Mongolia - Toward a market economy

A WORLD BANK COUNTRY STUD- 11170 FILE COPY Report No.:11170 Type: (PUB) Title: TOWARD A MARKET ECONOMY Author: WORLD BANK Ext.: 0 Room: Dept.: WORLD BANK COUNTRY STUDY SEPT. 199. Mongolia Toward a Market Economy Lg~ r1 4!nn I~~~ ILLmaa U W   A WORLD BANK COUNTRY STUDY Mongolia Toward a Market Economy The World Bank Washington, D.C.  Copyright 0 1992 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing September 1992 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. 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The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, Department F, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenue d'Iena, 75116 Paris, France. ISSN: 0253-2123 ISBN: 0-8213-2247-8  - iii - Abstract This report, the World Bank's first overall review of the Mongolian economy, describes the economic pressures that surfaced in 1991 and the vari- ous measures taken by the government since then. After an introductory back- ground, Chapters 2, 3 and 4 assess recent economic developments, the key reform and policy issues, and the country's development prospects in the medium term. Annex 1 provides background notes on the main sectors and selected issues. A statistical appendix is contained in Annex 2. The report was originally presented to the Bank's Board of Executive Directors in December 1991. Although this version has been updated, the revi- sions have been limited. While the economy is changing rapidly and most recent data and policy developments have- not been included, this analysis of structure and past trends of the economy is expected to be of interest to those working on reforming socialist economies in general, and Mongolia in particular.  - iv - CURRENCY EQUIVALENTS (As of June 30, 1992) Currency unit - tugrik (Tug) $1.00 - Tug 40 |(for offical comrcial trausactious) Tug 1 - $0.025 I $1.00 - Tug 250 1 (for free uarlt transactions) Tug 1 - $0.0004 FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES Metric System  -v- Preface Mongolia became a member of the World Bank Group (IBRD, IDA and IFC) on February 14, 1991. A World Bank economic mission visited Mongolia from June 21 to July 5, 1991. It was led by Mete Durdag, and its members included Alan Gelb, Frida Johansen, Kathy Ogawa (all IBRD); John Leimone (IMF); and Cevdet Denizer and Victor Gabor (Consultants). Ramesh Chander and Shahid Yusuf participated in the latter part of the mission's work and Peter Harrold contributed to the drafting of the report. The mission wishes to thank the Mongolian authorities, and in particular the Ministry of Finance, the Bank of Mongolia and the Ministry of National Development, for their support and coop- eration in providing the information and data used in this report. It also wishes to acknowledge the cooperation received and the benefit derived from recent work undertaken inter alia by the IMF, the Asian Development Bank (ADB), the United Nations Development Programme (UNDP), and by several United Nations Specialized Agencies. This report, the World Bank's first review of the Mongolian economy, analyzes the country's economic policies and development prospects at the time of membership. Statistics for 1991 were updated in July 1992 prior to publication.  - vi - ACRONYMS ADB Asian Development Bank Almag Province/Provincial Government BOM Bank of Mongolia (Mongolbank) (the central bank) CCA Convertible Currency Area CIS Commonwealth of Independent States CMEA (COMECON) Council for Mutual Economic Assistance EEC European Economic Community ESCAP Economic and Social Commission for Asia and the Pacific FDI Foreign Direct Investment FTC Foreign Trade Corporation GATT General Agreements on Tariff and Trade IBEC International Bank for Econoimic Cooperation IDA International Development Association IMF International Monetary Fund MCC Mongolian Coal Corporation (iYongol Nuurs) MFE Ministry of Fuel and Energy MFN Most Favored Nation MIAT Mongolian International Air Transport MND Ministry of National Development MOF Ministry of Finance MOL Ministry of Labor MPC Mongolian Petroleum Company MPR Mongolian People's Republic MPRP Mongolian People's RevolutiorLary Party MTI Ministry of Trade and Industry NMP Net Material Products PSIP Public Sector Investment Program PISC Petroleum Import and Supply Corporation REER Real Effective Exchange Rate SBA (IMF) Stand-By Agreement SNA System of National Accounts Somon County/County Government SSO State Statistical Office UNDP United Nations Development Programme USSR Union of Soviet Socialist Republics  - vii - Table of Contents Page No. EXECUTIVE SUMMARY . . . . . . . . . . . . . . . . . . . . . . ix I. GEOGRAPHY, DEMOGRAPHY AND HISTORY . . . . . . . . . . . . . . 