Mongolia’s Regional Development Selected...

World Bank Policy Note August 2005

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Mongolia’s Regional Development Selected issues

Summary

The objective of this policy note is to highlight key implementation issues and provide policy recommendations for promoting the Government’s stated goal of achieving balanced regional development based on an analysis of: i) the evolving regional dynamics within Mongolia, ii) its current intergovernmental fiscal setup and iii) the lessons from international experience on Regional Development and Economic Growth1. Although, regional development will have important implications for all sectors of the economy, this note includes a section on the impact of the mining sector on regional development in the country given its strategic importance in the long-term development of Mongolia. A detailed analysis of other sector-specific issues is beyond the scope of this policy note.

Key facts

Although per capita GDP figures suggest significant disparities between Ulaanbaatar and the rest of the country, these disparities are not so significant when the regions of the country are compared on the basis of household disposable income.

Mongolia is experiencing a geographical concentration of its population and economic

activities in the Ulaanbaatar metropolitan area. Meanwhile, in the rest of the country there is little sign of economic take-off, with a few exceptions.

Although improving, rural areas have less access to infrastructure, education, and health

services. In addition, in health and education, there is a disconnect between the needs and financing of service delivery within rural areas.

Since 2003 there has been a significant centralization of fiscal powers in Government.

Local governments are not involved in revenue collection and are responsible for limited service delivery.

The central government, which is responsible for service delivery in education and health

sectors, has delegated significant day-to-day decision-making powers to the heads of the service provision units (e.g., schools and hospitals). However, accountability mechanisms remain weak.

To finance their expenditure, local governments rely on central government transfers

which are allocated in an ad-hoc manner, without any explicit and predictable criteria. This has resulted in significant fiscal uncertainty for local authorities, thereby making budget planning difficult.

Typically, weak upstream and downstream linkages in the mining sector inhibit its role in

promoting a balanced regional development. Nevertheless, there remains an untapped

1 The national framework for regional development in Mongolia is laid out in the Regional Development Concept (adopted by Parliament in June 2001), the Law on Regionalized Development Management and Coordination (adopted by Parliament in May 2003) and the Medium Term Strategy on Regional Development 2001-2010 (adopted by Parliament in June 2003).

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potential to develop the SMEs sector in Mongolia, which can respond to mining industry needs.

Successful regional development policies for private sector development aim at

improving the investment climate in the regions. Policies which try to directly influence firm location have little chance of success, as market access and agglomeration economies are dominant factors influencing firm location.

Recommendations

Focus on reforms that improve the overall investment climate and public investments that favor multipurpose non-sector specific projects, including in infrastructure and human capital development (such as education in rural areas).

Provide clarity in the methodology of, and increase local government participation in, the

process for determining intergovernmental fiscal transfers to local governments (including the sharing arrangements for VAT and mining revenues). To this end, a committee consisting of the Ministry of Finance and the local governments could be formed to decide on the methodology for determining the revenue-sharing formula.

In making government spending allocations across individual budget entities in the health

and education sectors, there is the need to refine the budgetary allocation formula that is currently used by the line ministries by tightening the link between the costing of desired outcomes and spending priorities..

Devise future disclosure mechanisms for the local citizenry to keep abreast of how much

funds have been provided to the service delivery units of their concern and how it was spent (e.g., parents being informed of the budget execution in their children’s schools). The authorities should regularly publish information which can be effectively accessed by the public on fiscal transfers to service delivery units in an effort to increase accountability and efficiency in public service provision at the local levels.

Over the medium term, the structure of intergovernmental relations should be consistent

at both the political and administrative/fiscal levels.

In the context of the mining sector, consider developing an integrated framework for sharing the benefits accruing from the mining sector through a trilateral dialogue between the government, the local community and the mining company. The Government’s willingness to consider participating in the DFID (U.K.) initiated Extractive Industries Transparency Initiative (EITI) is a crucial step in the right direction.

Improve statistical information available in the regions.

o Currently, regional breakdowns for GDP, household incomes, investment and other relevant data referred to in this policy note are only available until 2002 In addition, information on internal migration is not reliable2. Given that Mongolia has experienced significant growth since 2002 to date, policy makers will not be able to benefit from the most recent regional dynamics in Mongolia in order to make critical judgments about the future structure of the economy. Over the long term, this data gathering and reporting exercise will enable better coordination

2 This was recently revealed during the conference on migration held in Ulaanbaatar in May 2005.


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and cooperation between the Central and sub-national governments, as well as inform the public about evolving priorities and the effective use of public resources.

o Data inconsistencies between macro and micro level data need to be reconciled. For example, regional income disparities vary depending on which statistics are used (e.g. per capita GDP or household income). Also, unemployment dynamics and income disparities vary to a great extent depending on the statistical source (macroeconomic or household survey data).


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Figure 1: Per capita GDP, income & Poverty 2002

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I. The Profile of Regional Dynamics in Mongolia

Economic growth in the regions beyond the Ulaanbaatar metropolitan area remains sluggish, especially in the rural areas. This trend is apparent using a variety of indicators (such as GDP, production, business registration, employment, demographics). Although infrastructure access in rural Mongolia has been improving, it is still very low relative to what is needed in order to jumpstart the growth process there. There are signs of increasing economic activity in some parts of the country, but overall social indicators show mixed results. Poverty incidence remains higher in the regions. Health, education, and basic infrastructure (water, sanitation and solid waste management service) outcome indicators show an improving trend despite lower access in rural areas (soums and bags).

Mongolia is rapidly experiencing a geographical concentration of its population and production activities.

1. With 1.5 persons per square kilometer, on average, Mongolia has the lowest population density in the world. Among them, only 1 person per square kilometer resides outside Ulaanbaatar. Its surface area is 3 times that of France and a population which is 24 times smaller (estimated at 2.5 million in 2004). Under these circumstances, the Government of Mongolia is considering to take on the unique challenge of achieving balanced regional development within the country. This has been articulated by the Government in the National Framework for Regional Development in Mongolia as laid out in the Regional Development Concept (that was adopted by Parliament in June 2001), the Law on Regionalized Development Management and Coordination (adopted by Parliament in May 2003) and the Medium Term Strategy on Regional Development 2001-2010 (adopted by Parliament in June 2003). 2. The overall population growth of Mongolia has remained low at 1.3 percent since the beginning of the 1990s. However, since the beginning of its transition, Mongolia has been experiencing a geographical concentration of its population and production activities in the Ulaanbaatar metropolitan area. In 2004, 34 percent of the population was officially registered in Ulaanbaatar, compared to only 15 percent in 1990. Unofficial figures suggest that this figure could be as high as two-thirds of the population. In addition, population growth outside Ulaanbaatar has been stagnant (and even diminishing in some areas), while Ulaanbaatar’s population has been increasing rapidly. Since 1993, population in Ulaanbaatar has increased by 56 percent whereas in the Western, Eastern and Central regions population has decreased over the same period by 4.3, 8.5 and 3 percent respectively. Following a similar trend, Ulaanbaatar’s GDP share has increased from 46.6 in 1999 to 57.8 percent in 2002.

