Mongolia Growth Diagnostics Elena Ianchovichina Senior Economist Economic Policy and Debt Department World Bank

Objectives Use the growth diagnostic framework to identify binding “constraints” to growth in Mongolia Rely on both direct and indirect evidence to identify “bottlenecks”

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Is private investment in Mongolia low? Gross domestic investment in Mongolia has been high by international standards Averaged 35% of GDP between 1996 and 2005 But most of it was official foreign aid and loans 59% of investment in 2004 The bulk of private investment went into a limited number of firms in mining and construction FDI was high and averaged 5.2% of GDP in Domestic private investment was financed mainly by own funds (72 percent in 2004), and not bank loans Domestic credit to the private sector has been growing at high rates, but most of the loans have been short term and financed trade, not productive investments

What are the reasons for the low private investment outside mining and construction? Is the cost of capital in Mongolia high? or Is the rate of return on capital in the sectors outside mining and construction low?

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Are real interest rates high? Real interest rates are high, but have come down substantially… Source: World Bank, SIMA

What is the reason for the recent fall in the real cost of capital? The fall in the real cost of capital was due to inflation rate increases rather than risk premium declines… Source: World Bank, SIMA

and Mongolia’s cost of capital is still high relative to other developing countries Source: Ricardo Hausman, “A framework for Growth Diagnostics”, Kennedy School of Government, Harvard University, May Mongolia

Why is the cost of capital still high? Cost of capital is high because of high bank deposit rates and risk premiums Source: World Bank, SIMA

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Why are bank deposit rates and risk premiums high? Is bad international finance the reason for the high cost of capital? International finance has been good Mongolia’s official debt is primarily concessional, long-term FDI inflows have been strong Outlook As of now the spread on ‘B+’ Fitch rated countries is 280 to 300 basis points Collateral can be used to bring down the spread further down But, new tax law affecting mining may result in a drop in FDI and outlook will change if there is a negative TOT shock

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Why are bank deposit rates and risk premiums high? Is bad local finance the reason for the high cost of capital? Domestic saving increased due to strong growth and BOP position Rising official reserves and commercial bank assets pushed the 2006 liquidity ratio to 600% and credit growth was highest since 1992 But, the cost of capital is high due to poor financial intermediation

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Why are bank deposit rates and risk premiums high? Poor financial intermediation is responsible for the high cost of capital Bank deposit rates are high due to intensive competition among financial institutions Spreads are high due to a combinations of factors: Difficulty in assessing credit risk; High bank operating costs; Low profitability of banks’ non-lending assets;

Are the high cost of capital and limited access to capital the reasons for the large number of firms without loans? 72.1%27.9% With a loanWithout a loan All firms 100% 4.0%68.1% AppliedDid not apply 25.9%42.2 Did not need a loan Discouraged Why? High cost of Capital 22.0% Collateral 18.7% Low return To capital? 42.2% Lack Collateral 3%l Why? Low return To capital? 1% Loan Maturity of 1 year 27% Loan Maturity > 5 years 0.9% Source: Mongolia Productivity and Investment Climate Survey (PICS) 2004.

Discrepancy between complaints and data Cost of capital Whereas 56% of the firms in PICS complained that the cost of capital is a severe obstacle to business growth Only 22% of the firms in the survey did not apply for a loan because of the high cost of capital Access to capital Whereas 42% of firms claim that access to credit was a severe obstacle 70% either obtained a loan (28% of firms) or did not need a loan (42% of firms) Access to long-term financing is limited Collateral requirement is excessive due to problems with assessing credit risk Conclusion: while the cost of capital is high, it is not the primary reason for the small number of firms with loans

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) resource management poor natural

Is the rate of return on economic activity in Mongolia low? Efficiency has improved Productivity growth was positive in 2004 Return to capital has been positive and high compared to other countries

Not all sectors enjoyed high returns to capital Returns to capital in manufacturing and transport were negative

What are the reasons for low returns in Mongolia’s lagging sectors? Are the low returns due to low social returns? or Are the low returns due to low private appropriability (i.e. low private returns)?