1 Geography .... . . . . . . . . . . . . . . . . . .. 1 Natural Resources .... . . . . . . . . . . . . . . 1 Demography . . . . . . . . . . . . . . . . . . . . . . . 1 Political and Economic History . . . . . . . . . . . . . 2 II. RECENT ECONOMIC DEVELOPMENTS AND THE EMERGING CRISIS . . . . 5 A. Background .... . . . . . . . . . . . . . . . . . . . 5 B. Production, Expenditure, and Employment . . . . . . . . . 5 Production .... . . . . . . . . . . . . . . . .. 5 Expenditure . . . . . . . . . . . . . . . . . . . . . . 8 Employment and Wages ... . . . . .. 9 C. Need for Stabilization . . . . . . . . . . . . . . . . . 11 Public Finance .... . . . . ..... . . . . . . . 11 Monetary Developments ... . . . . ..... . . . . . 17 Inflation . . . . . . . . . . . . . . . . . . . . . . . 17 Foreign Trade and Balance of Payments . . . . . . . . . 19 Summary . . . . . . . . . . . . . . . . . . . . . . . . 24 III. KEY REFORM AND POLICY ISSUES.. . 26 A. Introduction ..26 B. Macroeconomic Management. . 26 Financial Sector Reform . . . . . . . . . . . . . . . . 26 Public Finance Reforms ..29 Policy Coordination ..31 C. Improving Incentives ..33 Price and Market Reforms . . . . . . . . . . . . . . . 34 External Sector Reforms ..37 Foreign Trade.. 38 Foreign Exchange Policy ..39 Foreign Direct Investment (FDI) . . . . . . . . . . . . 40 Enterprise Reform and Privatization . . . . . . . . . . 40 Privatization ..43 Private Sector Development . . . . . . . . . . . . . . 44 Public Enterprise Management . . . . . . . . . . . . . 44 D. The Social Safety Net ..44  - viii - Page No. IV. DEVELOPMENT PROSPECTS . . . . . . . . . . . . . . . . . . . . 46 A. Background . . . . . . . . . . . . . . . . . . . . . . . 46 B. The Government's Program and Scenario . . . . . . . . . . 46 Production .... . . . . . ...... . . . . . . . 47 Saving and Investment . . . . . . . . . . . . . . . . . 48 Trade Prospects and External Resource Requirements . . 49 C. Risks and Other Possible Outcomes . . . . . . . . . . . . 50 D. Creditworthiness .... . . . . ..... . . . . . . . 53 BOXES IN TEXT 1.1 Mongolia's Relationship with COMECON . . . . . . . . . . . . 3 3.1 Key Economic and Structural Reforms . . . . . . . . . . . . . 27 3.2 Mechanics of Privatization by Vouchers . . . . . . . . . . . 42 TABLES IN TEXT 2.1 Growth of NMP and GDP at Constant (1986) Prices, 1987-91 . 6 2.2 Sources of NMP Growth, 1980-91 . . . . . . . . . . . . . . . 7 2.3 Gross National Expenditure, 1986-90 . . . . . . . . . . . . . 8 2.4 Financing Investment, 1986-90 . . . . . . . . . . . . . . . . 9 2.5 Population and Employment, 1988-90 . . . . . . . . . . . . . 10 2.6 Summary of State Budget, 1980-91 . . . . . . . . . . . . . . 12 2.7 Structure of Public Finance, 1987-91 . . . . . . . . . . . . 13 2.8 Financing the Budget Deficit, 1980-91 . . . . . . . . . . . . 16 2.9 Monetary Survey, 1986-91 . . . . . . . . . . . . . . . . . . 18 2.10 Price Indices, 1980-90 . . . . . . . . . . . . . . . . . . . 19 2.11 Summary of Balance of Payments, 1986-91 . . . . . . . . . . . 20 2.12 Terms of Trade, 1986-91 . . . . . . . . . . . . . . . . . . . 22 2.13 International Reserves, 1980-92 . . . . . . . . . . . . . . . 25 3.1 Structure of Subsidies, 1989/90 . . . . . . . . . . . . . . . 32 3.2 Monthly Food Rations, June 1991 . . . . . . . . . . . . . . . 35 3.3 Number and Value of State Enterprises to be Privatized . . . 41 4.1 Key Macroeconomic Indicators, 1990-94 . . . . . . . . . . . . 49 4.2 External Financing Requirements, 1991-94 . . . . . . . . . 51 ANNEXES 1. Main Sectors and Selected Issues . . . . . . . . . . . . . . 55 2. The Statistical Annex . . . . . . . . . . . . . . . . . . . . 