There are important differences in GDP per capita and poverty headcount between Ulaanbaatar and the regions, yet these differences are not so large differences using household incomes

3. There are large differences in per capita GDP and poverty incidence between Ulaanbaatar and the rest of the country (see Figure 1). The Western region is the poorest, followed by Hangai, Eastern and Central regions. Poverty incidence is higher in regions, and highest in Western region, where 51 percent of the population is poor. Using household disposable incomes as the


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Figure 2: Origin of Migrants to Ulaanbaatar - 2002

0 5 10 15 20 25

Central

Hangai

Western

Eastern

thousands people

basis, one arrives at the same regional ranking. However, disparities between the capital city and the rest of the country are less pronounced in terms of household disposable income. Household incomes outside Ulaanbaatar are 80 percent that of the capital city, on average. Using GDP per capita as the basis, this share drops to 38 percent (Tg 847,000 in Ulaanbaatar vs. Tg 447,000 in other regions of the country in 2002). This result supports the evidence of well functioning labor markets, with a relatively mobile population and flexible wages.

4. When one looks at the composition of GDP by region, unlike other regions, 73 percent of Ulaanbaatar’s GDP was attributed to the services sector, specifically Wholesale and retail trade, transport, storage and communications services. (Table 1) Given the high share of the migrant population in Ulaanbaatar (UB), especially in the winter months, who are primarily involved in service sector activities the value added in the UB area gets translated into a more

equal household disposable income distribution (via remittances and transfers from their primary work location) than simply taking an average of the GDP generated in each region of the country.3 5. Agriculture is an important sector in all regions, but its relative contribution to the local economy varies. The Western and Eastern regions are dominated by agricultural activities (65 percent of regional GDP) and industrial activities are very limited, accounting for 4 and 7 percent respectively of GDP. In the Hangai region, while agriculture accounts for 34 percent of the region’s GDP, industry and in particular mining are also an important sectors, contributing by 43 percent to regional GDP, out of which 38 percent come from mining. Finally, the central economy is the most services sector oriented (37 percent of GDP) while industry is an important contributor as well (17 percent of GDP).

Migration origin has changed over time and so have migration motives

6. Out-migration location has changed over time. At the beginning of the 1990s, migrants into Ulaanbaatar were coming mostly from the remote Western aimags. More recently, they are primarily coming from the highlands (Hangai) and central aimags (20 and 24.7 thousands migrants in 2004, respectively. Figure 2). The highest shares of migrants have originated from Tov (12.8 percent) and Uvs (9.2 percent) aimags. By contrast,

3 There remains the need to examine any data limitations and gather more detailed breakdowns on the composition of regional GDP and population in order to explain this significant disparity between the relative per capita GDP and household disposable incomes over time in Mongolia.

Table 1: Regional GDP structure, 2002

W

este

rn

Kha

ngai

Cen

tral

Eas

tern

Ula

anba

atar

Tot

al

Agriculture, Hunting, Forestry 65% 34% 46% 65% 1% 20% Industry 4% 43% 17% 7% 26% 25% Mining and Quarrying 0% 38% 5% 2% 9% 13% Manufacturing 1% 2% 5% 3% 9% 6% Services 31% 23% 37% 28% 73% 55% Wholesale, Retail, Repairs 9% 11% 18% 13% 36% 26% Transport, Storage, Communications 6% 4% 6% 4% 20% 14% Total 8% 18% 11% 5% 58% 100%


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Bayan-Olgii in the West, Bulgan in the Hangai region, Darkhan, DundGovi and Omnogovi in the Central region each account for less than 2 percent of the migrant population in Ulaanbaatar.

7. Over the years the reasons for migrating (as suggested in the recent Urban Poverty report (UNDP, 2004) have shifted, away from educational purposes toward more economic factors such as: employment location, better livelihoods, and access to markets. Migration patterns thus seem to suggest revealed preferences for locations where economic opportunities exist. In addition, the report shows that migrants in Ulaanbaatar are less educated than non-migrants on average, leading to more poverty and less access to services among the migrant populaation.

Most of the regions are experiencing a population drain

8. Between 1993 and 2004 only the Hangai region posted a small net increase of population (by 1.9 percent). However, this increase was concentrated in Orkhon/Erdernet aimag-city, where the population has been flowing in due to opportunities in the mining sector. Outside Orkhon, the aimag’s population has actually decreased by 2 percent over this period. Meanwhile, in the Eastern and Western regions, the population is slowly decreasing. In the former, all 3 eastern aimags saw their populations decrease. In the Western region, 2 aimags (Bayan-Olgii and Khovd) attracted people from the rest of the other aimags of the region to record a steady increase in its population by 32 and 5 percent respectively between 1993 and 2004. By contrast, the remaining 3 western aimags (Zavkhan, Uvs and Govi) showed net population outflows over the period, by 22, 17 and 11 percent respectively.

9. Finally, population growth in the Central region has been stagnant over the last decade except in the OmnoGov’ and Dornogov’ aimags, where trade with China is taking place and where mining activities are developing. In Darkhan-Uul aimag-city the population is also somewhat increasing. Tov aimag, which surrounds Ulaanbaatar, is experiencing a drain of population, which has dropped by more than 18 percent since 1993. The other aimag associated with significant population loss is Arkhangai aimag, with a reduction of 10 percent of population since 1993.

Under current circumstances, only a few urban centers other than Ulaanbaatar appear to be expanding

10. While urbanization is taking place in UB (with a population size of 915,000 in 2004), elsewhere in the regions and aimags, the proportion of population living in aimag centers as opposed to soum centers or rural bags has remained the same. In fact, the population living in urban centers in other regions of the country has been decreasing by 10 percent since 1993. The share of population living in aimag or soum centers has also decreased, on average, from 36 and 26 percent respectively in 1993 to 33 and 22 percent in 2004.

11. Given the limited size of most urban centers with the exception of Ulaanbaatar, under current circumstances, agglomeration effects are likely to be somewhat limited outside the capital. For instance, Erdenet is the second most populous city in Mongolia with 77 thousand people, Darkhan (74 thousand), Choilbaisan (38 thousand), and Khovd (31 thousand). This proposition is reinforced by stagnant population growth in most of these urban centers over the last decade. While population in Ulaanbaatar has grown by 56 percent between 1993 and 2004, aimag center population outside the capital city has decreased by 10 percent over the same period.

Most of these are located in the west near Chinese and Kazak borders, in the mining city of Erdenet, and in the south near the Chinese border.

12. Urban centers recording population increase are very few. Among them, two aimag centers of the Western region which are located close to the western border with China are experiencing among the highest rates of expansion (47 and 19 percent respectively between 1993 and 2004). Erdenet city in the Hangai region has the second highest population increase (23 percent) over the


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Figure 3: Regional Investment Rates - 2002

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same period, but is showing signs of slowdown given the copper mine depletion. Finally, in the central region, population of Sainshand, the aimag center of Dornogiv aimag, has increased by 19 percent since 1993. Beyond these, population growth in other urban centers is either negligible or negative.

In the regions, economic growth remains sluggish, investment rate limited and employment stagnant

13. Evidence suggests that investment rates are markedly lower in the regions compared to Ulaanbaatar. Within regions, Bayan Olgii and Khovd in the Western region record higher rates of investment, 12 and 7.6 percent respectively in 2002. Formal employment statistics confirm sluggish economic growth outside Ulaanbaatar. Between 1995 and 2003, overall employment increased by only 10 percent, while over the same period, employment in Ulaanbaatar increased by 55 percent. Unemployment dynamics varies depending on statistical sources. National Statistical Office data, based on official figures, show a steady decrease in unemployment in all regions of Mongolia, from 6.2 percent in 1995 to reach a low level of 4.2 percent in 2003 outside Ulaanbaatar and from 3.6 to 1.9 percent in Ulaanbaatar. By contrast, HIES/LSMS 2002 data show a higher level of unemployment in the regions and Ulaanbaatar, respectively 6 and 8.3 percent. In addition, it reveals that unemployment has not decreased between 1998 and 2002 outside Ulaanbaatar and even increased in aimag centers from 9.3 to 10 percent.

