g. military coup), thereby implying the challenge of scaling up infrastructure. It does that Mongolian policy-makers have longer time not cover local government spending, mainly horizons than many of their developing country because Mongolia is currently highly fiscally counterparts. Fourth, Mongolia is not riven by centralized (though this will change starting in ethno-linguistic cleavages, which is a major 2013) with the central government accounting advantage given that in resource rich countries to well over 90 percent of spending. It also the combination of ethnic rivalries and resource does not cover several important sector-specific rents has often proven to be explosive. Fifth, issues pertaining to the electricity, heating, Mongolia is still a relatively egalitarian society roads, water, and sanitation sectors such as the that does not have traditional, landed elites or regulatory regime, tariffs, user fees, institutional other "oligarchs" that dominate the economic structure, sector governance, and capacity. This and political landscape (although this is limitation is both because such a comprehensive changing with the recent rapid growth). Sixth, assessment is beyond the scope of this study and there is a vibrant and free press, and numerous also because the World Bank has done three civil society advocacy groups, that can provide major sector-specific infrastructure assessments the necessary checks on the executive. Finally, of Mongolia in the past five years.8 in large part due to the legacy of communism, the education level of the population is high 25. The World Bank (2007) report for example, compared to other countries at similar income doesabroadsweepoftheinfrastructureagenda levels, increasing the ability of the population to and provides a number of recommendations for hold policy-makers accountable. improving infrastructure that remain relevant today, including: better aligning pricing with 23.These positive features suggest that costs through ensuring that tariffs are sufficient Mongolian policy-makersshouldintheorybeable for cost recovery, particularly in the electricity, to cooperate to achieve reforms. The resource heating, and transportsectors; the elimination of boom however, also implies that the political regressive subsides; improving sector efficiency economy environment, like the economy, is also and governance through greater independence highly dynamic and rapidly changing. Unless of energy and water supply and sanitation some of the reforms discussed in this report are regulatory bodies; increased community enacted quickly there is a real risk that a few participation in sector decision-making; reforms privileged elites could capture both the natural of state-owned utilities, in particular through resource rents as well as the political system. consolidation of retail water provision services There is a general recognition among policy and introduction of independent boards of circles in Mongolia that the old economic and directors; and improved planning and project political equilibrium is being disrupted by the implementation. staggering economic transformation underway, and that safeguards have to be urgently put in 26. This report supplements this broader study place to ensure that the new equilibrium that by going in-depth into this last area of public emerges is one of "inclusive" economic and investment management, and identifying some political institutions that enable the largest of the main issues that need to be urgently possible number of Mongolians to participate in addressed if Mongolia is to meet the challenge and benefit from the resource boom.7 of scaling up infrastructure. This narrower, more in-depth assessment is necessary given that this WHAT THIS REPORT DOES NOT COVER is an area where significant reform efforts are currently underway, but also where major risks 24. This report largely limits itself to the analysis are emerging. of the central government's public investment system, and it does so mainly with reference 7Acemoglu and Robinson (2012) distinguish between "extractive" and "inl- 8 See World Bank (2007), World Bank (2009), and World Bank (2010a). sit c l political institutions. 28 KEY PROBLEMS THAT NEED TO BE ADDRESSED 27. This chapter will argue that to date the An annual capital budget appropriation Government has been unable to effectively structure that is not well-suited to the achieve the broad requirements for meeting multi-year nature of capital projects, the challenge of scaling up infrastructure. particularly given Mongolia's short Unpacking each of the four elements in the construction season, which creates analytical framework reveals the following major pressures to disburse before the end of problems that need to be urgently addressed: the fiscal year and before the projects have been sufficiently executed. Spending in the right areas: Encouragin the rowth of the construction sector:. * Insufficient infrastructure spending on Regulatory restrictions that are hurting the geographic centers of economic the growth of the construction industry growth - the "growth poles" - in with the result that increased capital particular Ulaanbaatar. spending is out of sync with the * A highly fragmented capital budget with absorptive capacity of the economy, a large number of small geographically resulting in soaring pricesof construction targeted projects. materials. * A relative neglect of infrastructure maintenance resulting in the very poor NOT SPENDING IN THE RIGHT AREAS condition of the existing capital stock. Avoiding the "Dutch Disease": 28. Mongolian policy-makers are not making the *best use of their budgetary resources and are resulted in one "boom-and-bust" cycle under-spending on high priority areas and over- reudin on89.Te "boom-Sadb usit" cyclef spending on lower priority areas, with the result in 2008-09. he Fis ti Lof that the budget is not being used to maximize 2010 is meant to address this problem thprdcieoenalfteeoom.Ts through fiscal rules controlling volatility po i otnsuggest th edistribuTi and excessive expenditure growth, but there is a risk that the FSL will be regional equality issues are not important; all undermined through significant off- governments have to balance the needs of budget infrastructure financing, economic growth with those of equity. Rather, Implementing the balance is particularly skewed in Mongolia, Im lmentn rocts ell:to the detriment of the twin objectives of growth * Poor project preparation due to limited and poverty reduction. project appraisal, poor coordination between the MoF and the MED, and 29. The academic field of economic geography excessive powers of the parliament to provides the overall principles on where insert poorly designed projects in the infrastructure should be prioritized and how capital budget. its provision should be phased. Generally, * Lack of transparency and capacity in economic growth is highest in geographically public procurement, and politically concentrated regions, like cities or larger motivated award of contracts that metropolitan areas.9 The reason is that the result in a low value for money of concentration of businesses allows for forward infrastructure projects as measured by and backward linkages, as firms cater to the time and cost over-runs, business needs of other firms in their proximity, 9 Glaeser (2011). 29 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE creating more integrated supply networks and further financing demands on the country. The value chains. The proximity of firms reduces Government will be faced with a challenge of transport costs, increasing the attraction of the supporting growth poles while facing pressures concentration of business. The concentration of from politicians to meet the demands of their people in a particular location breeds innovation political constituencies. The key is achieving the as it reduces the costs of communications and right balance between these twin objectives. encourages knowledge spillovers, increasing returns to scale, and the scope for specialization 32. There are several indicators that this balance on specific business lines that can enhance the is not being achieved in Mongolia with regards productivity of businesses that operate in close to the infrastructure sectors. First, the growth proximity. "Growth poles" are these geographic pole of Ulaanbaatar has been significantly areas where business agglomerate. neglected compared to the rural areas. Second, the government's medium term plans 30. The World Bank's 2009 World Development emphasize huge industrial parks that carry high Report (WDR), entitled Reshaping Economic risks and may not be well suited to the country's Geography, lays out an analytical framework comparative advantage. Third, the capital that helps policymakers to determine policies budget is fragmented with a portfolio skewed that foster such growth poles. Economic towards a large number of small projects spread growth is always spatially concentrated - across sectors and regions and an underfunding globally, nationally, and locally. Where private of large infrastructure investments that are enterprise is unconstrained, agglomeration is a critical for economic growth. Fourth, capital natural process as it makes business sense for maintenance has been under-prioritized companies to locate next to other companies for compared to new investments, with the result the reasons stated above. The guiding principle that infrastructure assets are in a considerable for infrastructure provision then is to support state of disrepair. both economic growth in the growth poles and increased economic integration so that The relative neglect of the "growth poles" people, goods, and services can move between the growth poles and the lagging regions. In 33. According to the 2009 WDR, how much other words, infrastructure is the key for both government involvement - and what set of economic growth and the convergence of particular actions - is sensible depends on a living standards across the country despite the specific country's stage of urban development concentration of economic activity. (Table 1). The first and most basic stage is one where growth poles are not yet identifiable, 31. Political economy provides another guiding and in these societies the government should principle for infrastructure provision. Regional encourage the development of growth poles integration is necessary for politicians' re- by creating the conditions for businesses election. Most Mongolian parliamentarians to agglomerate. "Incipient urbanization" is are elected from specific geographical associated with agricultural societies, marked constituencies and need to demonstrate the by populations scattered across the country in benefits of mining to these communities villages and small towns. The secondary and through, among other measures, the tertiary sectors in these countries are not yet development of local infrastructure.10 While developed as industrialization is in its infancy. some of these investments, such as soum In these cases, a government's prerogative (district) roads and soum electrification, may not is to build the institutional foundations for be allocatively efficient given the prioritization development. These institutions are spatially of infrastructure over the medium term, they 'blind', meaning that policies should not are politically rational and will therefore place target the development of specific regions. ____________Experience shows that economies perform 10 With recent electoral reforms, the Mongolian electoral system is now a mixed better when the private and not the public one with two-thirds of the seats in parliaments elected from geographic con- stituencies based on a "first-past-the post" system and one-third elected from national party lists based on a proportional representation system. 30 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE sector determines which regions have the macroeconomic policy, including a strong fiscal largest potential for economic expansion. Key framework and prudent, growth-supporting institutions relate to property rights, particularly monetary policy. A legal environment that a clear legal framework for the ownership of allows factors of production to move to their land, an investment climate conducive to the most productive use is tantamount for growth development of the private sector, and sound poles to emerge. Table 1: The three stages of urban development Ae Incipient urbanization Intermediate Advanced urbanization urbanization Urban shares Less than 25 percent About 50 percent More than 75 percent Policy priority Build density Build density, reduce Build density, reduce distance distance, eliminate division Instruments for integration Institutions Land rights, basic Land use regulations; Land use regulation and education, health, water, universal provision of land taxation; universal and sanitation basic and social services provision of basic and social services Infrastructure Transport infrastructure Transport infrastructure; demand management Interventions Slum area development; programs to reduce crime and environmental degradation Source: 2009 WDR: Reshaping Economic Geography 34. Countries at the second stageof urbanization 35. It is important to note that migration - "intermediate urbanization" - already exhibit toward the growth poles at this stage should emergent growth poles. Once businesses be encouraged as labor, like other factors of have started agglomerating in certain regions, production, will be put to its best economic use governments can play a role in accelerating the in industrial hubs. Indeed, in most countries the clustering of firms by providing infrastructure. extentof internal migration isconsiderably higher To a large extent, this implies building transport than cross-border migration, not necessarily infrastructure connecting economic centers, from rural villages to cities but from lagging reducing transportation costs, and thus creating areas to growth poles. Many people move to incentives for more firms to set up production more economically dynamic regions in order to near to the growth poles. More broadly, it find better employment opportunities. These means that the government becomes more pull factors of agglomeration are productivity- involved in supporting the flow of the factors enhancing and should thus be supported by of production to the nascent growth poles. This government. In some circumstances, however, goes beyond building roads and railroad links it is the push factors that motivate people to and includes improving health and sanitation leave their homes. In this category fall areas that as well as educational institutions that attract lack the provision of basic services, including workers and enhance the human capital of the access to health care and education, thus driving workforce. people away. Push factors do not necessarily 31 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE channel labor to its most productive use which Figure 8: The Mongolian population has been rapidly accelerates the congestion of cities without migrating from the periphery to the growth poles increasing their productivity. Hence, whilst policy 70 should support the pull forces, it should aim to 60 t minimize those forces that are pushing people s0 to migrate. Push factors are best mitigated by 9 40 Om providing a basic level of public services across 5 Orkhon (Erdo..t the country. 2! Dornogobi W 0 *D~rkhanr (S.imh-nd) 0 36. Once growth poles have developed, at the 0 400 60 Soo 1000 1200 1400 third stage of development, governments' main -20 D UVS responsibility is to reduce social and economic D30 Zavkhan divisions and to improve the environmental 40 kilometersfrom Ulaanbaatar sustainability of agglomeration. This largely focuses on slums that often accompany Source: National Statistical Office industrialization and urbanization, providing for more inclusive development among the poorer 38. At its current stage of development, segments of society. At this stage, governments Mongolia hasthree growth poles- Ulaanbaatar, shouldthusfocusonenhancingthemanagement the mining regions of south Gobi (Omnogovi of existing areas of agglomeration, improving and Dornogovi), and the mining areas in the the conditions of businesses, workers, and the north in the cities of Darkhan and Erdenet - unemployed by minimizing negative externalities providing relatively clear guidance on where of industrialization. new infrastructure investments should be spatially targeted. These growth poles have 37.Spatially targeting dynamic economic seen a considerable increase in population over areas tends to succeed when applied in an the past decade (between the two population environment where markets are working well censuses of 2000 and 2010) through migration - supported by strong legal institutions -from the rural regions, or the "periphery." As - suportedFigure 8 shows, the growth poles have seen a where basic services are widely accessible, and significant increase in population - 60% for connective infrastructure links growth poles to Ulaanbaatar and 35% for Omnogovi - with the periphery. Addressing the negative fallouts significant depopulation in the periphery, in from urbanization requires that authorities have particular in aimags such as Zavkhan, Dundgovi, a legal basis to convert land from agricultural and Uvs. to residential and other purposes; in addition, suburban development requires that public 39. Applying the WDR's analytical framework services are adequately provided at the fringes; to the Mongolian regions, the government's public transport must be of an appropriate policy should aim to enhance these growth standard to allow workers to commute to poles. Realistically, the agglomeration effects business areas, managing the demand for of mining areas, measured in number of jobs transportation; finally, authorities should focus created, including downstream processing on reducing crime and addressing potential activities, will be limited as this sector tends to threats to the environment arising from be capital intensive. For example, in 2009, the industrialization and urbanization. mining industry accounted for only 16,000 jobs. The majority of the Mongolian work force will realistically live and work in Ulaanbaatar where jobs, especially in the services sector, will be concentrated. 40. Policy priorities should thus be two-pronged: First, infrastructureshould be provided thatlowers 32 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE distance to density in the mining growth poles projects, for example the energy and roads in the north and south in order to increase the projects financed by the Millennium Challenge agglomeration effects and downstream activities Corporation, focus on the growth poles and in these regions. Transport infrastructure will therefore it may be that donor financing is be particularly important in order to transport enabling the Government to focus on the the raw materials to processing plans but also periphery. It also does not provide information to external markets, especially in China, thus on local government executed projects, which reducing the arguably the greatest development in 2011 were approximately 10 percent of the challenge to Mongolia, namely transport costs. national capital budget. Clearly, this points However, other priorities should include access to the need for more comprehensive data on to electricity, sanitation, health, and education. development projects, a shortcoming that the These policies are most closely related to areas Integrated Budget Law aims to correct. The of intermediate urbanization, according to the analysis also does not include the mining- WDR framework. related infrastructure that is being funded by the mining companies themselves (for example, 41. Second, in line with policies for areas Oyu Tologoi LLC is funding the road to China of advanced urbanization, urban planning and power generation). of Ulaanbaatar should be a priority. While Ulaanbaatar has a population of 1.2 million Figure 9: Ulaanbaatar has been relatively neglected inhabitants, it is still a small city by regional in central government spending on electricity and standards. Better managing the metropolitan transport infrastructure (2011 percent distribution of area will reduce the negative externalities of ministry capital budget allocation) urbanization whilst increasing the scope for *Ulaanbataar EDarkhan&Erdenet capturing the benefits from agglomeration. 1 Gobi Periphery&Other 42. An analysis of central government capital 80% spending suggests that the Government is not 60% following this principle (Figure 9). Ulaanbaatar has been relatively neglected in favor of the 40% rural areas, or the periphery, in the energy and 20% roads sectors. In particular the resources the government devotes to roads and bridges seem Mineral Road Education Health skewed in favor of the periphery: In 2011, the Resources& Transport, Culture& central government spent 44 percent on growth Energy Construction, Science poles, and only 30 percent on Ulaanbaatar, though this was an increase compared to the Source: WBstaffestimatesbasedonMoFdata averages in in the previous years (Figure 10). 43. Promoting urbanization also implies investing particularly evident for roads and bridges in the building and maintenance of a good road and transport infrastructure in the vicinity of cities. However, distance from Ulaanbaatar is 80.0 not a good predictor of spending on roads and 70.0 bridges (Figure 11). 60.0 50.0 44. It should be pointed out upfront that this spending analysis is handicapped by data limitations. The Government's capital budget 20 does not have any information on international 10 donors' grant-funded projects, and only includes 00 those loan funded projects for which there is 2007 2008 2009 2010 2011 Government counterpart funding. Many such * Ulaanbaatar Other growth poles Periphery &other 33 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 45. With this caveat in mind, the Government's standards of living across Mongolia. The point spending priorities do not suggest any targeted is on achieving the right balance between promotion of agglomeration effects, given that infrastructure for growth, and infrastructure traffic on 64% of the national road network for promoting convergence in living standards, is less than 200 vehicles per day, and on only and the appropriate phasing of the two. The 7% - urban roads - is it above 1000 vehicles appropriate balance and phasing would be to per day. This relative neglect of Ulaanbaatar is focus on new road construction and road repair obviously visible in increasing traffic congestion. in Ulaanbaatar in the immediate term; focus The number of registered vehicles has been on low cost upgradation of rural roads in the growing rapidly since 2004, with two-thirds immediate term; and then invest on rural paved of the fleet registered in Ulaanbaatar. The roads in the medium term. result of this growth, combined with the lack of investment in the city's infrastructure, has Figure 12: Growth poles have also been under- meant that average recorded traffic speeds in prioritized in government electricity and heating the city have declined from 25 km/h in 1998 expenditures (2011) to only 14 km/h in 2008. By contrast, there is less need for paved roads in many parts of the country as the dry, flat surfaces enables natural tracks to provide reasonable driving conditions. Indeed the official roads policy until the 1990s considered building paved roads in rural areas as an unnecessary luxury, a fact that is reflected in Mongolia's current road network."