95 MAP 1. IBRD 24156  - ix - Executive Summary Background i. For most of its 70-year history as an independent state, Mongolia has been a centrally planned economy with extremely close ties to the Soviet Union, particularly since 1946. During this period, the country has been gradually transformed from a rural, essentially nomadic economy to one with a large industrial sector, mainly for the production of semiprocessed raw mate- rials. Industrialization was made possible by large investments and loans from the Soviet Union, particularly in the early 1980s, which permitted Mongolia to run large fiscal and external deficits and to enjoy relatively high rates of growth. ii. This situation began to change in the mid-1980s as Mongolians became increasingly dissatisfied with the rigidities of the centrally planned system. Some reforms were initiated as early as 1986 but did not improve the situation dramatically. After popular demonstrations in March 1990 and the country's first multiparty elections in July 1990, a new coalition government was formed that pledged to "construct a market-oriented economy." Since then, the gov- ernment has embarked upon a comprehensive program of reforms covering the entire spectrum of economic policies, including privatization, price liberal- ization, and the establishment of new institutions for macroeconomic manage- ment. iii. The new policy framework coincided with two major external shocks that have seriously affected the economy. First, owing to its own economic difficulties, the Soviet Union terminated its financial and technical assis- tance to Mongolia in 1991, except for the completion of ongoing turnkey proj- ects; it has also found it difficult to maintain regular supplies to Mongolia of essential commodities such as cement, fertilizers, petroleum and spare parts. Second, the collapse of the Council for Mutual Economic Assistance (CMEA) system in 1991 has seriously disrupted Mongolia's external trade. iv. Thus, Mongolia's economic reform process has begun under adverse circumstances. The external shocks have had two major effects. In the short term, they have necessitated strong stabilization measures to reduce large structural deficits in Mongolia's fiscal and external accounts. For the longer haul, they have emphasized the need for immediate policy changes to reorient and restructure the economy, so that efficient, self-sustaining growth can be resumed as soon as possible. Recent Developments v. The impact of the rapidly changing external environment was first felt in 1990, when GDP fell by 2.1 percent, the first decline in many years. A steeper drop occurred in 1991, estimated at over 16 percent. Among the major sectors, the most rapid decline occurred in the construction sector, as investment decreased dramatically following the abrupt termination of external assistance. This has already created a rapid increase in unemployment, despite the moderating effect of the development of the private sector, which has been creating new jobs in response to economic liberalization.  vi. The reduction in foreign savings is leading to problems in financing the fiscal deficit, equivalent to about 17 percent of GDP in recent years. In 1991 the government resorted to heavy indirect borrowing from the central bank. Reforms under way, such as the conversion of enterprise profit remit- tances to taxes and changes in the price structure, have reduced old sources of fiscal revenue, while new ones are not yet fully effective. Credit to government and state enterprises together increased in 1991 by almost 50 per- cent. Credit to private enterprises also grew, fourfold. Estimating the impact of this credit expansion on inflation is not easy, because data are few and because the administrative doubling of most prices in January 1991 makes comparisons with earlier years unreliable. In addition, prices increased fur- ther, by an estimated 120 percent in 1991. The rapid growth of money supply in the face of declining production thus raises the specter of hyperinflation. This is why stabilization measures are being given top priority. vii. Perhaps the most serious impact is visible in the foreign trade sector. In 1986-89, Mongolia's current account deficit was equal to about 30 percent of GDP. The deficit declined sharply in 1991, as imports and exports of goods and services fell by about 75 percent and 45 percent, respec- tively, from their 1989 levels in the face of the CMEA and USSR difficulties. Reserves became negative as Mongolia turned to hard currency imports to sup- plement declining CMEA supplies. All this has been compounded by recently poor prospects for some of Mongolia's main hard currency exports--cashmere, wool, and leather products. viii. Thus, a wide range of measures is needed, both to arrest this seri- ous economic decline and to stimulate efficiency gains and create new sources of growth. Stabilization and Macroeconomic Reforms ix. Mongolia has moved swiftly to remove its old central planning sys- tem, and new institutions and policy instruments are being put in place. In May 1991, a new central bank was created and the commercial functions of the old monobanking system are being