Differences in GDP composition across regions depend on mining resources availability but these differences do not translate into household higher incomes

14. The main source of income in the regions comes from livestock (29 percent), monetary wages (25 percent) and trading (13 percent)4. The main difference between Ulaanbaatar and the regions is the predominance of livestock as the primary income source in the latter as opposed to monetary wages in the capital. Within the regions, the central zone relies relatively more on monetary wages (32 percent of income) and relatively less on agriculture (19 percent), which is related to the relatively more advances development of the service industry (Table 2). 15. All regions in Mongolia are rich in mineral resources and mining activities are present everywhere, especially in the Hangai region. However, household sources of income of this region are not very different from, say, the very agricultural Western region. The reason is that mining activities are more capital intensive, as opposed to agriculture which requires important labor inputs and limited capital. Typically, capital income is transferred to investors/shareholders of the extractive industries and does not necessarily directly go to the local community. In

4 LSMS 2002 data

Table 2: Household Source of Income (LSMS, 2002) Business

Monetary w

ages

In-kind wages

Pensions

Allow

ances

Livestock

Agriculture

Trading

Other

Other

Western 23.1 0.5 8.4 1.9 31.1 3 14.1 9.3 8.6 Hangai 22.7 1.2 11.4 3.1 36 0.2 10.1 7.5 7.7 Central 32.3 1.5 11.9 2 18.5 2.1 13.2 6.3 12.3 Eastern 18.1 2.5 10.9 4.4 32.1 1.1 15.3 7.6 8 Ulaanbaatar 47.5 0.7 14.5 2 0.7 0.2 13.8 7.1 13.4


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addition, the current fiscal setup does not capture resources from mineral extraction. Given the existing tax breaks to extractive industries, mineral revenues are not redistributed through the government budget to the extent desirable. 16. Mongolia’s granary is located in the center of the country in the Central and Hangai region, where 3 aimags, namely: Selenge, Bulgan and Tov, account for 74 percent of total grain yield (2003 figures) and one aimag, Selenge, accounts for half of national production. Potatoes and vegetables production is more evenly distributed, with the central region production remaining dominant around 50 percent of national output, the Western and Hangai regions contributing for between 14 and 20 percent. The Eastern region crop production is small, between 3-5 percent.

Mongolia’s extensive livestock sector should be able to maintain its comparative advantage for the foreseeable future

17. While herding is present in all regions, its importance in the local economies varies. Half of households in Hangai and Western regions are herders. Livestock in these respective regions account for as much as 32 and 29 percent of national herd. By contrast, only 29 percent of households in the Central region are herders and the share of livestock heads is only 22 percent. Although 41 percent of Eastern region households are herders, the total herd of this region accounts for a low 15 percent of national total, suggesting small sized herds on average in this region. 18. The Government’s regional development strategy promotes livestock intensification and closer integration of crop and livestock farming. The dairy sector is normally at the forefront of such development. A World Bank supported assessment in 2003 showed that the private sector was responding to a strong demand for milk by investing in improving production. Since then, there has been continuing development in the semi-intensive dairy sector, yet the rate of change has been somewhat slow and the share of imported packaged UHT milk remains high in Mongolia. In this regard, there remains the need to identify successful private sector innovations and to analyze the reasons for their success. This, in turn, may be used as a basis for publicizing appropriate farm models in different locations of the country, depending upon their own market situations. 19. Based on the use of natural pastures, for the foreseeable future, the extensive livestock sector should have a comparative advantage for breeding and production of store animals. The herds may subsequently be fattened in more intensive units, if the market conditions are favorable, and based on feasibility studies based on market principles.

Industrial activities are concentrating in Ulaanbaatar without much job creation in the regions

20. In conjunction with population and GDP, industrial activities are becoming increasingly concentrated in Ulaanbaatar. Half of industrial sales were conducted outside the capital in 2003, compared to 62 percent in 1995, declining steadily since then. Looking at business registers leads to the same conclusion. Between 1998 and 2003, less than 3 percent of new 9,545 business entities were created in the regions, which led virtually to zero net job creation outside Ulaanbaatar.

Rural areas face specific investment climate constraints such as difficult access to finance

21. Preliminary results from the Investment Climate Study prepared by the World Bank show that businesses in rural areas do not face the same constraints when compared to very urbanized areas such as Ulaanbaatar, Darkhan, Erdernet. In rural areas, constraints such as market access, access to information, and implementation of national regulations seem to be more of a problem. Businesses in rural areas export less than urban areas (3.4 and 7.8 percent of total sales respectively), sell 92 percent of their production within their aimag. Importing goods does not seem so much of a constraint (49 and 59 percent of total inputs are imported in rural and urban


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Figure 4: Basic Infrastructure

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areas respectively). In rural areas, 23 percent of interviewed businesses don’t agree that interpretation of regulations is consistent and predictable, against as much as 51 percent in urban areas.

22. Access to credit and high interest rates are perceived to be the major constraints in rural areas. In urban areas, taxation (including rates and administrative barriers), seems more of a problem. This perception is supported by the observed lower financial depth outside Ulaanbaatar. Individual deposits and total loans outside the capital account for only 4 and 7.3 percent of GDP, while in Ulaanbaatar the same indicators are 26 and 27 percent respectively (2002). Survey data show that rural businesses rely less on bank loans

and more on internal funds to finance both working capital and new investment. In addition, average terms of bank loans are less favorable in rural areas. For example, the required collateral and interest rates are higher. While further analysis is needed to determine whether or not rural areas are credit constrained, these indicators show that there is a need for a tailored policy response to improve investment climate in rural areas.

Infrastructure access has improved between 1998 and 2002 but rural areas lag behind

23. The 2002 LSMS Survey conducted by NSO shows that basic infrastructure access has increased markedly between 1998 and 2002 (Figure 4), especially in aimag centers. In 2002, 97 percent of households have access to electricity; compared to 70 percent in 1998. Water access has also improved (73 percent in 2002 compared to 70 percent), while access to sanitation recorded the greatest increase (from 19 to 69 percent between 1998 and 2002). Rural areas, largely composed of herders, have also recorded an improvement in basic infrastructure.

Yet, the level of access remains very relatively low. As for telecommunication, the tele-density outside Ulaanbaatar remains low, where 10 percent of population subscribes to mobile or fixed telephones. Mobile technology penetration is higher than fixed technology, accounting for 63 percent of total phones subscriptions. Yet this share is lagging behind the share of mobile phones in Ulaanbaatar which is as high as 81 percent.

Table 3: Access to Finance - Rural and Urban

Rur

al

Urb

an

Share with a term loan from a bank or financial institution: 15 28 For the most recent loan or overdraft: Share that require collateral: 100 90 Average value of collateral required (as % of the loan): 460 308 Average annual interest rate on loan: 55 39 Share with term less than one year 83 78 Share of working capital from: Internal funds or retained earnings 75 66

Bank loan 17 7

Financing of new investments from: Internal funds or retained earnings 80 60

Bank loan 6 13

Table 4: Telecom indicators

Teledensity Mobiles 2004 % population % total

Western 6% 51% Hangai 9% 56% Central 16% 73% Eastern 8% 58% Ulaanbaatar 49% 81%


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Figure 5: Infant mortality

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Education quality is significantly lower in rural areas and as a result rural students do not have equal access to upper secondary education5.