& Figure 11: Distance from Ulaanbaatar is not a good predictor of roads expenditures 45000 Ulaangom r Mandalgobi Heating plant and heating lines 35000 S30000 *Bulgan 8 *~25000 f u20000r tnSainshand .15000 * Bay'khongor *Khovd 10000Peihr 5000 UiSukhbaatar i the 0 0 200 400 600 800 1000 1200 kilometers from Ulaanbataar Source: WB staff estimates based on MoF data 46. This is not to say that the rural areas Source: WB staff estimates based on MoF data should be neglected. Rather the need forruraipa economic integration implies connecting the 47.eSedi i the energypoessectorvisg lsmilal half of the investments in power transmission, so that jobs can move to the countryside, aund policy that international experience suggests han sligymre than Thalf h spending isthn what is required in terms of current demand - services to be delivered more easily and cheaply Ulaanbaatar, Erdenet, and Darkhan represent 70 across the country, which will help to equalize percent of national demand - and are certainly 11 ADBp(2011). 34 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE less than what is required going forward given Figure 13: Education spending is spread throughout the rapid population growth of Ulaanbaatar and the country (2011) the need to provide ger area residents with more efficient and environmentally cleaner heating Education systems. The use of raw coal in heat-only boilers and household stoves by ger area households is considered one of the main reasons for the worsening air quality in Ulaanbaatar; yet Ulaanbaatar received less than 20 percent of the Ministry of Mineral Resources and Energy's capital allocation in 2011. &otihery 48. By contrast, spending priorities in the social sectors are well aligned with the principles of economic geography which emphasize that while growth poles should be fostered, basic Source:WBstaffestimatesbasedonMoFdata services should continue to be provided at an adequate level across the country. Education 50. Clearly however, the current plans are in and health spending does not seem to depend large part motivated by the political reality of on distance to Ulaanbaatar which is consistent electoral politics and the perceived need of with the notion that basic services are provided elected policy-makers to show some results irrespective of the location of growth poles of the mineral boom to the local politician. (Figure 13). The variance of education spending Therefore, some balance has to be struck across regions is considerable which may between what is economically the "first best reflect the state of already existing education option" and what is politically feasible. One infrastructure. option would be to emphasize lower cost upgrading of natural tracks in rural areas Poor prioritization in medium-term plans so as to enable them to provide all-weather access through the construction of bridges and 49. This poor prioritization is also reflected in culverts, and increased maintenance through the medium-term development plans. In the periodic smoothing of the road surface, thereby Ministry of Road and Transportation's $5 billion providing quick, visible improvements for the medium-term road sector strategy, only 21 users at relatively little cost." This strategy could percent is allocated for Ulaanbaatar's roads potentially be both politically and economically as compared to 37 percent for national roads rational. connecting the aimag centers, and 42 percent for highways in the main trade corridors (Figure 51. Mongolia's 2007-15 National Development 14). In terms of prioritization, from a purely Strategy (NDS) emphasizes a need to discourage technical point of view, it would be more migration and slow down the urban growth by advisable to have a phased strategy with the creating satellite cities and promoting regional initial focus over the next five years on (i) on the centersthatwill provideemploymentalternatives. construction of new north-south trade corridors The NDS proposesto develop Baganuur, Nalaikh, connecting the mining areas and Ulaanbaatar and Bagakhangai, all in relative closeness to with the border crossings in Russia and China, Ulaanbaatar, as potential satellite towns. Actual through the planned national highways; (ii) spending on these settlements so far has been the construction and rehabilitation of roads in negligible. However, a feasibility study was Ulaanbaatar. The large scale construction of carried out in 2011 and 2012 on establishing paved roads linking the aimag centers should the industrial park in Sainshand. As the capital be deferred to a second phase. city of Dornogobi Province, Sainshand lies to 12 Ibid. 35 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE the south east of Ulaanbaatar, bordering the wasted resources. Third, it likely increases the Gobi desert. According to the latest census its costs of the public investment portfolio as it population is below 20,000. It currently does not forgoes some economies of scale. Fourth, the have dynamic industries and does not qualify as large number of small projects taxes the limited an emerging growth pole. Artificially promoting human resource capacity of the line ministries its development is therefore a risk, considering that prepare and implement these projects, and that the scale of the proposed investment is of of the Ministry of Finance that has to screen and the order of 100 percent of GDP. approve them to be financed from the budget. It is therefore likely that a portfolio with many Figure 14: Mid-term plans also under-emphasize smaller projects will be of poorer quality than Ulaanbaatar a portfolio of the same size with fewer, larger Planned roadconstruction (20112016), billions of MNT projects. 1,271,21% Figure 15: Distribution of investment projects by ,319,fo e s Netional roads size, 2008 lconnecting aineag centers) -2 r human rs c Highcpiways otrade t ln m 6,175corridors) t Ulaanbaatar roads 28% of projects a re 2,585, 42% betweenttoa $400k and Planned ~ ~ ~ ~ ~ $4 roa costucio (211216,bilonefcNtpoecs $4M i size66% of the Source: Department of Roads projects are U,p,sy rNtinl oassze 2008 i less than Fragmented capital budget size 52. Related to the above point of the neglect Suc:W tf siae ae nMFdt of the growth poles, the vast majority of Suc:W tf siae ae nMFdt budget-funded capital projects in Mongolia are The neglect of maintenance small and geographically targeted. To take the example of the 2008 capital budget, the total 54. Another stark objective indicator of the project portfolio for new investments of roughly misallocation of resources in Mongolia is the $900 million was spread out over 758 projects, gross under-spending on capital maintenance implyinganaverageprojectallocationof$1.2M. and repair in relation to the country's needs. However, the median project size was much Due to years of neglect, the state of disrepair lower. As Figure 15 shows, 66% of projects in the energy and roads sectors is approaching were less than $400,000 in size (500 million crisis proportions. The electricity sector has MNT), and another 28% were under $4 million, immediate capital repair needs estimated by If one considers $8 million (10 billion MNT) as the Ministry of Fuel and Energy at MINIT 170- the threshold for a "large project", then only 180 billion (or approximately 2 percent of 2011 2% of the portfolio was made up of these large GDP), and 60% of the national paved road projects. In terms of cost, these large projects network is in poor condition and in need of accounted for 40% of the portfolio, capital repair and rehabilitation, at an estimated Ifucost of MNT 730 billion (or roughly 7 percent 53. Such high fragmentation rdcs tive of GDP). In Ulaanbaatar, 70 percent of the 629 efficiency for several reasons. First, these k ae od edcptlrpi ste projects tend to be uneconomic. Second, have xed teef life. Heer, the frag enttion lik ly rsulsin dupicatonmi a lloecation of ei re s u ine M ogolia ri the government has emphasized new investments 36 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE over capital maintenance. As Figure 16 (left Figure 16: The under prioritization of capital panel) shows, the growth in nominal capital repairs and maintenance repair expenditures (twelve-fold increase since Growth in investments and capital repair 2003), which includes both periodic maintenance expenditures and rehabilitation, has been significantly below the trend in the growth in new investments (thirty-five-fold increase), with the result that -New investment the ratio of capital repairs to new investment Capital repair - both current investment and 2-year lagged investment, to take into account the fact that 12 maintenance needs are for older assets - have, for the most part, been declining since 2007. 1 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 55. Detailed assessments of the roads sector underline the systematic neglect of routine maintenance that results in costly renovations R pi e and reconstructions later on. The recent 0.40 ADB roads study estimated that the current 0.35 0.30 spending on roads maintenance in Mongolia was only meeting 20 percent of the routine and 0.20 periodic maintenance needs, which was below 0.15 the average of even Sub-Saharan Africa. This 0.10 neglect is both fiscally and economically costly. Neglecting routine maintenance reduces the 2005 2006 2007 2008 2009 2010 2011 2012 2013 lifespan of a road and requires much more costly Ratio of capital repair to 2-yr lagged new investment rehabilitation later on; in Mongolia, the costs of Ratio of capital repairto new investment rehabilitating a road can be five to ten times Source:WBstaffestimatesbasedonMoFdata that of periodic maintenance. Poor maintenance Note: 2012 and 2013 are budget numbers also increases transport costs which has a direct PUBLIC INVESTMENTS NOT GROUNDED IN impact on reducing economic activity. A SOUND MACRO-ECONOMIC STRATEGY 56. It is encouraging to note thatthe government 57. Mineral-rich countries need to effectively haspaidmoreattentiontomaintenanceintherlast deal with two macroeconomic challenges: the two years, tripling capital repair expenditures in volatility of mineral prices and real-exchange nominal terms since 2009, although this growth rate appreciation due to over-spending (the has leveled off. Much more needs to be done to "Dutch Disease"). Mongolia went through both meet the periodic maintenance needs and a classic boom-and-bust cycle from 2005 to clearing the huge backlog and the trend lines in 2009. The economy grew by 9 percent on Figure 16 need to be reversed over the next 5 average between 2004 and 2008, triggering years, with capital repair expenditures outpacing a spending boom that saw the non-mining new investments. It is also encouraging to note deficit (i.e., expenditures relative to non-mining that the IBL now clearly specifies that the future revenues) increasing from a deficit of 1 percent maintenance needs of new capital projects have of GDP in 2005 to a deficit of over 1 5 percent to be explicitly included in the project proposals of GDP in 2008. Mongolia was then hit hard if they are to be considered for financing, when the global economic crisis of 2009 caused commodity prices to crash. The economy contracted by 1 .3 percent, foreign exchange reserves were quickly depleted, and Mongolia required the assistance of the IMF with the necessary painful fiscal adjustment. 37 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 58. The Fiscal Stability Law (FSL), passed by in 2008 to over 25 percent in 2009 and 2010, the parliament in June 2010, and which goes and continue to be sizeable today (Figure 17). into effect in 2013, recognized this problem These BT schemes weaken the FSL as spending and put in place fiscal rules to smooth volatility on them is not reflected in the budget in the by using long-term prices to estimate mineral current fiscal year, even though the construction revenues and required budgets to comply to a activities are taking place, and shows up later structural deficit of less than 2 percent of GDP; when repayments are due. The BT schemes to control expenditure growth to less than for rural roads are also a particularly expensive nominal GDP growth and therefore avoid over- financing option as construction companies heating of the economy; and to ensure long- need to borrow at commercial rates to finance term fiscal solvency through caps on public them rendering these projects an estimated debt. Any excess revenues after the application 25 percent to 30 percent more expensive than of these rules are meant to be saved in a Fiscal the equivalent budget-funded project. These Stability Fund, which has to maintain funds of schemes involve very little transfer of risk from at least 5 percent of GDP. Given that future the government to the private sector partner, savings are likely to be much higher, Mongolia and the increase in the financing costs of the is currently in the early stages of thinking about project - which will eventually be passed back a comprehensive Sovereign Wealth Fund, to to the budget - is not compensated with achieve the objectives of fiscal stabilization any efficiency gains in delivering the services and protect the budget and the economy from involved. commodity price volatility; savings, in particular to meet future pension liabilities; and economic The Development Bank of Mongolia development through financing of high priority socio-economic projects. 61. The DBM is fast becoming the main source of public financing for infrastructure projects 59. There is a big risk that the FSL will not be in Mongolia. The lending operations of the effectively implemented through off-budget DBM are not covered under the structural financing of infrastructure that bypasses the balance or the expenditure rule of the FSL (DBM fiscal rules. Specifically this risk is in the shape of borrowings are covered under the debt rule). As (a) "build-transfer" (BT) projects in the roads and per the Law on the Development Bank (2011), energy sectors that were financed byconstruction and a subsequent parliamentary resolution, the companies themselves on the condition of DBM is meant to finance the development of repayment from the budget at a later date; (b) the new railways to transport minerals, roads excessive lending by the Development Bank of connecting the aimags to Ulaanbaatar and each Mongolia (DBM), in particular for non-revenue other, energy sector projects, public housing, generating public infrastructure projects; and (c) including subsidized mortgages to low income a weak regulatory framework for public-private households, and the Sainshand industrial park. partnerships (PPPs). TheDBM raised $600 million (or6 percentofGDP) financing from an international, government- "Build-Transfer" schemes guaranteed bond in 2011, and is looking for additional financing options, such as a domestic 60. In 2008, a Mongolian parliament resolution bond flotation. It may also receive some of allowed "build-transfer" (BT) projects in the the proceeds of the Government's $1.5 billion roads and energy sectors that were financed sovereign bond flotation of November 2012. by construction companies themselves, usually Its project plan for 2012 includes a number of through commercial borrowing, on the condition non-revenue generating projects such as rural of repayment from the budget at a later date. roads, and financing the operational expenses These schemes increased from 3 percent of of the Erdenes Tavan Tolgoi (ETT) state-owned the total value of the budget funded projects coal mining company. Its roads portfolio alone 38 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE amounts to approximately $700 million, or 27% 63. This view is understandable, and there are of the 2012 total government capital budget in a few prominent examples of well-functioning terms of value (Figure 17). The DBM has also development banks-in Korea, Malaysia, Brazil, issued a guarantee on an $83 million loan from Turkey, and South Africa - that demonstrate the China Export-Import Bank for a housing thatunderaproperframeworktheseinstitutions development project. can indeed be instrumental in providing finance to under-served sectors. However, the 62. The DBM, if it operates under a sound history of development banking is also littered macroeconomic and corporate governance with examples where these institutions were framework, can play an important role in used as a non-transparent way to finance Mongolia's infrastructure development. The pet infrastructure projects, or to bypass fiscal logic of development banks is one of market limits, which ultimately required costly budget- failure whereby commercial banks underfund funded bailouts as the projects financed by the important projects such as long gestation development banks did not generate sufficient infrastructure projects, or do not provide access cash to pay back the creditors. It is critical that to finance to small borrowers. For example, one Mongolia quickly internalizes these lessons of study by the Business Development Bank of the many failures and few successes. Canada found that the six most common target markets for development banks are: (i) micro- 64. In a natural resource context such as enterprises/start-ups; (ii) small and medium Mongolia's, the decision to use the DBM for sized enterprises (SMEs); (iii) international trade/ project financing needs to be governed by two globalization; (iv) housing, (v) infrastructure factors. First, while in general public investments and (vi) rural/agricultural sector.13 Implicit in the in infrastructure, education, and health, together Government's decision to establish the DBM is with straight savings in foreign currency, are also the issue of timing. While revenues from the best use of natural resource revenues, they the mines will start flowing in the future, the need to be phased in a way so as to avoid Dutch infrastructure needs are great, and it is believed disease effects from an investment boom. 14 that borrowing now to meet these needs is Publicinvestmentswilloverthemediumtolong- a sensible decision given that in the future term increase the productive capacity of the revenues will be sufficient to meet the costs of economy and help to diversify economic activity financing these projects. away from the natural resource sector. However, in the short run if investments increase at a Figure 17: Alternative forms of infrastructure pace much higher than the absorptive capacity financing have been increasing in prominence of the economy then this will result in inflation Contractor-funded and DBM-funded roads projects as and an appreciation of the real exchange rate a percentage of all budget-funded projects (by MNT with its consequent negative macroeconomic value) effects. In Mongolia, as discussed in more detail below, this effect is clearly visible today with the soaring prices of construction materials as the construction sector is unable to expand capacity 29% 25% at a commensurate pace. An optimal strategy 27% would therefore, be to spread the investments * 15%s over time by limiting the growth in annual 3%14 m 1 m investment spending to avoid such over-heating 2008 2009 2010 2011 2012 of the economy, which is precisely the logic of E Contractor funded DBM funded the expenditure growth rule of the FSL.11 Source: Bank staff estimates using MoF and DBM data _______________ 14 Sachs (2007), IMF (2012). 13 Cited in Gu6ierrez et al (2011). 15 The DBM is currently only covered under the debt rule of the FSL. 39 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 65. Second, these alternative forms of financing parliament annually in its spring session. are sensible only if the projects undertaken This requirement compromises the generate a sufficiently positive cash flow to independence of the DBM. While the justify the higher cost of capital as compared Government, as shareholder, can certainly to budget funding. The DBM's current portfolio establish prioritiesfor DBM lending, specific of roads connecting the aimags, which are projects should be technically evaluated generally non-toll roads, and mortgage loans by the DBM and approved by either its to low income households, will never generate management or the board of directors. sufficient funds to recover the borrowing costs. Certainly the Government needs to make Therefore, these projects should be funded from the decision on whether or not to issue tax revenues in the state budget and not from a guarantee on a project; but the ideal more expensive borrowing from international sequencing should be that the DBM should capital markets which will eventually require to prepare a list of potential projects based be repaid from the budget. on their feasibility and the Government can then decide which of these it will 66. In addition to these concerns about macro- guarantee, rather than the Government or economic sustainability, there is a big risk of parliament approving a list of projects and political interference in the choice of projects then asking the DBM to finance them. thatthe DBM finances which would compromise * Lack of clarity on who is the shareholder: the quality of these projects. The main problem Article 16.2 states that the Government of is that the DBM's legal framework presently has MongoliawiIIbetheshareholderoftheDBM. several weaknesses that need to be urgently This is a vague specification as international addressed. These include: experience dictates that it is important that the government designate a shareholders * Insufficient clarity on the mandate: Article representative - a specific individual (e.g. 8.1 of the Law sets the mandate of the Minister of Finance) or ministry/agency - DBM as to finance large-scale development to exercise its shareholder rights to prevent projects and programs approved by the multiple ministries conveying potentially parliament, with Article 10.1.3 elaborating contradictory messages. For example, that these projects should enhance decisions on the DBM are currently being economic growth and be oriented towards made by the Cabinet which compromises value-added goods. The mandate makes no its independence. explicit reference to cost recovery, implying * Lackof sufficientindependenceof theboard that the DBM can fund projects that should from the government: Article 17 states that ideally be funded through tax revenues. the board will be selected and dismissed The mandate is also not clearly articulated, by the Government, and independent leaving a wide range of activities for the members will be in a minority ( of 9). DBM. There is also no mention of funding Article 22.1.10 further specifies that board being complementary to that of the private members can be appointed for a period sector, which creates the possibility of the "up to 3 years" and that the Government DBM crowding out private sector funding has authority to dismiss a board member and eventually hindering the development prior to the completion of his/her turn. In of the private sector. order to preserve independence, the more * An imbalance in the authority of the successful development banks provide parliament vis-a-vis the DBM board on the stronger tenure protections, with board choice of projects to finance: Article 8.1 of members appointed for a fixed tenure, the Law states that the DBM must finance ideally with the tenure not coinciding with projects approved by the parliament, the electoral cycle, and with a due process and that this list will be approved by the specified for their termination. Serving 40 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE government officials should ideally also of between 12 percent and 30 percent be a minority in the board. However, it is are more common among the better- often recommended that the Ministry of performing development banks. Finance has a strong presence in the board to minimize fiscal risks. This presence of Weak regulatory framework for PPPs the MoF is particularly recommended for the DBM given the huge increases in 67. More generally, public-private partnerships capital expenditures going forward and (PPPs) are likely to be increasingly used to finance the particular risks associated with mineral and execute infrastructure projects in Mongolia. price volatility. The legal framework for PPPs, which is set out Article 22.1.5 allows the government partly in the Law on Concessions (2010) and to "have a direct contact with the bank partly in the IBL, is quite weak. The Concessions and other authorities regarding credit law adopts the term "concessions" rather than policy of the Development Bank and its PPPs, though the IBL uses the term PPPs. This implementation, and express its stand". difference is significant in that the emphasis in This potentially opens the DBM to political the Concessions law is on providing business interference, and is contrary to the stated opportunities to the private sector rather than principle in Article 6.1.2 of independence protecting the government from fiscal risk. for the DBM. Some of the categories of concession included in * Lack of a clear supervision function: Good the law, in particular the BT schemes discussed practice in the regulation and supervision above, involve very little transfer of risk from the of development banks requires the state government to the private sector partner, and to separate its ownership and supervisory should not be allowed. roles. The supervisory function should aim to protect the state against credit risk and 68. The IBL, and related recent amendments to the private sector from unfair competition, the Concessions law, have addressed some of and to ensure that the institution is the more glaring weaknesses in the regulatory transparent, and undertakes sufficient risk framework. For example, the Concessions management, monitoring, and evaluation law used to give a prominent role to the of its projects. The supervisor should have State Property Commission (SPC in carrying the appropriate legal capacity to take out the feasibility studies of PPP projects, and remedial action when the institution fails in implementing approved projects, thereby to meet requirements. The Law on the creating a separate process than that for budget DBM does not clearly specify the role of funded projects. This provision has now been the supervisor. The MoF has oversight changed under the IBL, which gives the planning responsibilities on the issuance of loan agency (formerly the National Development and guarantees, and the DBM is required to Innovation Committee (NDIC) and now the provide the Bank of Mongolia (the central Ministry of Economic Development (MED)) the bank) with financial reports. However, this responsibility for conducting feasibility studies falls far short of the necessary supervision forlargeprojectsthatcanbepotentiallyfinanced function. Ideally, the DBM should be from various sources, including PPPs. The PPP supervised by the Bank of Mongolia. unit in the SPC has now been transferred to the * Excessive authority to lend: Article 24 sets MED which should help in ensuring that the the maximum loan-to-equity ratio at 50:1, planning and appraisal of potential PPP projects implying a capital ratio of 2 percent, and is integrated with the planning and appraisal Article 13 allows the DBM to issue loan for budget funded projects. The mandate of guarantees to third parties. These are very the MED could potentially also be extended lax standards that can create undue fiscal to cover the marketing and promotion of the risks for the Government. Capital ratios PPP concept; preparing and disseminating PPP 41 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE guidelines; and developing the methodology capacity in the MoF for an independent review for PFS and VFM tests. Under the IBL, the MoF of project proposals based on analytical criteria.16 has now been correctly given the sole authority The Investment Division of the MoF, which had on evaluating fiscal risks of PPPs and issuing prime responsibility for this task until recently guarantees, again addressing a major weakness saw a modest increase in staff from 6 to 7 in the Concessions Law. Given Mongolia's officials over the past 8 years, a period in which circumstances, some further safeguards to the capital budget increased fourteen-fold. This reduce fiscal risks could be introduced, which gross lack of expertise has meant that for all are discussed in the next chapter. practical purposes the project review process is limited to ensuring that the proposals for POORLY PREPARED PROJECTS new constructions have the necessary technical drawings to comply with the requirements of the 69. A major problem in Mongolia is that most Construction Law, and that the cost estimates projects that enter the budget are poorly follow the required norms. prepared. They have inaccurate cost estimations that require frequent additional financing in 72. The NDIC was created in 2009 to build much supplementary budgets; there is littlejustification needed capacity in strategic planning and project of the projects based on national and sectoral appraisal at the center of government. The priorities; the future maintenance costs of the parliament had repeatedly rejected the option of projects are not calculated; and members of expanding the planning function within the MoF parliament insert a number of projects during through, for example, the creation of a separate the budget debate session that have even more planning department with additional staff, inaccurate cost estimations. presumably concerned that a more powerful MoF would undermine its own authority. The Limited project appraisal NDIC was therefore a politically more acceptable option and has a vital role to play to ensure 70. Until the passage of the IBL, there was no that there is a comprehensive medium-term legal requirement for the economic appraisal of strategy for economic and social development projects prior to their inclusion in the budget. - including the Southern Gobi mines - that The Public Sector Finance and Management Law takes into account the considerable inter- of 2003, which was Mongolia's primary budget sectoral coordination required, the adherence legislation until the passage of the Integrated to environmental and social safeguards, and the Budget Law in December 2011, was largely various options for infrastructure financing. The silent on the modalities for public investment NDIC was in 2012 elevated to the MED to give planning and budgeting, and the MoF the planning function greater authority. regulations on preparation and prioritization of public investment projects were skeletal. 73. The IBL greatly strengthens the legal There were no project appraisal guidelines that framework for capital budgeting and specifies specified what economic and financial analysis the precise roles of the MED and the MoF. needed to accompany project proposals, and Articles 28 and 29 of the Law require that what would be the basis of appraising these only projects that have gone through a proper projects. Without such systematic approaches, appraisal process would be considered for it was very difficult to determine inter-sectoral financing, with the appraisal methodology to and intra-sectoral priorities, and to determine be specified in guidelines. It then details two which projects are feasible and which are not. distinct processes, one for large (greater than 30 billion MNT) and another for small projects. 71. The corollary to this regulatory weakness For large projects, line ministries submit their is the lack of capacity in the line ministries to proposals to the MED that then reviews these conduct economic analysis, and the lack of See Raaram etal (2010) for the framework for key aspects ofa good public 4 investment Dvis i o h F i a prm4epniilt2o hstskutlrcnl MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE proposals to determine whether or not the a new or improved school building or more project could be potentially financed based teachers and educational materials. Should the on government priorities, the medium-term government build a new road in a particular fiscal framework, economic return, and inter- area or spend more on maintaining existing regional equity considerations (Articles 28.3.1 infrastructure? Such comprehensive decision- to 28.3.10). Projects that pass this pre-feasibility making taking into consideration both the capital (PFS) stage enter a rolling four-year Public and recurrent budgets is difficult to achieve if Investment Program (PIP) as a stock of potentially two separate organizations are responsible for financeable projects. The Cabinet approves the preparing the capital and recurrent budgets (a PIP annually, with the MoF then responsible "dual budget"). It may for example, result in for all financing decisions - whether to fund investment projects being built that do not have projects from the budget, loans, concessions, or adequate maintenance funding budgeted for potentially the Development Bank of Mongolia. the future. For small projects (less than 30 billion MNT), line 76. The IBL also improves the comprehensiveness ministries submit their proposals directly to the of the budget. Currently, Mongolia's capital MoF, which is then responsible for the review budget does not include projects funded by process. foreign loans and grants, and only indicates a lump sum allocation for projects financed by 74.Why does the IBL split this responsibility for local government own source revenues. The IBL project appraisal between the MED and the will now require that the capital budget include MoF? It does so for two reasons. First, neither projects from these other financing sources, the MoF nor the MED have enough capacity on thereby increasing its comprehensiveness. their own to handle the huge task of ensuring that good quality projects are prepared. By 77. Effective implementation of these provisions focusing on large projects, the MED can in the IBL are conditional on good coordination devote more time to ensuring that the overall between line ministries, the MED, and the MoF, project makes sense before significant budget and calibrating project appraisal methodologies resources are committed in the full feasibility with the human resource capacity in these study and engineering design (Box 2). Smaller, agencies. Recent developments raise the risk less complex projects do not require this degree that the Government will create a dual budget of analysis and can be handled by the MoF. This thereby resulting in policy fragmentation. distinction between large and small projects is necessary as project appraisal is a complex oo Codnan b the Ministry activity and Mongolia has limited technical ofveinanent expertise, and therefore it is necessary to initially focus this limited technical expertise on the 78. To date, coordination between the planning larger projects. agency and the MoF has been poor. Until the 75. Second, it ensures that the MoF retainsconsiderable responsibility for the overall financing decisions and the oF, wo le oth the of all projects, large and small, and can discuss NDIC and MoF issuing circulars in 2010 and with line ministries their overall priorities taking 2011 to line ministries to submit their capital into account the capital and recurrent budgets project proposals to them with the result that in an integrated manner. Sound budgeting line ministries were undertaking two separate requires that the capital and recurrent budgets be processes, one for the NDIC and one for the considered in an integrated manner by proposing MoF. This confusion persisted even after the line ministries to achieve policy objectives. For passage of the IBL, with the NDIC seeking example, improving student learning outcomes proposals from line ministries for all projects for in a particular aimag can be achieved through its review and for eventual inclusion in the PIP. 43 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Box 2: Stages of project appraisal for large, complex projects Pre-feasibility The objective of the pre-feasibility study (PFS) is judge whether or not the project proposal is good enough to merit additional resources for a full feasibility study. It is key stage for (a) screening out clearly bad projects before major design costs are incurred or political commitments made, (b) for reviewing the major design elements in a project (technology, scale, timing, location, organization, ownership) and (c) for identifying what additional information is required for the subsequent feasibility stage. Feasibility This is the detailed analysis of projects that survive the first stage of screening. Added surveys, studies, testing should be conducted to reduce the uncertainty in key factors determining the viability of the project. Engineering design The detailed design of the project consisting of the engineering specifications and construction designs, and plans for procurement and implementation. These become the basis for final budgets and the contract. Source: Glenday and Kaiser (2012) 79. With the elevation of the NDIC into the - for example, in 2008 parliament increased MED the Government has also, as per the Law the number of new projects by 60 percent on Government Structure (2012), given the and the annual capital budget by 25 percent, responsibility for evaluating all projects to the an intervention that is unusually high by both MED, in effect creating a dual budget. This developing and OECD country standards (Table move is a mistake for the reasons noted above: 2). The schemes proposed by parliament are MED will not have sufficient capacity to properly generally small and geographically targeted; the evaluate the over a thousand project proposals average cost of a project over its lifetime was that it will receive each year from line ministries, 1.5 billion MNT in the final budget approved with the result that project preparation will by parliament as compared to 2.2 billion MNT continue to be poor. And splitting organizational in the budget proposed by Cabinet. These responsibility between the MED and MoF for schemes are generally less well prepared than the capital and recurrent budgets will make it line ministry schemes, and often lack even basic difficult to achieve overall policy objectives. A documentation such as technical drawings classic example of this policy fragmentation, and and cost estimates based on the established one which is found repeatedly in many countries, normatives. An audit of the 2011 capital budget is new capital investments with insufficient by the Mongolian National Audit Office (MNAO) programming for maintenance needs. identified a number of projects that were approved before the technical drawings were Extensive insertions of projects by parliament prepared, thereby violating the Construction Law. Some of these new projects flow from 80.Another problem has been the extensive the Local Development Fund, or the allocation powers of parliament to amend the budget given to each parliamentarian for earmarked or which generally has resulted in weakening the "pork-barrel" spending in their home districts. public investment portfolio. Parliament has These constituency funds were introduced in regularly significantly increased and altered 2003, and the annual allocation per MP has the capital budgets submitted by the executive increased hundred-fold since then from 10 44 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE million MNT per MP in 2003 to 1 billion MNT as many projects proposed by line ministries per MP in 2010. The Local Development Fund also have this feature. As noted above, 66% amounted to approximately 15% of the capital of projects are small and often geographically budget in 2010. However, the total number of targeted, a more accurate measure of the scale constituency-specific projects is much larger, of constituency-specific schemes. Table 2: The Mongolian parliament significantly changes the capital budget, as for example in 2008 1Allocation for Cost per Number Budgeted cost C the fiscal year project of capital (Millions of 8 (Millions of (Millions of projects MNT) M NT) MN T) Approved by Cabinet 479 1,043,617 456,058 2,178 Passed by Parliament 757 1,139,953 571,338 1,505 Source: Bank staff calculations based on MoF data PROBLEMS IN PUBLIC PROCUREMENT ANDcirongverarguadbt the n a capaityie ctL CONTRACT IMPLEMENTATION procee a n local government s will oppotuntiesforinfuencfrm"nterste" gnedatoy esald upoick tor keer pc w iie tho 81. Public procurement is usually the most vulnerable part of the public investment systemicaltnd 8.wMonoliahasrvryrfw espeialied.prcure as procurement requires government officials to most pulic offiials il exercise discretion and make decisions over large ministe taen procurement enbl sums of money at specific points which provides Mnlas iadtnt their reguarcas Tere arln opportunities for influence from "interested" ne ob cldu ucl oke aewt parties. These problems are particularly evident r ecai prcuemen itsi in Mongolia given the small size of the formal sector, the large overlap between political and 8.Mnoi a eyfwseilzdpoue construction industry circles, and considerable mn tf n otpbi fiil nln anecdotal evidence of political influence in the mistesakonpcumntrpnibly award of government contracts. Mongolia also i diint hi eua ak.Teeaen features the usual technical problems of poorspcaiepruemnuitinnyoth procurement planning, limited human resourcesprcinetteshacnpovdtencsay in public procurement, which combined with expertise in preparing bidding documents. The the political interference result in a low value for result of this shortage of specialists is that regular money of infrastructure projects as measured by administrative staff, particularly relatively senior time and cost over-runs. officials such as Director Generals and Directors, spendlan inordinate amount of time from January Capacity constraints to April in the tendering process (the figure of "over 50 percent" was regularly mentioned 82. The rapid growth in capital expenditures in discussions). This represents a significant has naturally meant that the scale of public opportunity cost vis-a-vis other responsibilities, procurement has also greatly expanded, such as policy-making and monitoring. increasing seven-fold since 2006 (Figure 18). This increase has greatly stretched the already thin capacity of line ministries, which have been responsible for the bulk of public procurement, as well as local governments. With the changes 45 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Figure 18: Public procurement has increased seven- Weaknesses in procurement planning fold since 2006 1,600,000 Public procurement by method used (millions of MNT) 85. Poor cost estimation is the biggest problem 1,400,000en y milon MT in procurement planning. The reasons for this 1,400,000 1,200,000 problem are both institutional and the general 1,000,000 overheating of the economy that is resulting in 800,000 rapidly rising prices of materials and other inputs 600,000 to construction. On the latter, the unit cost 400,000 normatives used by the Department of Roads for 200,000 budget planning have doubled overthe past two 0 20 207.20 209 21 201 to three years (Figure 20), but lack of adequate 2006 2007 2008 2009 2010 2011 * Na'l cmpeitiv bidingE Cmparsonreal-time data, and limited technical staff, has g Nat'I competitive bidding U Comparison ta e fd t U Direct Contracting 0 Limited Bidding meant these normatives out 15Other quite quickly and do not provide an accurate 1,400,000 Procurement by entity (millions of MNT)of the actual costs of construction. On 1,40,00 Prcurmen byntiy (illonsof NT)the former, politicization of the budget planning 1,200,000 process has generally meant that project costs 1,000,000 based on these technical normatives prepared 0 Line minimas by the Department of Roads are revised 800,000downwards by line ministry decision-makers so 600,000 Others that more projectscan be included within the line 400,000 ministry's overall resource envelope. Therefore, 200,00 tLthe final project cost amount approved in the 200,000 budget is at times substantially lower than 0 what was proposed by the technical staff in 2006 2007 2008 2009 2010 2011 the ministry. The general opinion of technical Source: MoF data staff in the Department of Roads is that the budgeted unit cost of road construction (cost 84. Mongolia's short construction season - from per kilometer) is unrealistically low in Mongolia April to October - makes timely contract award resulting in substandard quality. extremely important. Prior to the June 2011 amendments, procuring entities were required 86. This problem of unrealistic costs is then to have their procurement plans approved exacerbated in the tendering process where the by the MoF by the first week of January, one default position of the evaluation committee month after the parliamentary approval of the is to award the contract to the lowest bidder, budget. This left a very short window of three and not the lowest technically qualified bidder. months to complete the various stages of the This tendency encourages bidders to submit procurement cycle so that construction could unrealistically low bids, and then to seek commence in April. Based on discussions with adjustments during contract implementation, Ministry of Roads and Transport officials, on resulting in time and cost over-runs that are average the tendering process for roads projects detailed below. takes about three months, creating a significant probability that projects would be delayed by at least 6 months to the next construction cycle (Figure 19). The June 2011 amendment seeks to address this problem by requiring the procurement plans to be finalized together with the budget, thereby giving procuring entities an additional month to conclude a contract. 