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Is human capital a constraint to growth? According to PICS 2004, shortage of skilled labor is not a concern, except for large firms Skilled labor is abundant, and job creation for skilled workers has been limited Unemployment among workers with secondary and tertiary education was 64 percent in 2004 But, quality of education is poor and there is a mismatch between skills demanded by the market and skills workers bring to the market

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) resource management poor natural

Is poor infrastructure a constraint to growth in Mongolia? Survey results: Infrastructure is not a constraint as service interruptions do not result in large production losses due to spare capacity But, transport services are expensive and poor quality Domestic market is small (low income, low population density) and remote (poor geography) Transportation services for freight are limited, costly and unreliable Majority of goods moved by rail and rail transport costs are very high Transit times are long and uncertain due to complex transit procedures including customs and trade rules High oil prices have put upward pressure on road and air transport costs

Rail transport costs are high Source: Staff estimates based on data from Broadman (2005) and World Bank (2006)

High transport costs coupled with long and uncertain transit times result in excessive trade costs Source: Doing Business database

Excessive trade costs are a binding constraint to growth Hurt Mongolia’s export competitiveness Hurt the growth of Mongolia’s manufacturing sectors Prevent firms from: Integrating with global manufacturing networks Expanding markets, and realizing economies of scale Diversifying the economic base

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) resource management poor natural

Is poor natural resource management a constraint to growth in Mongolia? No, but… The quality of natural resources are eroding even as their contributions to public and shadow economies are increasing Natural resource degradation threatens Mongolia’s progress towards sustained long-term economic growth; its costs – in terms of lowered labor and land productivity, biodiversity, tourism and government revenue, as well as public health related expenditures – continue to climb; reduces the options for future generations. Lack of data makes assessments of environmental degradation challenging, but indirect evidence suggests that illegal wild life and logging trade, and mining activities are responsible for the increasing environmental costs

Threats to the environment come from three profitable activities ‘Illegal’ wildlife trade has led to dramatic population declines; The loss of species: will force herders to either purchase meat or consume own livestock hurting incomes of vulnerable groups limit the growth of industries relying on wildlife as an intermediate input. ‘Illegal’ logging is unsustainable, and: has lowered timber prices driving legal operators out of business; has limited revenue from forest-use fees; raised the costs of forest management; has affected negatively non-timber forest products. The environmental effects of mining are worse in Mongolia than in other countries due to its large and unregulated artisinal mining sector

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Is macroeconomic instability a constraint to growth? No Monetary and fiscal policies have insured macroeconomic stability in recent years Absence of REER appreciation for now, but the threat of ‘Dutch’ disease is real if commodity boom persists Fiscal performance improved due to the commodity boom and improved budget management, but the quality of fiscal adjustment deteriorated Public capital spending and maintenance declined by 1.4% of GDP Fiscal pressures will persist in the run-up to the 2008 elections Heightened concerns about financial sector instability The incidence of NPLs increased from 8.3% in end-2003 to 10% in mid-2005 Macroeconomic stability depends on the stability of the terms of trade

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Is the tax burden too high and distortionary? Mongolia’s informal sector is large and growing, signaling indirectly that the tax code is a binding constraint to growth The tax base is narrow 100 taxpayers provided over 90% of revenues Tax administration is weak; rent-seeking and tax evasion are wide spread The tax code creates: incentives to avoid paying taxes by staying small disincentives to start-up businesses A planned overhaul of the tax code will address some of these problems The windfall profit tax on copper and gold, introduced in 2005 may have a negative effect on FDI inflows in the mineral sector; has led to a drop in official sales of gold and may encourage illegal trade Duty exemptions on imported inputs used in the production of exports likely to do more harm than good to the economy Export tax on raw cashmere encouraged smuggling to China, not downstream processing

Is corruption an obstacle to growth? Mongolia ranks 9 th out of 62 countries, in terms of the share of firms reporting corruption as a major obstacle to growth Corruption is perceived to be the number one obstacle to growth, according to PICS Has worsened since 2001 according to Transparency International Government procurement affected The process of obtaining permits is nontransparent The process of acquiring land is extremely bureaucratic and costly, and is associated with corruption