24. Recent analysis shows that children attending soum level schools are 13 percentage points less likely to score an ‘A’ on the central exams6, as a result of a lower access to quality education. Students in Ulaanbaatar schools score better than those in schools located in all other regions of the country. The differences in education performance across the latter regions are not noticeable. As a result of these differences in educational performance between UB schools and others, there are significant divergences in the net enrollment rate between the countryside and the rest, which appear in lower secondary levels and accentuate in upper secondary schooling. These results hold even after controlling for a number of factors, including parental education, poverty and gender. 25. To address this quality issue in rural education, the authorities may re-assessing the per-pupil funding formula and providing for those sparsely populated soums that are at a greater disadvantage from the budget allocation point of view. In addition, increasing the quality of teachers in rural areas and the incentives to get professionals to teach in remote areas is crucial.

Health indicators are steadily improving in all regions

26. The 1998 LSMS suggests that there has been significant decline in the quality of health service in rural areas. Unfortunately, the 2002 LSMS does not report on indicators for rural health services. Health outcome data shows that there has been a steady decline in infant and child mortality. There is a disconnect between health outcomes and health care spending, as evidenced by the weak correlation between health outcomes and expenditures indicators 7. 27. As part of the regional development strategy, three Regional and Diagnostic Treatment Centers (RDTC) were established in the east (Dornod), the south-central (Uvorkhangai) and the west (Khovd). Ulaanbaatar is located to serve the north-central region. The RDTCs are aimed at providing tertiary care in the regions. Other RDTCs are to be established, although there is currently no specific plan in place. More information is needed on whether tertiary patients are using or by-passing these regional facilities, and whether RDTC receive adequate funding. 28. To summarize, the regional dynamics in Mongolia suggests a concentration of population and production in the Ulaanbaatar area, unequal social services provision between rural and urban areas, and highlights the need to look at Mongolia’s regional development from the point of view of existing comparative advantage of different regions, their investment climate and their needs for infrastructure. The issue of intergovernmental fiscal relations is key in the context of how the development strategy would be financed. This issue is addressed in the next section of this policy note.

5 These findings come from the recent World Bank Poverty Assessment policy note “Being left out of upper secondary schooling: Mongolia’s rural poor”. 6 Based on 8th grade examination results in Mathematics and Mongolian language from all schools in the country. 7 For instance, a correlation of 0.15 is found between infant mortality and soum spending,


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II. Intergovernmental Fiscal Relations

Local governments need clear responsibilities, revenues commensurate with their service provision responsibilities, and predictable budgets in order to support the implementation of any regional development strategy. Currently, there is lack of clarity in the process whereby central government determines the amount transfers and VAT share to local governments each year. This results in a disconnect between resources required by local governments for service delivery and resources allocated by the central government for this purpose, thereby frustrating budget planning. Thus, there is a critical need to clarify and simplify the process for determining central government transfers to local authorities, including VAT and mining revenue sharing arrangements.

There has been a marked move towards fiscal centralization since 2003 29. The intergovernmental fiscal mechanism has its legal basis in the General Budget Law and the Public Sector Management and Finance Law (PSMFL, 2003). The former law regulates the revenue relations and the latter one the expenditure responsibilities. With the promulgation of the PSMFL most of the taxes that were previously shared with local governments were centralized, along with service delivery responsibility in all major sectors. Annex 1 shows the tax assignments and administration for Mongolia as at end-2004. Tax laws and rates are determined and administered by the central government after getting approved by the Parliament. Local governments have insignificant discretion in determining rates of taxes assigned to them8. Currently, the Value Added Tax (VAT) on domestic transactions is the only tax that is shared with aimags based on a local population pro rata formula. Income taxes, excise taxes, VAT on imports, and royalties on gold are centralized. Some local taxes, including property tax, non-gold resource usage fees, and some local levies are assigned to local governments. Local governments have very limited power to institute new taxes nor to adjust the tax rates. In 2004, aggregate local government spending accounted for only 8 percent of total revenues and equivalent to 7 percent of total expenditures. Revenue collection is centralized with the General Department for National Taxation, with no involvement of local governments 30. All revenues, including those assigned to local governments, are collected by the General Department of National Taxation (GDNT), which is an agency that reports to the Ministry of Finance. For assigned taxes (see Table 2.1), GDNT representatives transfer in totality the collections directly to local government accounts, while all other collections are transferred to the central treasury. GDNT representatives at the Province (aimag) and District (Soum) level report to the tax authorities of the immediately higher level of government. Soums report to tax authorities at the aimag level, and aimags report directly to GDNT. Local governments have no control over higher tax authorities. This implies a weak monitoring of taxes assigned to local governments.

Local governments are currently responsible for limited service delivery. 31. Article 52 of the PSMFL specifies that local governments will deliver the following services, which are financed from local government revenues: (i) measures on public hygiene, (ii) local environmental conservation and protection, gardening and maintenance, (iii) pest eradication and control, (iv) local road maintenance, (v) operation of local water and sewerage system, (vi) flood prevention and soil protection, (vii) outputs associated with local public infrastructure facilities,

8 The General Taxation Law Article 18-3 states that Aimag Hurals may define at the margin the rates of 4 revenues: (1) License fees for the use of natural resources except minerals, (2) Payment for use of natural plants, (3) Payment for use of other widely spread minerals, (4) Payment for use of mineral springs.


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(viii) fire prevention, protection, and mitigation, and (ix) measures to fight and prevent infectious livestock and animal diseases. Besides these, all other services are to be provided by the central government. Table 2.2 shows the division of roles and responsibilities by sector between central and local governments in Mongolia.

Provision of education and healthcare services is done via agency contracts between central government and local governments. 32. By law the central government is responsible for service delivery in the education and health sectors. The central government determines the overall policy and funding in each sector while service provision is done via agency contracts between the central government and the local government. Box 1 presents the institutional and intergovernmental fiscal framework for the educational sector.

Box 1: Intergovernmental Fiscal Mechanism in the Education Sector The PSMFL has vested the responsibility of education provision with the central government. The national policy and the formula determining school financing are established by the Ministry of Education. This financing formula comprises a fixed cost component (energy, water, and heating) and a variable cost component (teacher salaries and other operational costs) 9. Based on the financing formula, schools propose a budgetary requirement to the respective aimags who, in turn, collates requirements for all schools within the aimag and submit the total requirement to the Ministry of Education. The variable cost component contained in the proposal is based on an assumption of the number of pupils who shall be enrolled at the respective school. The central government then decides how much resources will be provided at the aggregate level to the education sector. Once the sectoral resource envelope is determined, the Ministry of Education provides an allocation for each school. Experience shows that schools generally assume more pupils would be enrolled, while the central government provides fewer resources than requested. Even after budgets for each school are fixed, schools can ask for amendments to their allocations by providing justifications. These amendment requests are transmitted to the central government via the aimags. The system for approving/disapproving amendments is not clear and provides room for patronage. The Ministry of Education enters into performance contracts with aimag Governors for delivery of education services in their respective jurisdictions. These contracts set out the curriculum that will be taught at local schools and the resources that will be provided by the Ministry of Education. At the aimag level there is an education sector coordinator who monitors the performance of schools within the respective aimag. The sector coordinator reports to the Ministry of Education in consultation with the Governor. aimag Governors appoints school principals in consultation with the Ministry of Education. The principal is vested with the responsibility to run the school and to ensure that education is imparted to students. She/he has the authority to appoint teachers and utilize the school budgets according to guidelines established by the central government. The principal reports to the aimag education sector coordinator on performance. Schools are classified as individual budget entities and as such have sub-accounts in the Treasury Single Account. The funds flow arrangement works as such that the Ministry of Finance, on advice from the Ministry of Education, credits each school sub-account with the approved budget. This credit is treated as funds provided through the aimag budget, but only notionally because aimags Governors do not have any control over these funds. All non-wage expenses are paid directly by the central government, upon submission of respective bills by principals to aimag Treasury offices. Only wage payments are made directly to the Principals. It is the responsibility of the central government to ensure timely provision of resources for schools.