46 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Figure 19: Average time taken at each stage of the procurement cycle * Procurement Planning (within 30 days after the approval of budget by Parliament, 2 Ial) * Appointmont of Evalualion committee members in the ministry Ifron 2 J )-7 days * Preparation of bidding documents - 7 days * Prior-review by MOF of bidding docurnenLs for large projects - 10 days * Advertisement min 30 days Total: 83-90 days " B Wdeud rIDri - 14-2 day~ * Prior-re. lew by MoF of evaluation reports for large projects - 10 days Source: Bank staff estimates based on * Contract award -7 days, to await any complaint on the d1cision discussions with Ministry of Roads and Transport officials Lack of transparency and political interference 88. This practice of large-scale direct contracting was greatly reduced in subsequent, and is now 87. Weaknesses in the legal framework for prohibited, except in the case of special items procurement also raise questions on the quality such as pharmaceuticals, in the revised PPLM that of capital budget execution. Asthe Government's goes into effect in October 2012. However, the recent audit report details, the major problem government began to directly award contracts in this framework is the provision for direct to consortia, or groupings of road construction contracting that was introduced in 2007 in the companies, created in 2011 to address capacity roads and energy sector. In 2007, 174 billion limitations in the road sector (more on this MNT, or 43 percent of all of contracts, were below), although the implementation of this awarded through direct contracting (Figure was delayed due to difficulties in forming the 18), often with no accompanying technical consortia. Importantly, the DBM is not subject documentation with allegedly numerous to the PPLM and parliamentary resolution of technically unqualified, and politically well 2011 listed 27 national and city road projects, at connected, companies winning construction a cost of approximately 700 billion MNT, to be contracts (Government of Mongolia, 2008). financed by the DBM using direct contracting Many road construction projects were also over the 2011-2013 period. broken down into smaller schemes to enable 89. Political influence in the award of contracts is smaller and less qualified companies to be repeatedly mentioned as a significant problem. directly awarded the contract. Figure 20: Increasing costs of road construction This is most clearly evident in the extensive use of direct contracting in 2007, and is also the Unit cost normatives for roads (thousands USD motivation behind the raising of the threshold per km) for international competitive bidding from 1 1800billion NT to 10 billion MNT in the June 2011 1600 amendment to the PPLM. A review of the sample 1400 1200if' ~ captaIity oad projects showed that all of the directly awarded 1200 Capitalcityroad 000~iinra contracts incurred significant time overruns 1000111.ilMining road 800 *00 600 tate paved road more than double the estimated completion 400 time in some cases, and the quality of projects 200 suffered considerably."7 It is also evident from 0 2008 2009 2010 2011 17 World lank (201d b). Source: Department of Roads 47 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE the close connections between members overhaul of the public procurement systems to of parliament and construction companies. address these problems. The most significant According to publicly available information, changes introduced are: 8 percent of the members in the Parliament own shares in construction companies, with Transferringtheprocurementfunctionfrom the top 10 local construction companies, which line ministries to both local governments combined received 30 percent of the road and a new central procurement agency construction contracts in the past five years, (CPA); all owned by either members of parliament or A new role for civil society organizations individuals with close ties to the Mongolian (CSOs) in procurement monitoring; Peoples Party or the Democratic Party. The creation of a new Procurement Inspectorate to ensure compliance with the Poor monitoring law during the bidding and bid evaluation 90. Line agencies are responsible for day-to- day monitoring of contract execution, but are 93. The Central Procurement Agency (CPA) not well organized to perform this function. will be responsible for the procurement of all In the roads sector, the Department of Roads large, national contracts to be financed from is the responsible unit and dedicates a team of the central government budget, as well as 2-3 engineers per project for large projects to for establishing framework agreements for be located at the project site. The Department's common use items (such as office supplies) that budget only covers the supervisors' salaries will then be purchased by line ministries. It will and allowances, and they have to depend on be responsible for all procurement activities up the contractors for on-site accommodation and to the award of a contract, with line ministries transport, which creates a conflict of interest. then taking over on contract implementation The Department acknowledged that many of and monitoring. The agency was established in these engineers are easily influenced by the October 2012, under the office of the Deputy construction companies and that therefore, Prime Minister. there was a need for an independent monitoring agency. 94. The stated rationale for the creation of the CPA is to both increase procurement capacity 91.This need has now been authorized in a and to increase transparency and reduce the parliamentary resolution and starting in 2012 risks of corruption. The aim is to establish an consulting companies will be contracted entity that specializes in procurement and which to carry out monitoring of road and bridge would be staffed by professionals dedicated full construction. However, ensuring that these time to this purpose, as opposed to the current supervisors are truly independent is a challenge arrangements where regular officials from line in a small country like Mongolia. One option is ministries conduct procurement in addition to partner these supervision engineers with civil to their normal duties. This separation of the society organizations to maintain checks and procurement function from line ministries is balances and to complement competencies. The also meant to allow the latter to focus on their engineers would bring the necessary technical main responsibilities of policy-making, planning, skills of contract monitoring; the CSOs would implementation and monitoring. It is also facilitate community feedback, and publicize anticipated that this centralization will improve the results through media and other channels. transparency as it will be easier to place controls on, and to monitor, the procurement activities The reforms underway of one central entity, through for example the limited resources of the MNAO as compared to 92.The Government, through the 2011 revisions several line ministries, in particular with the roll- to the PPLM, has recognized the need for a major out of e-procurement. 48 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 95. The government chose not to pursue the Transparency Initiative, the International Budget option of creating specialized procurement Partnership, EITI) and third party monitoring units in line ministries to address the present of service delivery (e.g. Road Watch in the deficiencies and there is little in the way of Philippines and Twaweza in East Africa) are rigorous cross-national empirical evidence as to examples of the growing movement to monitor which institutional arrangement - centralized and demand greater accountability for public with a specialized entity or decentralized with expenditures. The rationale for these initiatives line ministries - is better in terms of efficiency is that citizens have greater incentives to ensure and transparency.18 It does seem to be the case that contracts are implemented correctly as that in the Mongolian political economy context they are the ones who benefit the most from it is easier to create a new agency than to the construction of a school, well, health clinic increase staff numbers in an existing ministry as and the delivery of school desks, textbooks the latter can result in a potential imbalance in and medicine. Often, community members can the influence of the various political factions that monitor procurement projects more effectively control the different ministries. An example of than government structures since they are this was the debate that took place three years physically closer to them than government ago on whether or not strengthen the planning agents. In some contexts, communities can function in the MoF or to create a separate use locally embedded, social sanctioning planning agency, with the latter option proving mechanisms to demand better performance to be politically more feasible for precisely these from local workers and government officials.19 reasons. 98. In order to effectively monitor procurement 96. In sum therefore, it may only be possible performance however, communities need to to address this urgent need to increase overcome obstacles that often inhibit collective the transparency and capacity of public action, including poverty, inequality and social procurement in Mongolia through the creation divisions (e.g. ethnic and religious divisions).20 of a separate specialized agency. The move Procurement monitoring of large infrastructure does appear to have broad support; for example projects, such as power grids, highways, and all the state secretaries of the line ministries dams, also requires an understanding of the unanimously endorsed the option when it was technical specifications of the procured item, a under discussion in parliament, stating that skill that is often in short supply even in OECD procurement activities were seriously distracting countries. Moreover, in a small country such as them from their prime responsibilities of policy- Mongolia, CSOs can also be subject to similar making and service delivery. problems of conflict of interest and collusion that besets the private sector. 97. The authority given to CSOs in the PPLM is very extensive when compared to similar pieces 99. In short, for CSO monitoring to be of legislation in other countries, and if effectively effective these organizations have to be free implemented will make Mongolia quite unique from undue political influence, have sufficient in institutionalizing citizen oversight over public capacity to monitor procurement and contract procurement. This change is in keeping with implementation, engage in a constructive a trend seen in many countries over the past manner with the government, and be able to several years for a greater push for transparency generate sufficient action on its findings, from and CSO oversight of public expenditures. The the government and the broader public. The rise and spread of international transparency next chapter provides some recommendations initiatives (including Construction Sector on the effective implementation of this key 18 There are many cases of successes and failures of central procurement agen- reform initiative. cies. The good examples are unsurprisingly in countries that are generally well governed, such as Korea and Chile, while the bad ones are in some of the sub- Saharan African countries. With the current state of knowledge it is impossible to 19 Ostrom (1990), Tsai (2007), Booth (2010). conclude whether the organizational form of the procurement function matters 20 Devarajan et. al (2011). iTdependently of the rroader Instinutional context of the country. 49 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE INFLEXIBILITIES IN BUDGET EXECUTION to vendors for projects managed by the Ministry of Fuel and Energy despite a majority of the 100. Given these problems, actual budget contractsnotbeingcompletedasperschedule." utilization of the capital budget is surprisingly In other words, payments are made before the high, approaching 90 percent over the past five end of the fiscal year for work to be performed years. As Figure 21 shows, however, between in the following year, which undermines quality 50 to 60 percent of the expenditures occurred controls. A parliamentary resolution of 2011 in the fourth quarter for 2010 and 2011, with has formalized this de facto bad practice, by approximately30 percent occurring in December authorizing advance payments as long as the alone. Seasonality is part of the reason for this contractor is able to demonstrate the presence skewed disbursement pattern. Given that the of construction materials, such as cement, construction season is from April to October, steel, and stones, on the construction site. This some of these fourth quarter expenditures are resolution was rightly criticized in the MNAO likely to be payments for the works completed audit report.22 by October. Line ministries also have an incentive to disburse since the capital budget is annually 102. The shortness of Mongolia's construction appropriated and any unspent funds are re- season, and the difficulty in accurately appropriated by the MoF at the end of the fiscal anticipating the costs of construction materials year. While on paper there are strict guidelines during budget preparation call for the need for for payments, involving certification by both greater flexibility in budget execution. The two the sector Ministry and the General Specialized usual methods are multi-year appropriations and Inspection Agency, it has been suggested that carry-over funding for multi-year projects; and this expenditure in the fourth quarter may greater authority for implementing agencies for not represent actual project implementation. changing the approved line item appropriations The Investment Division, which authorizes the by switching the budgetary provision from slow- payments, does not have a good picture of the moving to fast moving projects (virements). status of implementation of projects, and is unable to provide any checks. 103. On the former, the IBL introduces the provision of carry-over funding - i.e. the Figure 21: Disbursements from the capital budget authorization to spend unused appropriations, are highly skewed with half being done in the last together with next year's appropriation, in the quarter next fiscal year - for multi-year capital projects Monthly capital expenditures (as percent of that should help reduce this pressure for budget allocation) disbursement. Specifically, the law allows for a 100 876B maximum of 3 percent of the line ministries total 90 473B capital budget to be carried over for multi-year 80 projects for a period of up to three months. 70 ~2010 60 283B addrsse 50 2011 104. While this rightly 40 the multi-year character of capital projects by 30 I 20 providing some over 10 time, it does not go far enough. Given the short 0 1 2 duration of Mongolia's construction season, a 1 23 4 5 6 7 8 9 10 11 12 Month three-month carry-over may reduce some of Source: MoF data the end-year pressure to disburse, but will not provide sufficient to time to pay for additional 101. This point is made strongly in the MNAO work since the next construction season only audit reports, which noted that in 2007 commences in May. Therefore, greater flexibility disbursements of 115 billion MNT were made is warranted. 21 Government of Mongopia (20 8). 22 o ernment of Mongoia( 2012) 50 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 105. Until recently the parliament constructing roughly 800 km of roads annually, appropriated the capital budget project by the construction demand in 2011 was three project with no authority for line ministries times as much, and actual construction has only or the MoF for virements between projects averaged 300 km a year for the past three years without parliamentary approval. The IBL has (Figure 22, right panel). Similar bottlenecks are significantly increased flexibility by giving found upstream in the availability of cement, line ministries authority to enable virements other raw materials, and equipment, as indicated between projects within their portfolio with by the rapid rise in, for example, cement prices the sensible restriction that budget adjustments - the price of locally produced cement has cannot be made between capital and recurrent tripled over the past five years. expenditures and that the adjustments cannot be used to finance new programs and activities 108. Clearly, some drastic changes need to take that were not included in the budget. place in the sector if Mongolia is to achieve its ambitious infrastructure plans, which includes 106. An additional inefficiency in budget a recognition that foreign companies will execution is the excessive involvement of the have to play a major role in ameliorating these Investment Division of the MoF in authorizing bottlenecks. Below we briefly explore some of payments for projects. Currently every payment the main constraints that impede the growth of for each project needs to be first authorized by the construction sector. the Investment Division before the payment can be made by the Treasury Department. Given Restrictions on immigration that there are annually well over a thousand projects, each with between one and twelve 109. Restrictions on the hiring of foreign payments annually (depending on the size of workers are the main regulatory constraint to the project), approximately 50 percent of the the construction sector. Due to the labor force Investment Division's staff time, by their own shortage -approximately 500 engineers and admittance, is spent in authorizing payments, 5,000 skilled laborers are employed in the detracting from the much more important task roads construction sector, about half of what is of project appraisal and budgeting. currently needed -it is essential for companies to obtain laborers and specialists from abroad. CAPACITY LIMITATIONS IN THE However, the Labor Law requires a specific CONSTRUCTION SECTOR quota to be kept between the number of local and foreign workers. The law also requires a 107.1mproving government systems for high premium (monthly fees) per foreign worker planning, budgeting, procurement, contract which approximately equals the average salary implementation, and monitoring have to be of a local construction worker. These restrictions matched with ensuring that there are no are particularly difficult for smaller companies. regulatory hurdles that prevent the growth of There is also ample evidence that the law is not the construction industry to meet the rapidly being implemented in practice, as there is a big growing demand, and addressing capacity gap between the officially registered foreign constraints. The Mongolian roads construction workers and the actual number of foreign industry is currently incapable of meeting the workers suggesting that many foreign workers huge construction demands of the medium are either illegally residing in Mongolia or are term plan. While the industry has been growing working under tourist visas. Even though the steadily, of the 186 registered road construction registered foreign workers have increased 15 companies, only 59 are currently active, and fold from 105 in 2006 to 1586 workers in 2010, of these 59 only 10 have the capacity to build according to unofficial estimates there were roads above 50 km in length (Figure 22, left about 4000 Chinese workers alone in 2010. panel). While the companies are capable of 51 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Figure 22: Capacity limitations in the roads 111. These immigration policies are particularly construction sector problematic for a labor-scarce, geographically Capacityvast, and natural resource rich country such as Numberof ncompanies Mongolia. Skilled workers make up 20 percent Numbrof ompaiesof Mongolia's labor force of 1.1 million (NSO data), many of whom are being drawn into 29 No acive the booming mining sector. This is a familiar 9 Less than10 km phenomenon in resource-rich countries where 127 Active, 59 10-30 km factors of production are drawn to the mining 5g30-50km sector at the expense of other sectors; it is 10 particularly pronounced for a labor-scarce country. As a result the construction sector faces severe skilled labor shortages. With the shortfalls in recertification and retraining, lack of standardized training opportunities for new Road construction, in km workers and limited numbers of graduates each 2179 year, many of whom are pulled into the mining sector, these constraints are unlikely to be easily relaxed. eFigure 23: Machinery and equipment import (percent Soh year-on-year change) 300 M _ 1250 Local companies Actual construction on Demand in 2011 200 construction capacity average 150 Source: Department of Roads 100 110. The time and steps involved in obtaining a soiIiI *or emtefrrnefrom the Moeneti longmoan issue. Although the law states 24 working days are required to receive government approval, Se-9 Mr1 e-1 a-1 Sp1 the numerous steps listed below are often not completed until August! September when the Source:NationalStatisticalOffice construction season is finished: fFigure 24: Number of registered construction vehicles * Lette apofa eterc from the Mongolian Immigration Agency to the Ministry of Social Welfare and Labor; 7000 * Approval letter from the Ministry of Social Welfare and Labor to the Mongolian Immigration Agency;14000 3000 p Visa approval letter from the Mongolian f 2000 Immigration Agency to the Ministry of 1000 Fo reig n A ffairs; 0 ................ ***** ...................... 1002+7 2008 2009 2010 2011 * An official invitation letter from the -00years Ministry of Foreign Affairs to the -4-Dumptruck -U-Hauler Concrete miser Mongolian Consulate. 52 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Restrictions on the import of equipment widening gap between local and import prices, as imports were not able to meet local demand 112. Equipment imports (new and used) from and local supply is not growing fast enough. neighboring international markets including China, Japan, and Korea, and the number of 114. The price of cement, which is not regulated registered construction vehicles have tripled by the government, fluctuates dramatically over the last 3 years (Figure 23 and Figure 24). during the course of the construction season, There are however, some restrictions in the with the peak of the season in July. Each year, Customs Law on the import of equipment that the demand becomes very constrained after negatively impact the sector. Foreign companies a certain point in the summer. Due to border are allowed a 1 year VAT exception, after which logistic issues with China, there are serious point the equipment is required to leave the supply bottlenecks. Thus, for example, the country. Given thatan average road construction price of cement soared from 65 USD per ton in project can take up to 3 years, foreign companies January 2007 to more than 160 USD per ton in face significant time constraints if they wish August 2010. to bring their equipment from overseas. The stated rationale for this policy is to prevent Figure 25: Increases in cement prices (percent year- the domestic sale of this imported equipment. on-year change) However, the concern regarding abuses by local companies needs to be weighed against the 120% economic benefits and national impact, and 100% Locallyproducedcementprice should also focus towards providing incentives to equipment importers both for foreign and local companies. 