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

Mongolia Growth Diagnostics

Elena IanchovichinaSenior Economist

Economic Policy and Debt DepartmentWorld 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

micro risks:

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 naturalresourcemanagement

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 1996-2005 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?



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

Are real interest rates high?Real interest rates are high, but have come down substantially…

0

10

20

30

40

50

60

70

80

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

%

Mongolia Cambodia Vietnam Kyrgyz Republic

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…


-2

0

2

4

6

8

10

12

14

16

18

2001 2002 2003 2004 2005

Interest rate spread (lending rate minus deposit rate)

Inflation, consumer prices (annual %)

and Mongolia’s cost of capital is still high relative to other developing countries

Real interest rate

-6

-4

-2

0

2

4

6

8

10

12

14

Tur

key

Slo

veni

a

Bra

zil

Chi

na

Alb

ania

Hun

gary

Egy

pt

Rus

sia

Indo

nesi

a

Mor

occo

00

Cro

atia

Bul

garia

Est

onia

Mor

occo

04

Ken

ya

Cze

ch

El S

alva

dor

Slo

vaki

a

Phi

lippi

nes

Indi

a

Mol

dova

Alg

eria

Ban

glad

esh

Nic

arag

ua

Bos

nia

Om

an

Pak

ista

n

Ecu

ador

Pol

and

Rom

ania

Source: Ricardo Hausman, “A framework for Growth Diagnostics”, Kennedy School of Government, Harvard University, May 2006.

Mongolia

Why is the cost of capital still high?Cost of capital is high because of high bank deposit rates and risk premiums

0

5

10

15

20

25

Mongolia Azerbaijan Cambodia KyrgyzRepublic

Vietnam Uruguay

Deposit interest rate Interest rate spread (lending rate minus deposit rate)




Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

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 loan Without a loan

All firms100%

4.0% 68.1%

Applied Did not apply

25.9% 42.2

Did not need a loanDiscouraged

Why?High cost of

Capital22.0%

Collateral

18.7%

Low returnTo capital?

42.2%

Lack Collateral

3%l

Why?

Why?

Low returnTo capital?

1%

Loan Maturity of

1 year27%

Loan Maturity >

5 years0.9%

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



resourcemanagement

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

TFP growth estimates in 2004 (%) (Cobb-Douglas)

α=0.3 α=0.4 α=0.5 γ=1 (CRTS) 5.8 5.2 4.5 γ=1.2 (IRTS) 5.0 4.2 3.4 γ=0.8 (DRTS) 6.7 6.2 5.7

TFP growth estimates in 2004 (%) (CRTS CES)

σ=0.8 σ=1 σ=1.2 α=0.5 7.1 4.5 2.6

Source: Staff estimates

Not all sectors enjoyed high returns to capital

Returns to capital in manufacturing and transport were negative

Industries’ contribution to real growth in Mongolia (percentage points)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Agriculture 1.2 1.6 2.5 1.7 -6.2 -6.2 -3.5 1.1 4.1 1.9 Industry -1.7 -0.9 0.9 0.0 -0.2 3.7 0.4 1.6 4.0 -0.1 Manufacturing -2.4 -1.4 0.3 -0.5 -0.4 2.2 1.2 0.7 -0.1 -2.2 Mining 0.6 0.6 0.6 0.5 0.6 1.2 -1.2 -0.3 4.1 1.7 Construction 0.1 -0.1 0.0 0.0 -0.4 0.3 0.4 1.2 0.0 0.4 Services 1.6 3.2 -0.1 -0.1 3.4 1.5 6.0 3.1 1.5 4.3 Utilities -0.8 -0.1 0.1 0.1 0.2 0.4 0.2 0.0 0.1 0.1 Transport 0.5 0.0 0.6 0.0 1.2 1.4 2.0 1.5 1.8 -0.3 Trade 0.3 3.2 -1.2 -1.6 1.3 0.1 2.7 1.4 -0.7 4.3 Other services 1.6 0.1 0.4 1.4 0.7 -0.3 1.1 0.2 0.3 0.3

Source: Staff estimates based on data from World Bank (LDB).

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)?



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



resourcemanagement

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

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Kazakhstan Uzbekistan Tajikistan Kyrgyz Rep. Mongolia-Exports

Monglia-Imports

$/T

EU

/km

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

Export costs

0

500

1000

1500

2000

2500

3000

3500

US

$ p

er T

EU

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



resourcemanagement

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

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 9th 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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



resourcemanagement

poor natural

Mongolia is the 37th least diversified economy among a group of 100

countries

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

Mon

golia

Vietnam

Kazakh

stan

Kyrgy

z Rep

ublic

Cambodia

Uzbek

istan

Ghana

Urugu

ay

Herfindahl Index Hirschman Index

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

0

1000

2000

3000

4000

5000

6000

7000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

LC

U i

n t

ho

usa

nd

s

Agriculture Manufacturing Mining Services Total

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)

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

1990 1995 2000 2004

Herf

ind

ah

l In

dex

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% o

f exp

ort

s

Herfindahl Index Export share of five largest exports

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 2002-06

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



Low social returns

Low appropriability

government failures

market failures

poor

geography

low human capital

bad infra

-

structure

micro risks:


taxes




“self

-

discovery”



bad local finance

low domestic

saving

poor inter

-

mediation

Growth diagnostics



poor natural

resourcemanagement

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

Documents

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