Agency contracts have devolved significant functional powers to the heads of service provision units, who are appointed by Aimag governors in consultation with the central government.

9 The methodology for determining per-unit costs has some issues which are outside the scope of this Policy Note.


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According to the agency agreements the Aimag governors appoint the head of the respective service delivery units. This is the extent of Aimag governors’ effective power. Once appointed, the heads of the service delivery units have the autonomy to hire staff and determine their base salary and allowances. The central government determines the minimum amount of budget that is to be spent on salaries (70 percent in the case of education), and provides the total allocated fund for the service delivery entity to the head of the agency via sub-national treasury offices that are part of the central treasury. The funds flow arrangement is such that the central government directly provides funds to service delivery units, and reflects the totals in each Aimag spending numbers. For all practical purposes local governments have no control over funds designated for education and health service delivery units in their respective jurisdictions. Although heads of service delivery units have authority to hire staff, the human resource framework does not allow them to terminate staff appointments. 33. Once hired, service delivery staff become civil servants under the administrative service cadre. They are then governed by the Law on Civil Service and the Labor Law. The civil service is managed centrally and these employees become part of the workforce of the respective portfolio ministry. The civil service management framework does not allow the heads of local service delivery units to terminate employment of staff. As a result, the heads of local service delivery units have little power to modify the structure of human resources establishment and to manage individual performance, thereby impacting adversely on effective service delivery incentives.

Consistent with reduction in assigned responsibility of local governments, there has been corresponding reduction in local government spending. 34. Figure 1 shows expenditures at the local level along with own revenues of local governments, between 2001 and 2004. As can be seen, there was a significant reduction in expenditures by local government after 2002, with a compensating increase in expenditures by the central government. This shift in expenditure depicts the shift in service delivery responsibility from the local government level to the central government. The reduction in local government revenues depicts the centralization of taxes. Local governments are not allowed to borrow commercially 35. With regards to sub-national borrowing, the PSMFL allows local governments to borrow from the central government in case of unforeseen expenditure needs or revenue shortfalls, but not from commercial sources. It is the central government that has the sole authority to borrow from non-governmental sources. Local governments have limited civil servant appointment powers 36. Of the total civil servants in Mongolia, only 7 percent work directly for the local government, including aimag administrative staff and some political positions. By law provincial governors nominate candidates for local government political positions like Soum and Bag governors, and provincial Parliaments have the authority to confirm nominated candidates to these positions. Civil servants working for local governments are paid out of local government budgets. Although

Figure 1: Spending by Level of Government at the Local Level

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teachers and doctors are engaged by respective school principals and hospital administrators10, their salaries are paid from resources appropriated to respective sector ministries. Notwithstanding the limited role of local governments in service delivery, they are still dependent on financial support from the central government 37. Figure 2 shows the composition of total spending at the local government level between 2001 and 2004. Local government budgetary resources comprise assigned taxes, VAT share and transfers from the central government. As can be seen total spending at the local level has increased over time, but the spending is being financed directly by the central government. Local government assigned taxes accounted for about 12 percent of total expenditures in 2004. Local government share of collections from domestic VAT and transfers from central government comprised 25 percent of total expenditures. The remainder 63 percent was direct central government spending at the local level. The current intergovernmental fiscal mechanism of centralized fiscal management has had many benefits in Mongolia. 38. Macroeconomic stability has been maintained. By limiting the risk for deficit accumulation at the sub-national level, with central government controlling revenue collection, expenditure allocations, and deficit financing decisions, the authorities have succeeded in bringing down the aggregate fiscal deficit,. 39. Wage arrears have been controlled. Prior to 2003, local governments exercised more authority on expenditure allocation. It became apparent that there were significant arrears on wages and services, even though funds had been released to local governments. Because civil servants had to be paid, the central government had to clear the arrears. As fiscal control was centralized, the problem of arrears on wages was resolved. 40. Timely budgetary transfers are being made to local governments. Once the national parliament approves the state budget specifying financial support to each aimag, the Ministry of Finance and aimag administration discuss the latter’s monthly cash-flow plans (prepared by aimags). After discussions, the monthly plan is approved by MoF and transfers are made to aimags according to these monthly plans. In addition, as funds are now directly sent from the central government to schools and hospitals through aimag treasury offices, there has been an improvement in funds receipts by these entities. Analysis of fund transfer from 2001 to 2004 also shows that the central government has been providing full funds to local authorities as per their approved budgets.

10 School principals and hospital administrators determine the base pay and allowances of teachers and doctors working in their respective institutions, in agreement with respective Aimag sector coordinators, who report to relevant sector ministries

Figure 2: Sources of Expenditure at the Local Level, 2001-2004

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Recommendations for improving the current intergovernmental fiscal setup

The authorities may wish to consider the following measures over the next six to twelve months period:

o Provide clarity in the methodology of, and increase local government participation in, the process for determining transfers to local governments, including VAT and mining revenue sharing arrangements. To this end, a committee consisting of the Ministry of Finance and the local governments could be formed to decide on the methodology for determining the revenue-sharing formula. At the moment the central government determines transfers to local governments, including VAT share, with minimal consultation with local government. In addition, there is no clear methodology applied by the central government in this regard. This results in significant fiscal uncertainty for local authorities, as they cannot predict what their resource envelope will be each year, thereby frustrating budget planning.

o Improve revenue administration of taxes assigned to local governments. Currently GDNT collects all central and local taxes. The representatives of GDNT at the local level are not accountable to the local authority, and report solely to the central government. Typically central government monitors revenue collection of central taxes very carefully, as the collections directly enter their resource envelope, while monitoring of taxes assigned to local governments is weak. There is need to improve revenue administration of taxes assigned to local governments. This policy note recommends that when devising the revenue collection framework, consideration be given to the capacity of local governments for collecting taxes, avoiding tax cascading by different levels of government, and maintaining the efficiency of the overall tax regime for private sector development and growth.

o Adequately fund local government and service delivery units to perform their mandated responsibilities while integrating donor-funded projects into the intergovernmental fiscal system. Presently local governments do not have adequate resources on their service delivery responsibilities, as mandated by PSMFL Article 52. As a consequence, local governments tend to use donor money to supplement their capital budgets. Because foreign-funded projects are not spread out evenly across the country, regions have inequitable access to foreign funding, creating disparities between regions. In the context of devising the budgets for local governments, there is need for the central government to take into account local financial requirements of authorities, in particular for infrastructure, while taking into consideration donor-financed projects.