60% Imported cement Bottlenecks in the supply of construction materials 20% 113. The recent spike in the demand for roads, 0% buildings, and infrastructure has resulted in a 2006 2007 2008 2009 2010 2011* significant increase in the demand for building materials. Cement is one of the most basic Source: NSO construction materials, and an essential item for Non-competitive public procurement the infrastructure development of the country. Cement consumption in Mongolia increased more than tenfold in the past 10 years, with the total current cement consumption at also hurt the growth of the construction approximately 1.5 million tons a year, with industry. The June 2011 revisions to the demand expected to triple in the next three PPLM raised the threshold for international years. Mongolia's own cement production competitive bidding from 1 billion MNT to 10 has been unable to cope with the increased billion MNT (approx. $8 million) which, while it demand, and prices for locally produced cement will have limited ramifications for most foreign have shot up since 2009 (Figure 25). Imports companies which generally tend to bid for large have only partially been able to off-set the price contracts above this threshold, is a move in the increase because Mongolia imports the bulk wrong direction. Similarly the extensive use of of its cement from China (unofficial estimate: direct contracting also creates barriers to entry. about 90 percent), which itself struggles to The Government has been encouraging the meet local demand. Since the first quarter of formation of consortiums - 50 national road 2011, beyond the sharply rising cement prices companies recently formed 5 consortiums - in in Mongolia, these pressures resulted in a order to meet national objectives and implement 53 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE large road construction projects, a move that ranging between 1-2 bidders for small and also risks reducing competition. In part due to large roads, and 3-5 bidders for medium sized these non-competitive practices - both de jure roads (Table 3). It should be noted that the low and de facto in the form of the privileged access number of bidders for small roads is due to the to contracts given to politically connected firms fact that these are usually local roads which only - as well as the above-mentioned capacity companies from the particular region in which limitations, the average number of firms the road is located find economic to bid on, a showing interest in road contracts, as measured fact that is likely to change with the increasing by those purchasing bidding documents, and number of local construction contracts going actually bidding for these contracts is very low, forwa rd. Table 3: Limited corpetition for road construction contracts Number of biddaefrsarass Nu de oth Naueofcnrat cmasngdies fo thpaiculrropninewic thdoadmeis loatdfidecnmitoin bids, Smnumbe ofze localaconstructionkcontracts-going Meimszdnatr fnracts pucasn bidin companies3-73- road Large sized contracts more than 50km 1-3 1-2 paved road Source: MORTCUD THE RESULT: LOW VALUE FOR MONEY percent (Figure 26). Of the 14 projects in the sample, all but 2 had time overruns, often 116. Weak budget and procurement planning, doubling or tripling the actual completion time political interference, and poor project as compared to the original plan, and 9 had cost implementation all translate into low value for overruns.23 Discussions with the Department money of public investments. Time and cost of Roads confirmed that inadequate planning, overruns are ubiquitous; a sample of roads poor cost estimations, limited budgets, and projects had an average time overrun of 120 limited capacity of construction companies all percent and an average cost overrun of 35 contributed to these delays. 23 The sample consisted of budget-funded, large national road projects completed, or espected to be completed, between 2007 and 2012. The sample excluded donor-funded projects, or contractor funded projects. Figure 26: Time and cost overruns are a common occurrence (based on a sample of 14 national roads projects) Percentage Time Overrun Percentage Cost Overrun Project No. Project No. 14 14 13 13 12 12 11 11 10 10 9 9 8 8 7 7= 6 6 5 5 4 4 3 3 2 2 ilo 5 1oo 200 300 400 500 -30 -10 10 30 5 70 90 110 130 -10 0 10 Perce2ntage Percentage Source: Bank staff calculations based on MoF data 54 POLICY RECOMMENDATIONS 119. Mongolia's GDP growth rate is likely to be investment management be strengthened now in the double digits over the medium to long and that regulatory safeguards be put in place term with the production from Oyu Tolgoi and to prevent these new resource rents from being Tavan Tolgoi, and the doubtless new mineral "captured" by relatively few privileged elites, or discoveries in the future. However, these "oligarchs", who could then become politically impressive growth numbers, on their own, are dominant thereby closing the window for deceptive given the special, enclave nature of reform for a long time. mining with limited forward and backward linkages to other sectors of the economy, and 121. There is considerable room for optimism low employment generation. One key aspect about Mongolia. Many policy-makers are very of linking mining production to broader-based well aware of this critical moment in Mongolia's economic growth and welfare improvement will history, hence the recent passage of a string of be the effective use of the many-fold increase good laws - the FSL, the IBL, and the PPLM. in government revenues over the next decade The technical solutions being proposed below and beyond through public investments in are therefore, likely to resonate with many of infrastructure and human capital. the politicians; moreover, because of some of the favorable aspects of Mongolia's political 120. This is a critical time for Mongolia as economy, in particular the presence of relatively research has shown that huge increases in coherent political parties that are able to achieve natural resource revenues puts great strains cooperative outcomes, these suggestions have on a country's institutions, particularly if those a better chance of being implemented than in institutions are already weak to begin with. many other developing country contexts. Mongolia is very vulnerable to this institutional decay given the close overlays between political 122. This chapter presents policy recoi- and business circles, linkages that explain many mendations to address the problems identified of the problems in public procurement and in each of the four key areas. A summary contract implementation as well as the extensive of the recommendations, and a suggested use of off-budget financing. It is imperative that prioritization for implementation, is presented these institutions of fiscal policy and public in the table below: aoiyReom ndtha eultroafgadsbnusi lc the mining regions. 2. In the rural areas, the government should focus on low-cost spot improvements (e.g., construction of bridges or culverts, maintenance of natural tracks) on the main national andwIndwfo local unpaved roads to make these roads all-season, thereby improving connectivity for rural communities. 3. The Government should be annually spending five times as much as it currently does on road maintenance to cover routine maintenance needs and to clear the backlog of roads requiring Immediate rehabilitation. This would only require a 20 percent reallocation from new investments to maintenance and repair and can be easily achieved. 55 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Achieving the Balance between Infrastructure needs and Macro-fiscal Sustainability 4. The Government should have a clear policy that (a) that the DBM only funds revenue- generating projects; (b) if it is to fund socially beneficial projects then the amount of lending to such projects be reflected in the state budget and therefore be capped by the structural balance and expenditures rules of the FSL; and (c) that there are some limits on the aggregate Immediate lending of the DBM, through adequate capital adequacy ratios and MoF oversight, to prevent overheating of the economy and to ensure macroeconomic sustainability. Such a policy will require amendments to the Law of the Development Bank. 5. The government should discontinue "build-transfer" (BT) schemes in the roads and energy sectors as they increase the cost of projects and involve very little transfer of risk from Immediate the government to the private sector, and should instead finance such projects from the I budget. 6. The government should consider imposing a cap on its aggregate exposure to fiscal risks through PPPs, perhaps initially at 2 percent of government revenues, a figure which could Medium-term be increased as experience of implementing PPPs grows. Strong Corporate Governance for the DBM 7. The Law on the Development Bank needs to be strengthened to reduce the risk of macroeconomic instability and poor quality of capital expenditures. This will require amendments to ensure clarity of mandate; a higher capital adequacy ratio; greater oversight Immediate by the MoF; independence for the board; supervision by the Bank of Mongolia; and performance contracts to balance accountability with independence. Strengthening Project Preparation 8. The Government should not create a dual budget with the MED and MoF responsible for preparing the capital and recurrent budgets respectively. Instead, the IBL provisions on planning and capital budgeting should be implemented with the MED responsible Immediate for reviewing large projects only. The Government however, could consider lowering the threshold for these large projects from 30 billion MNT. 9. The draft planning law needs to specify the consultative mechanisms, such as sectoral inter-ministerial groups, and a Southern Gobi Infrastructure Council, to mandate the :Medium-term collaborative process needed in developing the medium and long term planning documentsM m and scenarios. 10. The implementation of IBL provisions on project appraisal need to be calibrated to local capacity. The Government could start by focusing more on the cost side of cost-benefit analysis for most projects, with the more sophisticated full socio-economic cost-benefit analysis limited to large, complex projects. 11. Parliament proposed projects should be subjected to the same project appraisal process specified for line ministry projects in the IBL and supporting regulations. In terms of the budget cycle, this may imply that projects proposed during the parliamentary budget session, if they pass MED's or MoF's appraisal, could be considered for funding and Medium-term inclusion in the capital budget for the following fiscal year. Alternatively, for projects to be included in the same fiscal year there needs to be a formal mechanism by which parliament can propose projects early during the budget preparation process. Improving Budget Execution 12. The IBL should be amended to increase the carry-over funding provision for capital projects from three months to one year, while sticking to the 3 percent limit, to provide sufficient Medium-term time for the completion of works while minimizing fiscal risks. 13. The budget department of the MoF should not be authorizing payments for capital projects as this is a treasury function and it takes precious time away from the vital task of budget Medium-term planning and project appraisal. Greater Capacity, Transparency, and Oversight in Procurement and Project Implementation 14. In order to ensure transparency and adequate oversight over the Central Procurement Agency the Government should: establish an Oversight Council; use e-procurement; and for high profile contracts, use "probity advisors", typically an international audit firm, on bid Immediate evaluation committees to both advise on technical issues and to be an independent observer to ensure transparency and robustness of the process. 56 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 15. In order to clarify roles and responsibilities between the CPA and line ministries, the line Ministry/ Implementing Agency should have the majority vote in respect of the technical issues during bid evaluation (either when it comes to voting on technical issues or by way :Immediate of a separate technical evaluation sub-committee, whatever is most efficient). To provide a guarantee of probity, the CPA would be able to veto that technical decision whenever it considers the decision not to be genuine 16. Transition arrangements need to be in place as the CPA builds capacity to ensure that procurements are not delayed. It would be advisable for the CPA to begin slowly with Immediate some selective contracts to give it sufficient time; this provision however, would require an amendment to the PPLM. 17. It is recommended that the non-government participants on bid evaluation committees should be observers and not voting members, and should not comment on the technical evaluations but restrict their role to observing and commenting on the transparency of the I process and compliance to rules and regulations. 18. There should be a standardized reporting template an "observers report" for bid observers. The template should include a space to include detailed comments. The reports :Immediate should be submitted electronically and channeled to procuring entities and to the Ministry I d of Finance. 19. To be effective in contract monitoring, CSOs will likely need to partner with engineers or other technical specialists. The engineers would bring the necessary technical skills to the table, while the CSOs would help ensure that these engineers remain independent and that Medium-term their technical assessments are effectively used for advocacy purposes to ensure transparency and accountability. 20. A CSO network has an important role to play to ensure standards in CSO monitoring. This is particularly important given that CSOs can suffer from the same conflicts of interest as policy- makers. The network should be an umbrella organization with affiliates across Mongolia. In the short-term, the network should have very loose entry requirements: prior experience with monitoring government processes (e.g. EITI, budgets, and elections); compulsoryM m training for affiliates; and, agreement to its Code of Ethics. The network should monitor its members' participation in procurement monitoring and have the right to blacklist members for violating the network's Code of Ethics or government regulations and laws. 21. In the short run the World Bank and other donors can fund the CSO procurement network. The Government could also provide a budget line to the MoF to fund contract monitoring Immediate & and bid evaluations. In the long run, an independent foundation can be established to fund Medium-term different types of CSO activities, including procurement monitoring, which could be funded by the government, donors, and mining companies. Addressing Capacity Constraints 22. In order to combat the "brain drain" from the civil service, and to maintain its attraction for new recruits, the Government may need to be more flexible in its approach to civil serviceM m Medium-term pay by moving beyond across-the-board salary increases and giving additional market-based salary premiums to staff working in jobs in high demand 23. The Government can also learn from the experience of other labor scarce natural resource rich countries which relied extensively on importing both skilled and unskilled labor from overseas. Opening the borders to immigrants can plug the skills shortfall and produce Medium-term knowledge spillovers that accelerate human capital formation. This would require relaxing some of the restrictions on migrant workers in the Labor Law SPENDING IN THE RIGHT AREAS 60 percent of Ulaanbaatar's population lives in peri-urban settlements - ger areas - that are 123. The Government's current and medium- not fully integrated into the city's infrastructure, term infrastructure spending priorities need to a problem that will get worse if not urgently be reoriented to emphasize the growth poles, addressed with the continuing migration into in particular Ulaanbaatar, and to focus on the the city. Rather than discouraging migration to maintenance of capital assets to move awayfrom Ulaanbaatar and artificially creating alternative the current 'build-neglect-rebuild' syndrome. urban centers, as outlined in the national 57 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE medium term strategy, the Government needs roads maintenance expenditures is needed to to accept that this migration is driven by the meet the needs of the sector. This increase to 75 forces of economic agglomeration that, if to 90 billion MNT can be easily achieved given well managed, can encourage broader-based a modest reallocation from new investments to economic growth. maintenance as it is only 20 to 30 percent of the 330 billion MNT earmarked in the 2012 capital 124. On new investments, World Bank (2010) budget for new road and bridge construction. emphasized a number of priority areas for Clearly this is a "low hanging fruit" that can investment in Ulaanbaatar that bear repeating: show immediate results if the political will is construction of access roads within ger areas; there to implement it. better heating systems to improve efficiency and reduce air pollution; investments in solid waste 127. This budget reprioritization needs to management and community infrastructure; be complemented by improvements in the affordable collective housing for mid-tier areas; investment climate to encourage private and expansion of the city's electricity, heating, investments, particularly in Ulaanbaatar, in and water utilities. The ADB (2011) report on housing, utilities, and transport. To date, private the roads sector recommended focusing new investments in infrastructure have been limited, construction where demand is the highest: in large part due to regulatory, policy, and Ulaanbaatar's city trunk and feeder roads pricing constraints. There is the need for the (e.g., in the ger areas), the international transit introduction of independently regulated cost- corridors, and roads serving mining areas. recovery tariffs for electricity, water, and urban transport; improvements in the regulatory 125. This is not to deny that equity climate to encourage private participation; and considerations are not important. In fact, as improvement in land regulations to streamline ADB (2011) points out, low cost improvements the process of acquiring and fairly compensating in rural transport connectivity are feasible given for private land for infrastructure development. that Mongolia's terrain allows for relatively good driving conditions on natural tracks ACHIEVING THE BALANCE BETWEEN and gravel roads. These natural tracks can be INFRASTRUCTURE NEEDS AND MACRO- made all-weather through a focused program FISCAL STABILITY of spot improvements that would entail the construction of some new bridges or culverts 128. Mongolia learned from the 2008-09 crisis on the main national and local unpaved roads and passed the Fiscal Stability Law (FSL to to make these roads all-season, and regular smooth the effect of mineral price volatility, limit maintenance, thereby improving connectivity expenditure growth to avoid over-heating of the for rural communities while also laying the economy,andtoensurelong-termfiscalsolvency groundwork for their eventual paving. through caps on public debt. The experience so far in 2012 underscores the importance of strictly 126. The Government currently spends 15 adhering to the FSL in 2013, when it becomes billion MNT, or approximately $11 million on fully operational. Soaring government spending routine maintenance of the roads sector, which has been pushing up inflation, putting pressure amounts to 0.14 percent of GDP. The ADB roads on the balance of payments and requiring study estimates that maintaining the current large domestic government borrowing, putting road network effectively requires roughly $45 pressure on the banking system. million annually (in 2012 prices).24 An additional $20 million over six years is required to clear 129. There are however, emerging risks that the maintenance and rehabilitation backlog. the FSL's implementation will be significantly Overall, therefore a five to six-fold increase in compromised in letter and in spirit. Specifically, the current maintenance budget of annual these risks are: 24 The study estimated this at $39 million for 2011, which has been adjusted for inflation for 2012 58 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE * Considerable off-budget financing from of DBM lending and the nature of the projects the Development Bank of Mongolia that the lending is going to. In 2012, the DBM (DBM) for non-revenue generating committed $600 million in lending to projects projects that are not subject to the in roads, railways, utilities, cement production, FSL limits but which will require future low income urban housing, and mining. This budget funding to repay DBM loans; $600 million is equivalent to about half of the " "uil-trnsfr" BT prjecs i th rodsdisbursement from the state capital budget. A * "Build-transfer"(BT)projectsintheroads number of these projects, in particular roads and energy sectors that were financed whcmaeu 150ilonftelasad by construction companies themselves w $ on the condition of repayment from the working capital for ETT of $100 to $300 million, budgetwill not generate revenues, and for which budgt ata laer dte;funding from the state budget will be needed * A weak legal framework for public- to repay principal and interest. private partnerships (PPP). 