Is contract enforcement an obstacle to growth ? Mongolia’s institutions for contract enforcement are weak but improving and are not a binding constraint to growth Crime has been on the rise In 2004 firm’s losses due to crime added up to 1.6% of sales

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) resource management poor natural

Mongolia is the 37 th least diversified economy among a group of 100 countries Source: Database on export diversification (PRMED). The higher the index, the lower the degree of diversification

Comparative advantage vs. competitive advantage Mongolia specializes in primary commodities in which it has comparative advantage – land and mineral intensive products But is vulnerable to terms-of-trade shocks and environmental degradation, and uses its scarce resource – labor inefficiently

Value added per worker in Mongolia is low except in mining Source: Staff estimates based on data from Mongolian Statistical Yearbook (2004) and Government of Mongolia

Dependence on primary goods has grown in the past few years Two economic activities - livestock herding and mining - represented more than 40 percent of real GDP in 2005 Three commodities – copper, gold and cashmere – accounted for 67 percent of Mongolia’s exports in 2005 The vast majority of non-metal manufactured exports were textiles and apparel (76 percent)

Do Mongolian firms “innovate”? Diversification of the production structure requires “discovery” of an economy’s cost structure Firms must adapt new technologies to local conditions and “discover” which products they can produce at low enough cost to be profitable Mongolia’s manufacturing base is narrow but this is not because firms do not attempt to export new products; every year in the period New exports were 30% of exports at the 4 digit HS level Of these, 70 to 80% were new manufactured exports But half of new exports were discontinued next year, and manufactured exports represented a large share of these new exports discontinued the following year The process of “self-discovery” has been hampered by limited access to new technology & knowledge and access to markets

Access to new technology is critical for diversification and sustained growth – examples from resource-rich countries A leap from resource-based activities to high-tech industries is possible Emphasis on access to technology and training has been critical to: Finland’s Nokia A move from pulp and paper to a global leader in telecommunications Alliances with American and European companies and research institutions were critical Aggressive human-resource development programs Australia’s Broken Hill Proprietary Company (BHP) A move from local mining to shipping and ship building, and exporter of cutting-edge know-how on mineral detection and mining-related environmental knowledge Emphasis on building mining expertise in Australia has been critical to BHP’s success

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Coordination externalities Firms need services requiring simultaneous, large scale investments in order to: expand output of existing products; improve quality; expand the number of exported goods; Firms also need improved access to foreign markets and state-of-the-art technology

Negative coordination externalities in Mongolia Large informal exports of raw cashmere to China are indirect signal that the government has failed to address coordination issues in the cashmere industry Herders lack finance, information and infrastructure to improve raw cashmere quality Processors lack incentives and are reluctant to form strategic links with herders; Some of the consequences have been: Shortages of quality raw cashmere force processors to operate below capacity an obstacle to FDI from luxury makers of cashmere goods Environmental degradation Coordination of transit trade and logistics has been poor SPS restrictions on meat products in China and Russia have eliminated meat exports from Mongolia to these markets Firms are not competitive in global markets as they do not have access to modern technologies, market, and product quality information

The role of knowledge clusters Network organizations – or knowledge clusters – are the main strategic competitive asset of the Swedish forest industry The network of institutions is essential to: developing and maintaining international competitiveness; dissemination of skills and research from universities and research organizations to the industry Undertaking multi-industry projects

Concluding remarks  Mongolia has grown rapidly, but growth has been unbalanced  Private investment has flown into a small number of firms operating in mining and construction  Returns in manufacturing and other private sectors have been kept low by:  Costly and unreliable transport services and lengthy and complex transit procedures, including customs and trade rules  Negative coordination externalities  Mismatch of skills and poor quality of education  Limited access to modern technology, market information  Natural resource degradation threatens Mongolia’s progress towards sustained long-term economic growth  Diversify sources for finance and improve financial sector intermediation