Over the medium–term, it will be imperative for the authorities to adopt the following policy measures in order to achieve effective implementation of the country’s regional development strategy:

o Provide heads of service delivery with effective authority to terminate employment of staff hired by their respective units. As mentioned earlier, heads of service delivery units can employ staff but not terminate their employment. This weakens the incentive for staff to perform to the best of their ability and to be accountable to the head of their respective service delivery unit.

o Devise adequate disclosure mechanism for local citizenry to know how much funds have been provided to service delivery units. There is currently minimum public disclosure of funds allocated to and received by service delivery units. Since citizens do not know how many funds have been provided to service delivery units, they cannot effectively hold the head of service delivery unit accountable. Publishing information


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which can be effectively accessed by the public has managed to increase accountability and service delivery in other countries.

o In case of any changes in the administrative and/or political set-up, an appropriate intergovernmental fiscal system should be designed. The intergovernmental fiscal system remains the key vehicle for achieving the policies of the government. It is most important that the intergovernmental fiscal system fit the administrative and political setup, and not vice versa. Box 2 briefly presents some of the considerations in designing an effective intergovernmental fiscal mechanism.

Box 2: Key Principles to Consider for Designing an Effective Intergovernmental Fiscal System 11

1. The intergovernmental fiscal system must support the roles assigned to central and local governments.

2. Once the roles are assigned, the intergovernmental fiscal system should be designed to facilitate execution of those assignments.

3. Effectively sequence fiscal decentralization.

4. Determine the most suitable method of transfer – unconditional grants, conditional grants, and/or equalization grants.

5. Hard budget constraints should be applied and enforced, without exceptions.

6. Public administration need to be consistent with the roles and responsibilities assigned to different levels of government.

11 For detailed discussion of these principles please see, “East Asia Decentralizes” – World Bank 2005


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Source: General Department for National Taxation, Ministry of Finance

Tax base Tax rate Collection Assigned toIncome tax

Corporate income tax N N N NPersonal income tax

Wages and salaries and similar income N N N NSelf-employed persons N N N LLivestock tax N N N LOther income N N N L

Taxes on Property Immovable property tax N N N P

Taxes on goods and services Value added tax

on domestic goods and services N N N N/P*on imported goods and services N N N N

Excises on domestic alcoholic beverages N N N Non domestic tobacco products N N N Non imported alcoholic beverages N N N Non imported tobacco products N N N Non imported vehicles N N N Non petrolium products N N N N

Taxes on international trade Customs duties N N N NExport taxes N N N N

Other taxes Petrol and diesel tax N N N NMineral resource license fee N N N NPayment for use of mineral resource N N N N/PMotor vehicle tax N N N PLand payment N N N PStamp duties N N N LGun tax N N N LPayment for hunting N N N LPayment for use of natural resources other than minerals N N N LPayment for use of natural plants N N N LPayment for use of timber N N N LPayment for use of widespread mineral resources N N N LPayment for use of water and natural spring water N N N L

TABLE 2.1. TAX DETERMINATION AND ASSIGNMENT AS AT 2004

N=National (or central), P= Province (or Aimag), L= Local (or Soums)

Determination of Collection and Assignment

Taxes, fees and charges


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Policy FundingLegal

expenditureassignments

Servicedelivery

assignment General government services General public services 1/ Central /Local Central /Local Central /Local Central /Local Defense affairs and services Central Central Central Central Public order and safety affairs Central Central Central /Local Central /Local Education Kindergarten (0-3 year) Central Central Central Local 2/ Primary and secondary school (8-16) Central Central Central Local 2/ Vocational training and production Vocational secondary education

Central Central Central Central Central Central Central Central Tertiary education affairs Central Central Central Central Other Central Central Central Local 2/ Health Hospitals Central Central Central Local 2/ General hospital services Central Central Central Central/Local Inter soum' and Soums' hospital Central Central Central Local 2/ Health resorts (spas) Central Central Central Local 2/ Hygiene and Epidemiology Central Central/Local Central/Local Local Other Central Central/Local Central/Local Central/Local

Social security and social welfare Social security affairs Central Central Central Local Social assistance fund Central Central Central Local Other Central Central Central Local Housing and community amenity Central Local Local Local Recreation and culture Recreation, sports, culture and arts Central Central/Local 3/ Central/Local 3/ Local Radio and TV, information Central/Local Central/Local Central/Local Central/Local Fuel and energy Energy enterprises and other Central Central Central Central/Local Agriculture, forestry Veterinary affairs Central/Local Central/Local Central/Local Central/Local Forestation expenses Central Central Central Central/Local State stock office Central Central Central Central/Local Mining and mineral; resources, Geological institutions Central Central Central Central Scientific technological institutions Transportation and communication

Central Central Central Central Road foundation Central Central/Local Central/Local Central/Local Urban transport Central Central/Local Central/Local Local Other Central Central/Local Central/Local Central/Local Environmental conservation Local Local Local Local Water and sewerage Local Local Local Local Preventation of livestock diseases Local Local Local Local Fire prevention, protection, mitigation Local Local Local Local Pest eradication and control Local Local Local Local Flood prevention and soil protection Local Local Local Local

3/ Only in UB Municipality

TABLE 2.2. Assignment of roles and Responsibilities by Sector

Functions Roles and Responsibilities by government level

1/ Governors offices and Citizens Representatiive Hurals of local governments

Source: Government Authorities, 2005

2/ Via agency contracts between central government and local governments


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III. Regional Development and Economic Growth – Lessons from International Experience* -

International experience of policies aimed at jump-starting or accelerating economic growth in targeted regions have shown mixed results. Market access and agglomeration economies are dominant sources of increasing returns, as firms get considerable benefits from locating near firms in the same or inter-related industries as well as from locating in areas with existing infrastructure and service. This in turn, has led to economic concentration, transport hubs and a high degree of inter-regional market integration. Interventionist solutions of “moving people to jobs”(through out-migration or labor flows) are risky. Such interventionists policies, if successful in reducing inter-regional inequality, may reduce overall national growth. As Mongolia embarks on implementing its regional strategy, policymakers have to be cautious in selecting the instruments to achieve a more balanced economic growth. Instruments such as fiscal incentives or large scale infrastructure investment may become a drain on the public budget without generating the desired economic growth in the regions. It can even lead to accelerated depopulation and economic deterioration in lagging regions. Instruments or policies aimed at putting in place a level-paying field for private sector development by improving the investment climate and raising the level of human capital should be preferred instead.

Successful regional policies for private sector development aim at improving the investment climate in the regions…

41. Development experience from around the world suggests that interventionist regional development has largely failed in accelerating growth, except in brief spurts. The benefits associated with such policies have seldom justified the costs. This is as true of rapidly growing East Asian countries—Japan, Korea and Thailand—as it is for the slower growing regions of southern Europe and Northeast Brazil. Instead, accelerated growth has resulted largely from an improvement of the overall investment climate in a broad sense and the removal of major distortions in the economy—macroeconomic imbalances and disincentives; rigidities in transferring land, labor and capital to alternative uses; and fragmentation of the internal market for goods and services.

While policies which try to directly influence firm location such as fiscal incentives have little chance of success, as market access and agglomeration economies are dominant factors.