132. It is imperative that there be a clear policy Ensuring that the DBM is within the framework from the government that: (a) that the DBM of the FSL only funds revenue-generating projects; (b) if it is to fund social benefit projects then the 130. Infrastructure spending has to take place amount of lending to such projects be reflected within a sensible macroeconomic framework in the state budget and therefore be capped by that preserves short-term stability and long- the structural balance and expenditures rules of term fiscal viability. Over-spending on capital the FSL; and (c) that there are some limits on expenditures, if spent well, poses less risk of the aggregate lending of the DBM to prevent over-heating of the economy and of appreciating overheating of the economy and to ensure the real exchange rate since it increases the macroeconomic sustainability. productive potential of the economy. However, in a small open economy such as Mongolia's, 133. The Law on the Development Bank needs that is particularly vulnerable to commodity price to be amended to clearly state that the DBM's shocks, with an under-developed construction mandate should be to fund revenue generating sector, and public expenditure systems that projects or to fund projects where due to a have not been able to effectively handle the market failure the private sector is unable to rapid scale-up in spending, it is imperative that provide loans. The determination of a revenue- investment spending growth is calibrated to generating project can follow a two-stage both the absorptive capacity of the economy as decision making process: first, a pre-feasibility well as the capacity of the government's public study (PFS), as specified in the IBL, to determine investment management system whether the proposed project is a good project, such that the decision-making process on 131. Sensible phasing of capital expenditures such projects follows a similar logic with the implies complying with the fiscal rules set out preparation of the PIP; second, a "value-for- in the FSL for budget funded expenditures and money" (VFM) test, which determines whether placing adequate safeguards on alternative the project should be financed by the DBM or as forms of financing, most notably from the DBM. a traditional public sector procurement financed The lending operations of the DBM are currently from the budget. VFM tests are commonly not covered under the structural balance or the applied in deciding whether or not to finance expenditure rule of the FSL (DBM borrowings are an infrastructure project through a public- covered under the debt rule). This implies that private partnership. The Korean government the logic of the FSL is undermined if the DBM is for example, requires a quite complex technical used as a source of off-budget financing. These analysis, involves a comparison of a potential risks are particularly high given both the scale PPP project with the benefits and costs of a 59 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE comparator public investment project that 136. Limits on DBM lending can be achieved would be financed through conventional public by having a reasonable capital adequacy ratio, procurement. The calculations, which are something of the orderof 1 5to20percent, rather carried out by the Korean Development Institute than the 2 percent that is presently specified in (KDI), an agency of the Ministry of Finance, the Law on the Development Bank. In addition, take into account the financial incentives and given that the DBM is likely to remain a major guarantees that the government would have to source of infrastructure financing and given provide in order to satisfy the requirements of Mongolia's macroeconomic vulnerabilities, it the potential private sector partner. is also advisable to give the MoF authority to have oversight on the annual lending of the 134. A simpler approach could use a set of filters DBM. Specifically, the MoF could include in the by which a proposed DBM project is evaluated budget and the medium term fiscal framework before it can be approved.25 There are three (MTFF) ceilings on the aggregate level of new phases in this approach. Phase 1 is a pass/fail borrowing and lending by the DBM during the test which aims to eliminate projects which do coming three years, with the ceilings for the first not satisfy basic criteria for commercial financing year being binding on the DBM's operations. - such as an identifiable source of revenues, These ceilings would be calculated by reference suitability for implementation as a competitive to the ceiling on public sector debt included in tender, and availability of information. Phase 2 the FSL, and an estimate of the development involves a quantitative evaluation of each project projects described in the Public Investment against criteria such as the perceived appetite Program (PIP) that the DBM may be expected to and prospects for local or international private finance during the period concerned. Currently, sector involvement, the easiness and speed of as per the Law of the Development Bank, the implementation and structuring of a transaction, DBM requires "consent of the Government", in and the project's expected socio-economic and seeking loans; the Law does not reference the development impact. Phase 3 entails further FSL, and there is no reference to compliance economic and financial analysis of projects to with the MTFF. evaluate whether or not they are likely to be revenue-generating and therefore bankable. At Eliminating "build-transfer" schemes this stage, a cash flow-based analysis is required to assess a project's profitability and its ability to 137. BT schemes involve very little transfer of generate revenues to repay investors over the risk from the government to the private sector life of the project. partner, and increase the financing costs of infrastructure projects. The advice on this is 135. A parliamentary resolution currently simple: the government should discontinue authorizes the DBM to finance both revenue- these BT schemes and should instead finance generating projects and "socially beneficial such projects from the budget. projects". Applying the above VFM criteria will likely require significant changes in the DBM's loan portfolio which currently only has private partnerships two a priori viable projects, namely financing of the railways and a cement factory. If non- 138. Under the IBL, the MoF has now been revenue generating projects are to be financed, correctly given the sole authority on evaluating then they should be explicitly included in the fiscal risks of PPPs and issuing guarantees, state budget, and therefore subject to the FSL again addressing a major weakness in the structural balance and expenditure rule, the Concessions Law. However, this provision could logic being that these will eventually fall on the be strengthened further given the particular budget anyway in the form of subsidies to the risks that Mongolia faces. Some countries DBM. have established in law a quantitative limit on 25 Based on PPIAF-World Bank (2010). Mongolia - Strategy for Public-Private Partnersh ipsg Inception Report, October 2010. The study was carried out by the Public-Private Infrastructure Advisory Facility (PPIAF) and Cambridge Economic Policy Associates Ltd. (vEPA). 60 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE the government's aggregate exposure to fiscal majority government-owned and therefore risks through PPP contracts. In Hungary, for government ownership in itself is not a example, the total nominal value of multi-year determinant of success or failure." Rather, PPP commitments must not exceed 3 percent the better performing development banks of the government revenues in that year. In have been characterized by a sound regulatory Brazil, expenditure derived from PPP contracts environment and corporate governance is limited to 1 percent of the net revenues of principles, which include a clear mandate, the fiscal year. While in the longer term, it may clear ownership structure, independence of be preferable to incorporate PPP commitments the board, checks against political interference, into the fiscal rules set out in the Fiscal Stability strong supervision, and regular performance Law, in the immediate term, introduction of a assessment. financial cap would be advisable. This would limit the government's exposure to fiscal risk 140. These are all areas that are currently during the period when the PPP policy is being lacking in the regulatory structure of the DBM, developed and piloted, and the government is as elaborated on earlier, creating a high risk for building its capacity to assess risk, and design politicization. In other words, the risk is not only and implement contracts. Other countries (e.g., thatthe DBM will violate the principles of the FSL the United Kingdom) have experienced severe but that the quality of projects it lends to will be financial losses on PPP contracts in the early poor. Box 3 elaborates on these principles which stages of implementing their PPP programs. should be incorporated in an amendment to the Law of the Development Bank of Mongolia. STRONG CORPORATE GOVERNANCE FOR THE EV LOPVI NT AN OF ONGLIA 26 A recent survey by the World Bank of 90 development banks in 61 countries THEfound that 74 percent of the banks were entirely government owned while another 21 percent had private sector minority shareholders. 139. The vast majority of development banks across the world are either 100 percent or Clea Madat: Dvelpmen baks houd ovecermnte wnesipie in itsel isnotdia the sectors it should be operating in. The logic should be based on the market failure being addressed, and to ensure that the development bank is not unfairly competing with the private sector, nor financing activities with low potential for cost recovery and that should be done through the government budget. Achievements against the mandate should be regularly reviewed as the financial system develops to avoid hampering the development of the private sector, as for example done in the case of the Development Bank of Southern Africa. Financial sustainability: Development banks need to be financially sustainable, that is be able to repay creditors without requiring subsidies from the government. This can be achieved by giving the Ministry of Finance adequate oversight, such as setting limits on development bank borrowing, and ensuring that the development bank has proper risk management systems in place. The government could set a required rate of return, such as zero in real terms, or equal to the government's long-term cost of funding. Clear ownership structure: Government's ownership should be exercised through a shareholders representative, a clearly identifiable entity that is the exclusive channel of communication between the government and the development bank. Without a shareholders representative, any ministry or agency may see itself authorized to request financing from the development bank. The shareholder representative should be empowered to appoint the members of the 61 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE board of directors. The shareholder should aim to define the technical qualifications of each of the board members and these should be made explicit each time a vacancy on the board is being filled. To the extent possible, the shareholder should avoid nominating government officials as board members, and if they are to be appointed their numbers should be limited. Board independence: In order to achieve efficiency, development banks need to be organized as corporations, with shareholders, board of directors and management. An effective board is one the most important success factor for a development bank. Board members should be appointed for fixed term tenures, ideally staggered, with clear procedures for termination so as to protect them from undue interference. Board members should ideally not be sitting government officials, and have relevant experience in finance. Canada's BDC and Chile's BancoEstado, two high performing development banks, have instituted specific mechanisms to discourage political intervention in the credit decisions. In the case of BDC, the Board of Directors' is required to be notified ant time whenever a Member of Parliament, Senator, or fellow board member exerts undue pressure on a BDC employee to, for example, finance a specific project. BancoEstado's law bans the possibility of lending money to public institutions. Performance management: Performance contracts have proved to be a good instrument for achieving the difficult balance between autonomy and accountability that is needed in development banks. Performance contracts allow for autonomy which setting clear goals against which the board and management of the development bank will be held accountable. Contracts should ideally be concluded annually (before the start of the financial year), and made public to improve transparency and oversight. Supervision arrangements: The ownership and supervision functions of the government should be handled by different agencies. Development banks should be supervised along the same principles as private sector banks, with requirements for high levels of disclosure, and sound risk management, and which would also ensure a level playing field between it and the commercial banks. Any government guarantees of development bank borrowings should be specified in the budget and ideally development bank funding for projects should be included in the budget for informational purposes. The responsibility for supervision could rest with the central bank, with the development bank obliged to provide prudential reporting to the central bank with the same frequency and reporting format as the other commercial banks. Similarly, a development bank should be subject to annual on-site inspections by central bank, covering all its treasury and risk management functions. Sources: Thorne & Du Toit (2009); Gutierrez et al. (2011) STRENGTHENING PROJECT PREPARATION responsibility of evaluating and approving all capital projects to the new MED. This move is Ensuring a unified budget process a mistake for two reasons: first, it creates the problems of a "dual budget". Second, MED will 141. The NDIC was elevated to the Ministry not have sufficient capacity to properly evaluate of Economic Development (MED) in 2012. theoverathousand project proposals that twill This move reflected a common consensus in receive each year from line ministries, with the government that the NDIC as an agency below result that project preparation will continue to the rank of a ministry had insufficient authority be poor. to carry out its important and necessary mandate for planning. The recently approved government 142. Sound budgeting requires that the capital structure however, has also transferred the and recurrent budgets be considered in an 62 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE integrated manner to achieve policy objectives. factions represented by these ministries. It also Such comprehensive decision-making taking reflected the parliament's unwillingness to into consideration both the capital and create a powerful MoF that would undermine recurrent budgets is difficult to achieve if two its own considerable legislative powers over separate organizations are responsible for the budget. For both reasons therefore, the preparing the capital and recurrent budgets (a option of a powerful unified ministry of finance "dual budget"). It may for example, result in and planning does not currently appear to be investment projects being built that do not have politically feasible in Mongolia. adequate maintenance funding budgeted for the future. 144. Given thispolitical reality, the IBLattempted to strengthen investment planning by splitting 143. In many countries such a unified policy is the responsibilities between the MED and achieved through a powerful unified ministry the MoF, while maintaining a unified budget of finance and planning. In Mongolia, to date, process. As discussed earlier, the IBL added budgeting has indeed been integrated under the significant new provisions on the requirements MoF; however, the MoF has lacked the capacity that new projects had to fulfill, and detailed two to properly review the capital projects submitted distinct processes, one for large (greater than by line ministries - its Investment Division 30 billion MNT) and another for small projects. staff have not increased in the past 8 years This splitting of responsibility for reviewing large despite a fourteen-fold increase in the capital and small projects between two agencies was budget - with the result that these lacked necessary given that neither MoF nor the MED accurate cost estimations, had no economic had enough capacity on their own to handle the analysis, and had weak links to national and huge task of ensuring that good quality projects sector priorities. Attempts to increase MoF's enter the budget. For all projects the MoE is the planning and project appraisal capacity have single point of control on financing decisions. been repeatedly made and repeatedly rejected Importantly, the recurrent cost implications of by the cabinet and parliament. The reasons are the capital projects also need to be included in mostly political. All central ministries are small line ministry proposals and are an integral part in Mongolia and increasing the MoF's staff may of the capital budgeting process. Such a shared create a political imbalance and result in similar system for example, is found in Chile which has demands from all other ministries, demands that one of the most advanced public investment would have backing from the different political management systems in the world (Box 4). Box 4: The Relative Roles of the Ministry of Finance and the Ministry of Planning in Managing Public Investment: The Chilean System The Chilean system of public investment management (PIM) - in which responsibilities are shared between a planning ministry and a ministry of finance - has long been regarded as amongst the best anywhere. In broad terms the relative roles of ministry of planning (MoP) and MoE in Chile are as follows: " Formulating institutions (sector ministries or agencies, or regional and local governments) put forward projects for consideration to financing institutions, which submit projects for appraisal by entering the project into the Integrated Project Bank (BIP), which is an interactive database of all projects. s The Technical and Economic Analysis Unit in MoP (or in its regional agencies) conducts a pre-assessment study (pre-feasibil ity study). " If this is positive, the project enters into the National System of Investments (SNI), which is currently administered jointly with the MoF. The SNI currently comprises an online databank with over 300,000 entries-i.e., 'policy 'initiatives.' 63 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE * The MoP conducts technical and economic appraisal for all public investment projects, including PPPs. It uses cost-benefit analyses or cost-effectiveness analysis as well as legal, environmental and gender analysis. Every public investment project is subject to the same appraisal discipline, under a set of clearly specified methodologies regularly updated by the MoP. * MoP enters summary project data and its recommendation into the BIP system, and the results of its analysis are notified through the BIP. * Even though projects receive favorable recommendations from MoP, they must still obtain funds in the annual budget process. Each ministry/agency decides which package of approved projects to submit for budget consideration, and these projects enter the 'Budget Formulation' sub-system. * Both MoP and MoF analyze the recurrent costs of projects. * Funding agreements are reached with the Budget Board of MoF. * The law mandates that the capital budget sent by the MoF to Congress can only include projects within the SNI, which have also been favorably assessed by the MoP. This process screens out poor quality projects, and also rules out the possibility of members of parliament inserting investment projects that have not gone through the rigorous process - the only entry door is the SNI. * A decree is issued for assigning funds, which is approved by the Comptroller General. For projects lasting more than one year there will be a financing agreement with the MoF (Treasury Board) regarding phasing and timeline. * The executing agency is responsible for reporting progress using the execution section of the BIP system, and for updating project information in the BIP e.g. on contracts with suppliers. In addition, the Budget Board is notified of the budgetary advances. * The MoF (Budget Board) is responsible for monitoring financial progress against budget, while the ministries and agencies maintain physical and financial control over progress. * MoP is responsible for ex-post evaluation of a representative sample of projects. Source: Arancibia (2008) 145. Our advice therefore, is that the IBL be in terms of sectors, industries, and services. implemented and thatthe MED be responsiblefor Therefore, the draft Law on Development Policy reviewing large projects only. The Government and Planning should also specifythe consultative however, could consider lowering the threshold mechanisms to ensure that medium-term for these large projects from 30 billion MNT to strategy is prepared collaboratively. One a lower amount. The setting of the threshold organizational mechanism for this consultation should be based on an analysis of the public for the development of the Southern Gobi investment program and the distribution of is for the MED to have a Southern Mongolia projects by size, and realistic estimates of MED's Infrastructure Coordination Unit within it capacity to conduct project appraisals. to bring together the concerned ministries. The law should also mandate the creation Improving planning of inter-ministerial committees as the formal consultative bodies for the preparation of the 146. To be effective the MED needs to base medium-term plan. In Malaysia, for example, its advice on an effective consultation with the the preparation of the five-year plans involves line ministries and not fall prey to the tendency extensive consultations through inter-agency of all too many central planning institutions of planning groups (IAPGs) that involve not-only unilaterally identifying "winners and losers" line ministries but also civil society groups. 64 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE 147. The draft Law on Development Policy However, given that the MED is a relatively new and Planning currently sets out a large array agency with limited capacity, it may be advisable of planning instruments and documents. The in Mongolia for line ministries to conduct the authorities should consider following the PFS based on guidelines developed by the MED example of many developing countries which and then for the MED to review the PFS and prepare only one main planning document, then make the decision as to whether or not the namely a medium-term (4-5 year) development proposed project is sound enough for inclusion plan, which is sometimes described as a in the PIP. strategic plan for reducing poverty. The PIP would be issued as part of, or as an annex to, 150. The OECD countries, and other high the medium-term development plan, which may performing middle-income countries, such as be rolled forward annually. The first year of Chile and South Korea, have fairly advanced this rolled forward plan could be the Social and systems of appraisal in place that use some form Economic Guidelines (SEG) that are mandated of social cost-benefitanalysis. Korea forexample, in the Constitution. The core medium-term uses a multi-criteria assessment technique that development planning instrument could be evaluates project pre-feasibility studies on supplemented by additional instruments/ economic cost-benefit analysis, policy relevance, documents. For example, a long-term strategic and promotion of inter-regional equity. These plan could be prepared, or be included as an systems have a level of sophistication that has introductory section to the medium-term plan; gradually evolved over time, and which cannot and subsidiary plans, which are consistent with be realistically transplanted to Mongolia at its overall government priorities, could be prepared current level of organizational capacity. Instead, for sectors such as mining and agriculture, and what is required is a simpler system that can for the regions. immediately provide the much-needed rigor to the appraisal process, and therefore significantly Implementing the IBL provisions on project improve on existing processes, and which can appraisal evolve over time in sophistication in line with 148. The IBL represents significant progress in improving the regulatory framework for capital 151. It may be advisable for Mongolia to start projects by requiring that all projects go through by focusing more on the cost side of cost- a rigorous process - compliance with national benefit analysis for most projects, with the more and sectoral priorities, a socio-economic cost- sophisticated full socio-economic cost-benefit benefit analysis, estimates of future recurrent analysis limited to large, complex projects. costs - before inclusion in the PIP and the Simpler methodologies for smaller projects budget. Effectively implementing this provision are found even in advanced countries, such as will require clarity on (a) the precise roles and Ireland (Box 5). responsibilities of the line ministries and the MED in project appraisal and (b) calibrating the 152. Such a simpler approach was developed project appraisal methodology and requirements in the "Guidelines for the Socio-economic with existing capacity in the line ministries, MED, Appraisal of Projects in the Public Investment and MoF. Program of Mongolia" which were produced for the NDIC with the help of World Bank technical 149. As noted, the IBL requires that all large assistance. The proposed simplified appraisal projects undergo a pre-feasibility study process entails two. The first stage is a "yes/no" (PFS) prior to inclusion in the PIP, with the decision that can be used to reject bad projects responsibility to conduct the PFS given to the early in the decision process so that scarce MED. This centralization of project appraisal time is not wasted on any detailed evaluation is similar to the systems in Korea and Chile. of these projects. The second stage consists of 65 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE scoring projects that pass through this first-level frequent budget adjustments. There are at screening on the basis of simplified prioritization least three causes for cost over-runs: increases criteria. in construction material prices, use of overly simple