42. Fiscal incentives have been seen to yield a modest effect in influencing relocation decisions of firms from large agglomerations to lagging areas or small cities. At the margin, these programs may induce firms to choose among comparable jurisdictions with similar non-tax attributes. When choosing where to invest, typically looking more towards other factors such as the availability of appropriate human capital, the productivity of labor (including but not only labor cost), market access, supply of raw materials, political and social stability, and quality of the local infrastructure. In short, the benefits of agglomeration make firms less sensitive to differentials in tax rates. Cross-country experience suggests that large cities may be able to tax firms more heavily and still attract more new economic activity compared to smaller cities simply due to strong agglomeration economies. * This note summarizes the main findings of recent World Bank research on regional development, including Somik Lall, 2005, “What Explains Subnational Disparities in Economic Performance? Theory and Policy Interventions”, Deepak Bhattasali., 2003, “The Challenge of Regional Development in China”; Vivian Hon and Peter Fallon, 2002, “Regional Development Policies: Theory and a Review of the Evidence”.


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Thus, “Free zones” initiatives have a modest impact, if at all, if other conditions are not in place

43. Lessons from free zones experiences (either enterprise or export processing zones) show that the creation of a free zone, in itself, is not sufficient for spurring private sector development. Other conditions are necessary for success that include market access, attractive labor skills, productivity, and relatively cheap labor cost, are often structural and thereby likely to dominate any fiscal incentives the firm may receive from the government (central or local). In other words, in places where prerequisite conditions were met (China), free zones can serve as a signal of a business friendly environment and reach the desired objective of employment creation, export and economic growth. In places where the investment climate is less friendly to the private sector e.g., unfavorable locational advantage from the market perspective, low labor productivity or relatively high labor cost, free zones are likely to fail to attract sufficient investment. The fact that the government is often responsible for maintaining the infrastructure that may be put in place in these free zones, while granting tax exemptions to firms which would locate there or nearby anyway12, becomes a fiscally expensive proposition..

Investment is important, yet not sufficient

44. Investment is important for growth and poverty reduction.Yet the quality, or efficiency of this investment matters as well. In fact, one of the major weaknesses of the planned economy system has been an over-emphasis on the quantity of public investment. In Mongolia today, some development plans give insufficient attention to the efficiency of investment and focus on quantitative targets whereas the emphasis of policy should also be on raising the quality of investment. An exclusive emphasis on channeling investment to the lagging regions with inadequate attention to the efficiency would lead to a high unwarranted cost for promoting the growth of the domestic market. 45. The return on investment depends crucially on the investment climate. Focusing on policy reforms to improve regulations for private sector development, access to finance, basic infrastructure, human development, social protection matter as much as directing capital flows to regions. The most important feature of these investment climate components is that their effects are not necessarily limited to specific sectors, thereby limiting the risk of failure. For example, if ones wishes to develop tourism, the first important policy measure might very well be to implement an “open-sky” policy before any other measure is instituted.

Non-sector specific public investments are preferable

46. Mistakes in investment projects can be very costly but one cannot know with certainty the outcome of an investment project. The usual methods for dealing with this uncertainty include biasing the choice in favor of multipurpose investment projects and finding ways of diversifying risk. An industrial plant is a single purpose investment. The investment has little value if it does not realize initial projections. Many of the big failures of regional development policies concern large industrial investment projects. By contrast, infrastructure investments are location-specific, but their returns are not specific to a particular activity. A road built in a region with good tourism potential will increase economic activity in this sector, but will not only be used by the tourism industry but by others. The same is true of environmental protection projects. Human capital investments are multi-purpose in the sense that they are neither activity- nor location-specific. Most of the successful examples of regional development (for example Ireland, the United States) result from exceptional emphasis on human capital development. Within these “multi-purpose”

12 See for instance the free zones experience in the UK. The Northeast Brazil experience also shows that the availability of labor skills is crucial.


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projects some sector-specific prioritizing can be undertaken, e.g., towards vocational education in areas where there are likely to be jobs as projected in the country’s overall development strategy.

Infrastructure matters…

47. If well planned, public infrastructure stimulates economic activity, either by augmenting the productivity of private inputs or through its direct contribution to output. Furthermore, by enhancing a region’s amenities, public infrastructure may also attract households and firms, which further contributes to an area’s growth. In underdeveloped regions, infrastructure is needed to generate the minimum critical size of urbanization that can serve as a base for economic development. …but can lead to unexpected adverse outcomes depending on the type of infrastructure.

48. Public investment in infrastructure that facilitates transactions within a lagging region contributes to regional income convergence. Interregional infrastructure investments have had a significant impact on productivity, but a limited role in inducing industrialization in lagging areas. In addition, inter-regional infrastructure, without complementary investments in local infrastructure and public services may in fact worsen performance in lagging regions. Infrastructure investment that facilitates inter-regional trade (between a poor, lagging region and a rich core region) can have an unwanted effect of attracting firms from poor to rich regions. For instance, reducing transports costs between poor and rich regions has the same effect as the removal of tariff barriers. Competition from suppliers in other regions may drive local businesses out of the local market. Firms already serving larger markets in rich regions and benefiting from economies of scale and lower unit cost of production will be able to expand to lagging regions, compete with local producers, and possibly crowd them out.

Recommendations for regional development policy formulation

49. Linking the regional development strategy implementation with the Medium Term Budget Framework (MTBF) and Public Investment Program (PIP). Being cognizant of these possible unexpected outcomes, any regional development strategy should be firmly grounded on the basis of an analysis of the comparative advantage and investment climate in one region vis-à-vis others in the country. Associated public investment plans (PIPs) should then be evaluated in terms of efficiency of public expenditures and a determination of the role of the state in the provision of services to market participants. To this end, it is imperative to examine the evolving circumstances on the ground (i.e. the regional dynamics), and how such public investments will be financed. The issue of inter-governmental fiscal relations is critical in this regard. All this must then be reflected in the Government’s medium-term budgeting framework (MTBF) and the public investment program (PIP). 50. Improve statistical information available in the regions. Based on existing information, it is difficult to conduct any meaningful analysis of Mongolia’s regional development dynamics. For example, while aimag GDP shares are available since 1999, no regional GDP deflator is available, making difficult any growth dynamics analysis. Regional income disparities vary depending on which statistics, per capita GDP or household income, is used. Another example is the lack of information on internal migration, as recently revealed during the conference on migration held in Ulaanbaatar in May 2005. Finally, unemployment dynamics and income disparities vary to a great extent depending on the statistical source (macroeconomic or household survey data). Any regional policy should be informed by a set of reliable monitoring indicators. 51. Use market-oriented strategies rather than centralized government authority in determining the desirable administrative structure for regional development in Mongolia. For instance, in agriculture and livestock sectors in regional centers, feasibility studies for


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commercial activities should be conducted and lessons should be learned from successful innovations in the private sector. 52. Focus on investment climate type of reforms and multipurpose non-sector specific public investment against investment in particular industries or location. The former approach is market-preserving and limits the risk of failure, while the latter is risky and costly. While it is beyond the scope of this note to analyze in detail investment climate in rural Mongolia, the forthcoming World Bank Investment Climate report will suggest some policy measures. For instance, improving access to finance in rural Mongolia, investing in human capital and basic infrastructure are non-sector specific investments which will serve the most and limit the risk of failure. 53. Reconsider the economic rationale of large investment projects in light of their regional development impact and their associated risk. Examples follow:

o Increasing regional connectivity is certainly warranted for increasing people access to market and services. However, with limited resources, where to finance new road and to what standard, and balancing new roads with maintenance of existing roads should be carefully assessed, based on economic impact analysis, including financial constraints and projected usage. In this regard, while some sections of the Millennium Road project may actually meet the economic cost-benefit criteria, some other parts may not.

o In light of international experience, “free zones” experiments are successful only if other conditions such as market access, attractive labor skills, cost, and productivity, are in place to attract firms. It is recommended to consider the viability of the three planned free zones in Mongolia in light of these other necessary conditions

o Looking at regional dynamics, given the limited critical mass of population needed to benefit from agglomeration affects, it seems unlikely that all 8 urban centers designated as regional pillar centers in the regional strategy will be able to catalyze economic growth in the regions.

54. In rural areas, improve access to quality education. To this end, it would be useful to re-assess the per-pupil funding formula and provide for those sparsely populated soums that are at a disadvantage from the budget allocation. In addition, increasing the quality of teachers in rural areas and the incentives to get professionals to teach in remote areas is crucial. 55. In health, revisit budget resources allocation by refining the allocation formula to reduce the disconnect between health outcome and health care spending by tightening the link between the costing of desired outcomes and spending priorities.


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IV. Regional Development and the Mining Sector13

Typically, weak upstream and downstream linkages in the mining sector inhibit its role in promoting a balanced regional development. Nevertheless, there remains an untapped potential to develop the SMEs sector in Mongolia, which can respond to mining industry’s need and to promote regional development. Furthermore, local communities can benefit from mining activities provided that partnerships are created at the outset between the government, the mining companies, and local communities to ensure local consultation in the sustainable development of mineral resources and the sharing of economic benefits it may entail.. The Government’s willingness to consider participating in the DFID (U.K.) initiated Extractive Industries Transparency Initiative (EITI) is a crucial step in the right direction.

Upstream Linkages

56. An increase in mining production results in increased regional demand for intermediary goods and services. Part of this demand will be for infrastructure, such as roads (or ports). During the construction of this infrastructure, along with mine development and the setting up of processing facilities, one can mobilize a number of related enterprises. If the region exhibits large geological potential, construction activities can extend over a wide time span, creating a rather permanent demand based on temporary requirements. Once completed, this infrastructure creates positive, although static, externalities for example, a reduction of transportation costs or better access to markets for entities in the region, and some also the requirements for recurrent maintenance. 57. Another component of this increased regional demand from mining production is typically for intermediary inputs, such as machinery, equipment, chemical reagents, transport and security services, and electric power. Meeting this demand could be instrumental in further development of a diversified chain of suppliers. Table 4.1 illustrates the typical linkages one sees from mining sector activities.

Table 4.1: Typical Products and Services Required by the Mining Sector Catering Aggregate/ sand and gravel supply Haulage Clothing Semi-permanent buildings/dwellings IT / communications suppliers Footwear (Safety boots, etc) Drilling contractors Geological/Engineering/Surveying services Spare parts (grinding balls) Medical / Health Services Specialized export/import agencies Security services Lime supply Assay labs

58. A World Bank Report on the Mining Sector in Mongolia (2004) noted that significant domestic demand could well be created if a diversified industry structure develops in Mongolia comprising a few large operations and many medium and small mines. Apart from a few large mines in Mongolia (e.g. Erdenet Oyu Tolgoi and possibly other porphyry gold/copper and hard rock gold mines), most of the mines are likely to be small to medium, geographically diverse, and varied, and could well create significant domestic demand for domestic suppliers of good and services, such as high quality grinding balls, security and transport services, and safety equipment.

13 This note refers to the 2004 World Bank Report “Mongolia Mining Sector: Managing the Future”.


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59. As the mining sector in Mongolia is expected to grow at a moderate rate over the next 10 years, the potential to grow indigenous support industries, particularly small and medium enterprises (SMEs), is significant. In fact, a small number of companies are already actively engaged in supplying their outputs and services to the mining and exploration companies. Evidence of this can be found at the Borro Gold mine where the mining company had outsourced a range of services to a number of local companies to assist during the construction phase of the mine. SMEs are now supplying maintenance, haulage, catering, lime supply and transportation services to Borro. This level of SME activity will be maintained during the mining phase as local companies adapt to the needs of the client company.

Downstream Linkages

60. An increase in mining output augments the minerals and metals available for transformation in the domestic economy. The issue is the extent to which a greater availability of minerals and metals is favorable to the development of a manufacturing industry that uses minerals or metals as inputs or fosters the development of established domestic processing or manufacturing industries. Although this is a field scarcely studied, the main obstacle to promoting the production of manufactured goods from the metals or minerals produced in mining regions would be their distance from main wholesale and retail markets, and availability of appropriate manufacturing expertise. The question remains, however, whether the local supply of raw materials or metals somehow gives the local industry a comparative advantage to conduct business there. The potential for enhancing the access of the local industry to global markets must also be considered.

Development of local communities and sharing of economic benefits

61. Recent experience shows that three components are essential for effectively managing mining revenues at the regional and local levels. First, a partnership involving governments, communities and companies is required. This calls for a clear definition of the obligations and responsibilities of each partner. Second, local consultation is necessary for the process to deliver sustainable development, helps build trust and respect among the three parties and helps manage expectations on the part of the community. Third, there is a need to share the economic benefits. Local communities close to mining operations should benefit from the mining surplus captured by the state through the taxation regime and royalties.

62. In Mongolia, royalties from extractive industries are centralized and are redistributed via non-ring-fenced methods i.e. through general transfers. Sharing these revenues with local communities should be considered in the context of an overall debate on intergovernmental fiscal redistribution. Adopting a transparent intergovernmental fiscal system matching predictable resources at local level with the corresponding accountability and responsibility for managing those resources is the priority.

Recommendations to increase the impact of the mining sector on regional development

63. There is scope and potential in Mongolia to develop the private sector in the supply of goods and services that support the development of new mines, as they come on-stream in the coming years. This could not only reduce the cost of importing substitute goods, but also have a marked impact on local employment with the additional benefit of linking the mine and local community together. A promotional program may be considered to incubate and nurture fledgling SMEs in order to develop skills base in IT, accounting, marketing, promotion, finance, and general management. For example, a steel mill could supply grinding balls to the mines, provided that the required standards are met. Domestic footwear manufacturers could supply the mining sector, whereas now safety boots are imported. Potential also exists in the informal mining sector, where large numbers of unregistered micro-enterprises have emerged, non-farm SME


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development with “small-scale hand mining of gold, fluorspar and other minerals by local people” could be support a diversified livelihood strategy for sedentary agricultural communities. 64. To support private sector development, especially the SMEs, the government should devise and implement policies that focus on ensuring a level-playing field for all in the private sector to grow. In this regard, the upcoming World Bank investment climate and supply chain study aims at identifying the main obstacles to a good business climate in Mongolia and possible ways of addressing them 65. A trilateral dialogue and concerted efforts between the government, the local community and the mining company is also necessary for the formulation and implementation of community development plans. In addition, establishing an integrated framework for compensation and benefit sharing is warranted. However the sharing revenues from extractive industries should be considered in the context of a global approach to improving intergovernmental fiscal relations. To this end, the Government’s willingness to participate in the Extractive Industries Transparency Initiative (EITI) is an important step in the right direction. The challenge will be to apply the principles encouraged by the EITI to all the extractive industries and associated policy-making in Mongolia.

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