methods to estimate costs that served 153. The "yes/no" stage assesses project as the basis for project appropriations, and proposals on whether: projects inserted into the budget by Parliament that were not submitted for cost estimation in * Credible evidence is presented that there is the same way as Government-proposed capital demand for the project and the services it projects. will provide. The demand analysis should for example, show traffic volume projections 156. To improve cost estimates the Government for roads projects, trends in economic will need to budget funds for research so that growth, which will have an impact on the the costs for the various materials are regularly demand for infrastructure services such updated. In other words, the Government will as power, water and communications, have to spend more time and resources on and Population growth and demographic project preparation before an appropriation is trends (age distributions, etc) that affect approved, with the knowledge that some of demand for schools and hospitals; these projects may not eventually be approved. * There is a good explanation of which However,thisaddedinvestmentupfrontwilllikely strategic national priority-as specified in pay for itself through fewer delays and project a national or sectoral strategy or planning cost adjustments during implementation. document-the investment relates to and how the project meets the requirements of 157. The Government should also consider that priority giving implementing agencies more authority * There is a basic financial analysis, with in determining cost estimates. Currently in special focus on the estimation of capital Mongolia, a specialized body - the Ministry of (investment) and recurrent (operating) Construction and Urban Planning - develops costs, and that the assumptions used in cost estimates on construction materials for a preparing the project proposal are outlined number of line ministries. While this has the and are sound. advantage of specialization and objectivity, 154. Projects that pass through this first stage the specialized body may lack the detailed are then ranked on a multi-criteria basis involving knowledge of the particular project and alignment with national or sectoral priorities, imperfect coordination between the specialized potential impact, and feasibility. body and the requesting ministry may lead to changes to the project characteristics after 155. As noted in detail, inaccurate cost estimates appropriations have been made. arefa big problem in project preparation requiring Box 5: Formal Project Appraisal in Ireland The Irish Department of Finance has Guidelines for the Appraisal and Management of Capital and Expenditure Proposals in the Public Sector (2005). The Guidelines specify the methodology for appraisal depending on the size of proposed projects, with the following classifications: - Projects with an estimated cost below EO.5 million: A simple assessment to ensure that the project is in line with national priorities. - Projects between EO.5 million and t5 million: a single appraisal incorporating elements of a preliminary and detailed appraisal. - Projects between E5 million and p30 million: A Multi-Criteria Analysis (MCA). - Projects over E30million: A full-fledged Cost Benefit Analysis (CBA). Source: Glendtay et al (2012) 66 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Ensuring that projects proposed by MPs abide abouta majoroverhaul of the public procurement by the IBL system in Mongolia. The question is how to 158. Finally, it is important that parliament also onsthe CAacivilsoetytmonitorng. abides by the planning and capital budgeting principles laid out in the IBL. Mongolia's The Central ProcurementAgency parliament presently has no limits on changing the budget presented by the executive, and 160. The three key challenges that the CPA will has used its authority to include numerous bad face are how to ensure that the centralization of projects. The FSL restricts parliament's discretion procurement reduces corruption and increases in the fiscal aggregates by requiring the budget transparency; how to properly coordinate with to abide by the fiscal rules. It is equally important the line ministries that are still responsible for that individual projects proposed by members of preparing the technical specifications and to parliament-which the parliament will continue clarify that they remain accountable for contract to have the authority to propose - meet implementation; and how to scale up capacity not only the broad principles of sound socio- quickly. economic benefit outlined in the IBL but also the more detailed project appraisal methodology to 161. A priori, it is difficult to predict whether be specified in the implementing regulations. the centralization of procurement increases In other words, members of parliament should or reduces the risks of corruption and political be proposers, just like any line ministry, and interference. On the one hand, under the would need to support project proposals with wrong leadership, the CPA will have much the necessary pre-feasibility studies. Parliament greater ability than multiple line ministries to proposed projects would then be subjected to compromise the procurement process given the the same project appraisal process specified for scale of the procurement that will be conducted line ministry projects in the IBL and supporting by it. On the other, the centralization and regulations. This for example, is the case in separation of procurement from the contract Chile (Box 4). In terms of the budget cycle, implementation function may also reduce the this may imply that projects proposed during risk of political capture as compared to retaining the parliamentary budget session, if they pass both responsibilities in line ministries given MED's or MoF's appraisal, could be considered the close links between political and business for funding and inclusion in the capital budget circles. The reasons are both the lower cost of for the following fiscal year. Alternatively, for monitoring the procurement process in one projects to be included in the same fiscal year agency as opposed to several ministries; and there needs to be a formal mechanism by which the increased cost to those who would wish to parliament can propose projects early during influence contract award for their own personal the budget preparation process. and political interest since they would now need to effect the CPA as well as concerned GREATER CAPACITY, TRANSPARENCY AND line ministry staff since both will be involved OVERSIGHT IN PUBLIC PROCUREMENT AND in the bid evaluation committees. Retaining PROJECT IMPLEMENTATION procurement authority with line ministries and increasing specialized procurement staff in 159. Political interference and corruption are the them would not address this political economy biggest problems in procurement and contract problem since these staff would continue to be implementation in Mongolia. The small size of susceptible to the influence of their minister. the country, the close ties between politicians and construction companies, and the rapid 162. The key determinant of success will be the increases in government spending imply that extenttowhichtheCPA'soperationsaresubject fixing this problem is a top priority if Mongolia to transparency and oversight. The extensive use is to avoid the resource curse. The PPLM brings 67 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE of e-procurement will be important, though this the contract, the line ministries need to have a would not entirely solve the problem of political sign if icant voice in the tender evaluation process. influence in bid evaluation. The Procurement Therefore, the implementing regulations need Inspectorate under the MoF will also clearly to clearly state that the CPA takes responsibility have an important role to play in supervising the for facilitating the administrative processes, i.e. procurement process. The Government is also advertising, disseminating tender documents, considering the establishment of an Oversight receiving and opening bids, and organizing Council under the Prime Minister, and with evaluation committees. At the same time, it membership from the Independent Authority should be clearly stated in the regulations that Against Corruption (IAAC), and the National the line ministry takes responsibility for the Audit Office, to regularly review the functioning technical aspects of the procurement, such as of the CPA. Strong supervision arrangements, the preparation of technical specifications and either in the form of an independent body or related requirements in the tender documents the audit office are a common element in OECD and the technical evaluation. countries (for example the Authority for the Supervision of Public Contracts in Italy). 165. One way to achieve this division is that in the technical evaluation the line ministry should 163. These are all important measures. have the majority vote with respect to the However, given Mongolia's small size and the technical issues (either when it comes to voting fact that conflict of interests abound, it would on technical issues or by way of a separate also be advisable to subject some of the CPA's technical evaluation sub-committee, whatever is operations to international oversight. For high most efficient). In this way, the ministry cannot profile, and/or particularly sensitive contracting, later deny responsibilityfor the technical decision the CPA should consider the use of "probity should that have an effect on poor or improper advisors", typically an international audit firm, implementation for which they, in any event, on bid evaluation committees in order to remain responsible. To provide a guarantee provide independent procurement expertise of probity, the CPA would be able to veto in the event of disagreement. These advisors that technical decision whenever it considers would be one of the civil society or private sector the decision not to be genuine (e.g. through participants in the evaluation committee that is favoritism, incompetence or corruption) but it now mandated in the PPLM, and would be an would have to provide reasons for the veto. independent observer who comments during proceedings when the appropriate governance 166. The CPA will also need to quickly ramp up standards are not being met. This provides capacity, given that it is meant to handle the the opportunity for the evaluation committee procurement of common use items as well as to maintain a robust process throughout and specific goods, works, and services, a scope of minimize the ex post risks of legal action and responsibility that is much larger than that of delays. The results of these "observer reports" central purchaseagenciesintheOECDcountries, could then be presented in parliament, and with the notable exception of Korea (Box 6). The made available to the public. Government is initially planning a staff of 65 for the agency. Currently there is no transition 164. The creation of the CPA in effect implies arrangement in place - as per the PPLM, the that procurement is a shared activity between CPA and local governments have to handle the CPA and line ministries since the ministries all procurements starting January 1, 2013 - will continue to be responsible for providing which creates a big risk that sufficient capacity the technical specifications for the bidding will not be in place in time to have contracts documentsandforcontractimplementation.This finalized before next year's construction season places a premium on clearly specifying roles and commences. It would be advisable for the CPA accountabilities and on effective coordination to begin slowly with some selective contracts to so that all stakeholders know for what they are give it sufficient time; this provision however, accountable. If they are to effectively implement would require an amendment to the PPLM. 68 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Box 6: Central Procurement Agencies in the OECD Countries There are various organizational forms for central procurement agencies (or central purchase organizations) in the OECD countries, though the preferred model seems to be one of state owned companies with ownership resting with the Ministry of Finance. The general model in OECD countries is for these agencies to handle framework agreements, with line ministries responsible for strategic and specific procurements. A strong supervision function is also found in almost all of these countries, either exercised by an independent body, a competition authority, the audit office, or the courts. * Hansel (Finland) is a state-owned company under the control of the Ministry of Finance. It has a staff of approximately 60, and handles framework agreements for common use items for most government entities, excluding municipalities * SKI (Denmark) is a state-owned company with a majority stake held by the Ministry of Finance. It handles framework contracts and has a staff of 85 * Consip (Italy) is a joint stock company owned by the Ministry of Economy and Finance and is responsible for framework contracts for the central government, which are mandatory. It has a staff of 140. The Authority for the Supervision of Public Contracts, an independent agency under the Prime Minister, is responsible for the supervision of all procurement activities. * Office of Government Commerce (OGC, UK) is an independent office of the Treasury responsible for procurement regulations and oversight. Its executive branch is Buying Solutions, which handles a range of framework agreements * UGAP (France) is an independent public entity with a staff of 875 that manages framework agreements for the central government, local authorities and hospitals. * Public Procurement Service (Korea): PPS is one of the few examples of a central purchase agency in an OECD country that handles specific procurements as well as framework procurements. It annually handles goods procurements of $14 billion, or 46 percent of total public purchases; and works of $ 14 billion, or 39 percent of total public works. It is also involved in the stockpiling of raw materials and management of government property. Source: OECD (2011) Civil society monitoring of procurement in the rural areas. Partnerships between CSOs and supervision engineers in contract monitoring 167. The revised PPLM gives CSOs a big can potentially be effective in ensuring that role in bid evaluation committees and in the the supervisors are not "captured" by the monitoring of contract implementation. As contractors, as is currently the case; and that the noted earlier, similar initiatives have occurred technical analysis of the engineers is effectively in the Philippines and a few African countries, used for advocacy purposes with the effected pointing to a different model of oversight than community and the broader public. Responding in the higher income countries where this to this new authority, concerned CSOs from responsibility lies almost entirely with the state all over Mongolia have recently come together audit bodies. No concrete evidence is as yet to form a network - the Public Procurement available as to whether or not this model has Partnership - to facilitate the engagement been successful in increasing transparency and with the Government, provide necessary self- reducing corruption, and it is clear from these regulation and adherence to a code of ethics, experiences that the obstacles to successful and help in knowledge sharing and capacity implementation are many. The Mongolia building. initiative however, does have the advantage of being clearly authorized in law, which is not the 168. If CSO oversight is to be successful in case in most other countries, and of harnessing Mongoliathenitwillrequire:(a)thedevelopment a relativelyvibrant civil societysector, particularly of sound implementing regulations for the PPLM 69 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE on governing civil society's role in bid evaluation publication of reports in the mass media can help and contract monitoring; (b) appropriate self- to induce citizens to pressure the implementing regulation by civil society groups engaged in agencies and contractors to fix any problems in procurement oversight to minimize conflicts the implementation of contracts." of interest and to prevent CSOs from being "captured" by political and business interests; 172. To preserve the reputation of well and (c) a sustainable funding mechanism to performing CSOs, the CSO network and the support CSOs in these activities. government should have the ability to sanction C SOs. The CSO network can have the option to CSOS ROLE IN BID EVALUATION AND blacklist any members that makes egregiously CONTRACT MONITORING false claims in its reports, and also look into situations where there is a disagreement about 169. The PPLM is unclear on whether non- the findings between the government and non- government participants should be voting government observers. At the end of each year, members or observers of bid evaluation the MoF will receive the aggregated reports and committees. In order to maintain their complaints and should use a risk-based approach independence, it is important that the CSO to review this aggregated information. The MoF participants be observers and not voting should also work with CSOs and procuring members. Also, the liability issues entailed with entities to try and respond to problem areas. being voting members may also prove as a The Parliament and the Khurals (local councils) deterrent for effective participation of CSOs. should be encouraged to review and discuss the aggregated reports, which will strengthen their 170. The value of including non-government vibrancy in the process. individuals on bid evaluation committees lies in the scrutiny they will bring to the bid 173.Thecriteriathatareusedtoselectcontracts evaluation process; they are unlikely to possess for CSO monitoring should be transparent. High the specific sectoral knowledge needed to level authorization from the Cabinet and local comment effectively on technical aspects of the parliaments is probably necessary to guarantee bid. Therefore, the CSO members should ideally that CSOs receive access to the information not comment on the technical evaluations but from the procuring entities that they need in restrict their role to observing and commenting order to effectively monitor the selected pool of on the transparency of the evaluation process. contracts. CSOs should be able to monitor both This scrutiny might deter evaluation committee open and closed contracts and the performance members from violating evaluation rules. of the contractors and the implementing agency. Non-government observers may also discover Monitors should observe whether the work is violations, which they will then be able to report staying on schedule; the correct materials are to the government and to the public, which, in being used; the contractors' employees are turn, is likely to act as a deterrent for future getting paid; and, the contractor is fulfilling the violations. terms of the contract. To be effective, CSOs will likely need to partner with engineers or 171. A standardized reporting template - an other technical specialists for this exercise. The "observers report" - should be developed engineers would bring the necessary technical for bid observers. The reports should ideally skills to the table, while the CSOs would help be submitted electronically and channeled to ensure that these engineers remain independent procuring entities and to the Ministry of Finance. and that their technical assessments are Once the awards are made, the MoF suggested effectively used for advocacy purposes to ensure that the non-government observers be accorded thatthenongovrnmnt oserersbe ccoded 27 See Reinikka and Svensson (2005) for an argument as to how the publica- the right to release non-confidential versions tion of information in the media about the leakage of public resources can help of their reports to the general public. The tosolve information asymmetries, induc clientstodemand accountabilityfrom public officials, and lead to government responsiveness. 70 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE transparency and accountability. The monitoring 177. The network is developing a self-regulatory of closed contracts would likely need to focus regime that will constrain its members' on end user's satisfaction with the procured behavior consisting of: 1) entry requirements, goods and works. 2) monitoring mechanisms and, 3) the ability to sanction members. From a cross-national 174. The Public Procurement Partnership can perspective, these entry and sanctioning criteria play a role in recommending CSOs for contract can vary in strictness, and self-regulatory regimes monitoring. In the short run, the qualification may be completely private meaning operating criteria for CSOs to monitor contracts should without any authority from or coordination be rather loose (experience with monitoring with the state, or may involve a combination of budgets, service delivery, EITI). In the longer government and NGO coordination (Box). The run, CSOs can compete to monitor contracts rules governing entry into a networkvary and can based on their past performance with contract include: 1) accreditation, training, certification, monitoring. CSOs will clearly need to adhere validation and licensing mechanisms; 2) to the terms of the procurement and if they are evaluative mechanisms (such as ratings, grading, members of the CSO network, they will also and scoring systems); 3) sectoral codes and need to adhere to the network's code of ethics. other means to govern conduct (such as codes As long as they have the requisite experience, of conduct or ethics of various kinds); and 4) CSOs that are outside of the CSO procurement- open entry. monitoring network should also be able to participate in contract monitoring. 178. In the short-term, to encourage the growth of CSOs interested in monitoring procurement 175. Since the real value of CSO monitoring in Mongolia, it is recommended that the Public is their role in promoting transparency, it is Procurement Partnership enact loose entry imperative that the monitoring reports be requirements: prior experience with monitoring made public. However, the implementing government processes (e.g. EITI, budgets, and agencies should be given an opportunity to elections);compulsorytrainingforaffiliates;and, comment on the reports' findings before it is agreement to its code of ethics. The network made public by for example, allowing them a plans to offer training for its members on an certain number of days (-15 days) to be able to on-going basis. In the longer term, the network respond to the monitoring reports after which may consider enacting stricter requirements point the reports become public. If there are including, for example, certification and prior disagreements between the CSO monitors and experience with procurement monitoring the government over report, the CSO network procurement. Although stricter standards may should investigate. act as a disincentive for participation, stricter standards are likely to send more powerful THE CSO PROCUREMENT NETWORK signals of the high quality of member activities. 176. The Public Procurement Partnership will 179. Monitoring can range in stringency from be an umbrella organization with affiliates self-reported verification to peer-verification across Mongolia. The network's sustainability systems.2 In third-party verification systems, will depend on its members' ability to carry experts outside the organization certify out the procurement monitoring effectively compliance. Monitoring also varies in the extent and transparently. Poor performance and to which members are required to disclose misbehavior on the part its members can their monitoring information publicly. Stronger compromise the networks' funding by signaling monitoring can be expected to produce a poorthualitytatileornderminingvehe credibility of 28 A survey of N Os in Uganda found a large amount of variation in the report- the procurement law. ing requirements to granting bodies. According to survey respondents, the most prevalent form of reporting requirements is the final report folloed by final ac- counts. Most recipients are also required to submit progress reports and interim accounts and are visited by the granting body an average of five times per year (Barr and Fafchamps 2004). 71 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE more credible signal about participant quality, complaints or objections raised against the but stronger monitoring increases the cost NGOs by fellow members, government officials of participation for organizations, potentially or contractors. Other forms of monitoring limiting program participation. mechanisms can include third party evaluations and supervision from donors or government 180. The absence of a common metric to authorities. Sanctioning mechanisms for evaluate its members' performance makes the networks can include fines, public sanctions and task of monitoring member NGOs difficult. expulsion. Mongolia's procurement network Nonetheless, the Partnership plans to monitor emphasized that the network will primarily use its members' participation through oversight blacklisting as a sanctioning device on members from the board of directors, reviewing contract for violating the network's code of ethics or monitoring reports by looking into any government regulations and laws. Box 7: CSO Self-regulation and Sustainable Funding Self-regulatory regimes Gugerty (2007) identifies three types of CSO self-regulatory regimes: the guild, the voluntary club and the industry code. National guild systems are a form of professional self-regulation that exercises a monopoly over entry into a profession or industry. Only associations that are members of the guild are allowed to operate. A second type of voluntary regulation is the club, which are NGO-led associations, which lack a delegated monopoly over entry. Clubs develop standards, reporting requirements and monitoring mechanisms to which its members agree to adhere as a condition for entry. The major benefit clubs offer its members are reputational. The third type, the industry code of conduct, has no entry requirements aside from members' participation in the industry. The rigidity of the standards and reporting often vary across systems. Industry associations lack strong incentives to signal poor performance among members. Consequently, industry codes are likely to be less effective in influencing members' behavior than other forms of self-regulation. For example, the Ethiopian 'club' is voluntary and composed of a code of conduct developed by Ethiopian NGOs and sponsored by the largest NGO association in the country, the Christian Relief and Development Agency (CRDA). The original purpose of the code was to establish a general assembly of signatories who would elect a Code Observance Committee charged with monitoring adherence and hearing complaints. In practice, establishing a separate body was difficult to implement and instead, the code observance committee was housed at CRDA - the largest, most representative NGO agency. The code combines aspirational values and verifiable financial and management practices, including providing publicly available annual reports and audited financial statements. CRDA has a fairly extensive screening process for applicants and all new CRDA members are required to sign onto the code upon joining. There is a waiting list of nonprofits, which are trying joining CRDA as the organization offers access to donor funding and a range of support services. Although there is a screening process for new applicants, CDRA does not require on-going reporting and does not monitor its members' adherence to the code of conduct. Funding arrangements Different governments, notably in Eastern and Central Europe, have implemented different arrangements for supporting CSOs. For example, the Hungarian government instituted the "1n % mechanism", which allows taxpayers to allocate one percent of their income tax to one CSO of their choice. Most public funding is directed to CSOs through ministry budgets 72 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE (direct funding, grant programs or ministry funds or agencies) and independently resourced public funds. To support NGO's operational costs beyond what NGOs receive from taxpayer contributions, the Hungarian Government established the National Civil Fund (NCF) in 2003. The NCF is governed by a Council and a number of regionally based Colleges. The Council, which consists of MPs and representatives from a Ministry and CSOs, is responsible for developing the priorities, strategies, and grant-making policies. The Colleges, which consist primarily of elected CSO representatives, are responsible for grant-making decisions (Hadzi-Miceva 2008). In Croatia, various ministries, government agencies and organizations channel state funds directly to CSOs active in their sphere of activity. In 2007 the Government adopted a Code of Good Practice, Standards and Criteria for the Allocation of Grants for Programmes and Projects of Associations, the "Croatian Code", which sets out basic rules and procedures for all public authorities who distribute public funds. The Government Office for Associations and the Council for the Development of Civil Society, a specialized advisory body of the Croatian Government, is responsible for CSO policy and for interacting with CSOs. The Council is responsible for monitoring, analyzing, and evaluating the financing granted from the state budget, and ensuring compliance with the Code. The National Foundation for Civil Society (funded mostly from lotteries) was established in 2003 to support CSOs. The Foundation has comprehensive grant-making policies including policies governing conflict of interest. The Foundation signed agreements with four regional foundations, which are responsible for managing grant programs in their specific regions. From 1999 to 2009, 27,543 projects of CSO were funded by the state, amounting to more than 320 million Euro of funding allocated to the sector. Most CSOs (about 70 percent) rely on funding from the central and regional/local government's budgets as the main source of funding (ECNIL 2011). Sources: Gugerty (2007), ECNIL (2011), Hadzi-Miceva (2008). SUSTAINABLE FUNDING ARRANGEMENTS educated and wealthier members, but very little difference in the groups' productivity. 181. Sustainable funding arrangements that are shielded from political interference will 182. In the immediate term, the Government be essential for the success of civil society is considering providing funds for contract monitoring. While development partners can, monitoring and bid evaluations. In the and should, assist the CSOs in the early stages it medium to long run, an independent national is critical that in the longer term CSOs develop foundation can be established to fund different a revenue stream that is independent of donor types of CSO activities including procurement funding. The reasons are three-fold. First, donor monitoring. Examples from other countries (Box funding is unpredictable and volatile, which can 3) suggest a model in which the foundation has undermine CSOs' ability to plan its operations. a predictable and sustainable source of funding Second, reliance on donor and international - from the budget, development partners, NGO funding also risks making CSOs more mining companies - and an independent accountable to donors than to the communities board or council for making funding decisions they are meant to serve. Third and related, donor for individual CSOs in various streams of funding can change the composition of recipient activities (e.g. contracting out of service delivery, CSOs. Gugerty and Kramer (2006) for example, budget transparency, EITI, and procurement find an association between external support monitoring). for local groups and the characteristics of the groups' members. Among groups that received external support, there were larger numbers of 73 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE IMPROVING BUDGET EXECUTION commences in May. Therefore, this provision does not do enough to solve the problem. In 183.Mongolia's capital budget execution developing countries, such as Mongolia, it is faces two particular challenges: an extreme indeed advisable to limit carry-over spending to climate that reduces the construction season multi-year capital projects, with strict limits to to 6 months; and high volatility in the prices of how much can be carried over, as set in the IBL, construction materials that makes it difficult to so as to ensure adherence to fiscal rules and to fully anticipate costs during budget preparation. prevent large stocks of accumulated carry-overs While the latter problem can be ameliorated from threatening aggregate fiscal management. with more carefully researched cost estimates, However, the IBL should increase the carry-over there is a "structural" element to the problem provision to one year, while sticking to the 3 given that Mongolia is a small, rapidly growing percent limit, to provide sufficient time for the open economy. completion of works while minimizing the fiscal risks. 184. Greater flexibility in budget execution is required to meet these two challenges. The 187. Finally, the Investment Division of the MoF two usual methods are carry-over funding or should not be involved in the authorization of multi-year appropriations, and giving spending payments as this is a function of the Treasury agencies more authority for virements between Department. In some countries, such as projects. On the latter, the IBL has made Albania, the responsibility for issuing payment significant progress by moving from a system orders is decentralized, with spending ministries where only parliament had the authority for carrying out these tasks and reporting back virements to one where spending agencies to the center. In commonwealth systems, have significant authority subject to common payment authorization is the responsibility of restrictions on budget adjustments between the treasury. In any case, this is not the role of capital and recurrent expenditures. the budget department which should focus on the planning and project appraisal stages of the 185. Carry-over funding is a common feature budget cycle. in OECD budget systems to precisely prevent the normal bureaucratic tendency to spend ADDRESSING HUMAN RESOURCE the entire allocated budget for fear that any CAPACITY CONSTRAINTS savings would imply a cut in future budgets. Most OECD countries allow carry-over funding 188. Limited number of skilled personnel is to broad categories of expenditure subject to a persistent theme in many of the problems restrictions. These restrictions can take different identified in this report. Key ministries and forms, such as (1) a limit on the amount of carry- agencies in Mongolia are generally small - for forward allowed in any given year, e.g., usually example, approximately 150 staff in the case 3 percent of the appropriation; (2) a ceiling on of MoF, 50 for MED, and 400 for Ministry of the amount of accumulated carry forwards, e.g. Roads and Transport - and the potential for 10 percent of the appropriation; or (3) limits on significantly recruiting staff with the necessary the draw-down of accumulated carry-overs.29 technical expertise for planning, budgeting, procurement, and project implementation in the 186. The IBL introduces carry-over funding for near term is limited. Worryingly, the booming capital projects with the first type of restriction, wages in the mining sector are making it difficult limiting the carry-over to 3 percent of the total to recruit and retain good quality civil servants appropriation. However, it only allows carry- in key positions. While there is no hard data on over for three months, which implies that any the scale of this problem, anecdotal evidence spending in the next fiscal year would have to be suggests that Government staff in jobs that are completed before the new construction season in high demand in the private sector, such as 29 Lienert and Lbungman (2009) 74 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE finance, revenue administration, engineering, Distribution of civil servants, 2008 procurement, and information technology, are Political, tempted to leave the civil service due to the Special 2600, 2% 25,428, considerably higher pay - between five and 18% ten-fold - in mining and related companies. The Government is also facing difficulties in Admin. recruiting personnel in these jobs. While civil 10,503, 7% 140,258 service wages have been increasing through Support regular 15-30 percent across-the-board salary 73% increases over the past five years - the nominal wage bill has increased ten-fold since 2003, when the mining boom began (Figure 27, left panel)-these increases cannot keep pace with 190. If hard evidence reveals that "brain drain" the much higher growth in relevant private sector is a problem then one of the options for the wages. And this problem is likely to increase in Government is a more flexible pay policy, severity with continued high economic growth. replacing the current across-the-board salary The civil service wage bill presently remains increases with more targeted market-based affordable at 8 percent of GDP and 22 percent salary premiums so that the pay increases vary of revenue (Figure 27, left panel), but may by different categories of staff. The advantage not remain affordable if the government tries of the targeted approach is that it allows limited to consistently match the private sector with budget resources to be used more effectively in uniform salary increases for all staff. addressing the problem. 189. It would be advisable for the Government 191D. The composition of the civil service suggests to prepare a policy to ensure that civil service that such targeted approach can be feasible. wages remain competitive. The first measure The administrative service, or the managerial should be the gather more information on the positions in line ministries, agencies, and local scale of the problem and the emerging trends governments - the positions most vulnerable through a survey of civil service wages with to the brain drain - makes up only 7 percent of those paid in the private sector for comparable the civil service (Figure 27, right panel), with the jobs. bulk of the civil service consisting of teachers and medical personnel, who are classified in Figure 27: While the civil service wage bill the support service, that are unlikely to be as is increasing it is fiscally sustainable and the afetdbthmingom.As,whnte Government can afford to significantly in.crease afed btemini ngatv boomvAls, withll inisre the the salaries of the administrative service a agencies are likely to be equally impacted. Pay Trends in the civil service wage bill flexibility can take many forms, such as separate pay scales for different line ministries and Wage bil ss percent of GaP agencies or additional pay for specific types of 12 Wagd bili as percent of revenue jobs in line ministries. Given the relatively small 1 1-Noninal Wage bil(LHS,2003 24 size of the core administrative civil service, and b1 the huge increases in government revenue, 6 15 the government should be able to afford 4 1 significant additional pay for key staff in order 2 6 to effectively address this problem. The main 0 0 challenge will be political as such asymmetric dpay reform has proven to be politically difficult implement in many countries. However, the Sources: MoF and Civil Service Council positive underlying political economy factors in 75 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Mongolia, discussed earlier, give some reasons capacity. Forexample, it is unlikelythattherewill for optimism. be sufficienttime to getthe central procurement agency up and running to carry out all assigned 192. A number of OECD countries, and a few tasks over the next couple of years and middle income countries, have introduced pay therefore, the MoF should consider appointing flexibility over the pasttwo decades. Payflexibility a 'procurement advisor' for the purpose of both can take many forms, such as separate pay carrying out procurement on behalf of the CPA scales for different line ministries and agencies; (like a traditional procurement 'agent') in the additional pay for specific types of jobs in line initial stages but also, and more importantly, to ministries; additional pay for hardship postings 'mentor' CPA staff through on-the-job training or postings to remote locations; and greater use so that decisions will always, in practice, be of performance bonusues. made jointly. Similarly, NDIC would need to rely on academia, think tanks, and consulting firms 193.Separate pay scales for different to supplement its in-house project appraisal agencies. In Chile, the so-called "controlling capacity. The Government's recent discussion to institutions" - Treasury, Budget Office, outsource the supervision of road construction Superintendence of Pensions, Superintendence is a step in the right direction. of Banks - have a separate and higher pay scale. In Indonesia, pay also varies considerably 197.Theproblemofskillsscarcityisobviouslynot across central government ministries with the limited to the government and over the medium Ministries of Finance, Planning, the Supreme to long term, clearly additional investments in Audit Board receiving significantly higher pay. the education system, including tertiary and 194.Highervocational training to ensure that the economy categoiher alloafnceaz,spfor srpefi can drawon a highlyqualified pool of technicians, categories of staff. In Brazil, specific groupsoprts,egnr,adohrpofsial of employees such as in finance, budgeting, will enes Whl ecationl ls planning, management, legal and control have aroun esre-in e ecto csfor higher compensation levels compared to other as exeplfeiythe N orweg an pr , groups. In Chile, each institution receives a t s of deve solian syems budget envelope for the "critical functions" allowance from the Budget Office to distribute are hort-term so caneliein proviin among their staff, with agency heads deciding sc holar fortin aad at leading who receives the benefit and how much the selected person receives, up to 100% of their u remuneration. This allowance is normally used students to return for a clearly defined minimum to increase pay of middle-management positions period of time. A similar system operates in (for example, a Budget and Planning Manager Singapore and has helped build a highly skilled for a le a labor force. Alongside tying stipends to the for lie miisty).condition of return, ensuring adequate levels of 195. Performance bonuses: While there is basic services across the country can minimize considerable debate in the academic literature push factors encouraging emigration. on the effectiveness of performance pay, the use of performance bonuses in the public sector is almost universal in OECD countries - 28 of the 34 countries have implemented it in some form or another - and it is increasingly being applied in middle income countries. 196. The Government will also need to rely on contracting-in and contracting-out the necessary 76 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE Figure 28: Oil production and migration in the restrictive, which in particular is hurting the United Arab Emirates growth of the construction sector. Generally, 80 Migrants as% of population 3 well-managed immigration can help small, - Oil production(mn barrels rda RHS) resource-rich countries, attract skilled workers to 70 2.5 develop the growth sectors and transfer skills to 60 -the local labor force. Thus, for multiple reasons, 50 2 twill be imperativefor Mongolia to build human 40 1.5 capital both by investing in the skills of its native 30 -population but also by supplementing its capital 201 stock through immigration. 20 - 0.5 10 -CONCLUSION 0 0 200. This report has argued that translating the mineral resource boom into sustainable Sources: Energy Information Administration and World development in Mongolia is conditional Bank Bank on scaling up infrastructure, which in turn 198. Realistically however, these measures will requires significant improvements in four not completely ameliorate the fundamental key areas pertaining to the Government's constraint of labor scarcity in Mongolia, and public expenditure management system and the Government will need to learn from the the construction sector. It identified the key experience of other labor scarce natural resource problems that need to be addressed to ensure rich countries which relied extensively on that infrastructure is geographically prioritized importing both skilled and unskilled labor from and well maintained, and that individual projects overseas. Opening the borders to immigrants are well prepared, procured, and implemented. can plug the skills shortfall and produce It then made recommendations on improving knowledge spillovers that accelerate human some key pieces of legislation, on the details capital formation. Today's major oil exporters in that need to be specified in the implementing the Middle East all started to actively encourage regulations for the recently implemented laws immigration when oil was discovered in the such as the FSL, IBL, and PPLM, and proposed a 1960s (Figure 28). In 2010, migrants accounted strategy for addressing the common underlying for a considerable proportion of the countries in problem of limited human resource capacity. the Gulf region, with 25 percent in Bahrain, 30 percent in Oman, 44 percent in the United Arab 201. Following the parliamentary elections of Emirates, 74 percent in Qatar, and 77 percent in June 2012, a new Government has taken office Kuwait. These migrant workers played a critical in Mongolia. This political transition presents a role in the development of the construction and new window of opportunity to enact some of services sectors in the Gulf countries. This pattern these reforms that can help turn the country's is also found in non-oil resource rich countries. vast copper and coal resources into the sustained Botswana, for example opened its doors to improvement in the lives of current and future migrants to enhance its diamond production, generations of Mongolians. and has since managed to attract qualified workers from across the African continent as well as from more developed nations. 199. Currently, international migration flows to Mongolia are low with migrants accounting for only 0.4 percent of the country's population. As noted, the policy for migrant workers is 77 MONGOLIA: IMPROVING PUBLIC INVESTMENTS TO MEET THE CHALLENGE OF SCALING UP INFRASTRUCTURE REFERENCES Acemoglu, Daron and James Robinson. 2012. Government of Mongolia. 2012. Audit of the Why Nations Fail. New York: Crown Publishers 2011 Capital Budget. Ulaanbaatar: Mongolia National Audit Office. Arancibia, Hugo, 2008. 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