privatized. Now that the central bank is operational, it has begun to tighten monetary policy, and strict money and credit targets have been adopted as part of Mongolia's stand-by program with the International Monetary Fund (IMF). Clearly, with recent runaway money growth and rapid inflation, reimposing monetary discipline is the central bank's most important and immediate task. Beyond this, its main priority will be to establish itself and train its staff to regulate and supervise a private banking system, and to complete the privatization of its commercial banking functions. Privatization has not proceeded as fast as had been expected, not least because of the many bad loans on the books of these banks as a result of past directed credit. While it is necessary to remove nonperforming loans from the banks' portfolios before privatization, it will also be necessary to avoid monetizing such debts. x. Among the first measures that the government instituted were reforms of the taxation system, recognizing that old sources of finance would fast disappear. Indeed, continued adjustment of public finances remains at the heart of the stabilization effort and of the program to create a new economic system. Already, new corporate and personal income taxes have been insti-  - xi - tuted, and a new customs tax has replaced the old import price differential system. New indirect taxes have been imposed to fill the large revenue gap. xi. The authorities have begun to reduce public expenditures, primarily by postponing or eliminating investment expenditures and by cutting the size of the civil service. In addition, cost recovery measures are planned to reduce net outlays in health and education. The major area still needing effort is reducing subsidies, which account for a quarter of public expendi- ture. Industrial and trade subsidies should be eliminated rapidly, as part of the transition to a market economy. xii. On the external side, Mongolia has relied heavily on exchange rate measures and barter trade to adjust its external accounts. The rate moved from Tug 3 = $1 in June 1990 to Tug 40 = $1 today. However, a special rate of Tug 7 = $1 was maintained until November 1991 and then Tug 75 = $1 until March 1992 for barter trade with the Soviet Union. Foreign exchange retention is permitted (to differentiated ceilings) and can be exchanged in a third, par- allel exchange market, at higher rates. However, nothing similar to the lib- eralization of foreign exchange has taken place in trade, which is still domi- nated by the old trade corporations and by compulsory state orders. Removal of this monopsony situation is urgently needed to improve incentives for non- state corporations to increase export efforts. xiii. Finally, the authorities have yet to define clear policy coordina- tion mechanisms with regard to macroeconomic issues. The old central planning system has been formally discarded but has not yet been fully replaced by new institutions and processes. Despite help from international agencies, these mechanisms are only slowly emerging. Policies for Structural Chanze xiv. Mongolia has also moved to institute a wide range of policies to improve efficiency in its industrial, agricultural, and service sectors. These will need to be supplemented by medium-term development strategies and accompanied by a reorientation of the role of government. Price reform has been given a central role. Already prices accounting for some 70 percent of all transactions have been liberalized, and some of the remaining 30 percent (excluding some public services) are scheduled to be freed by the end of 1992. While this is encouraging, price liberalization needs to be accompanied by the abolition of the state order system, especially the state marketing organiza- tions in the agricultural sector. Instead, such organizations may offer in some cases minimum support prices to ensure some stability to farmers as new mechanisms are developed. For the remaining public services, appropriate pricing policies will be necessary, especially passing through the full cost of imported products, where the highly overvalued barter exchange rate has caused severe distortions. xv. The government has placed privatization of state-owned enterprises at the center of its reform program. Over 2,000 enterprises, including 340 large ones, are to be privatized through a voucher system. Originally, the government hoped to achieve this over a twelve-month period, but has since adopted a more realistic three-year timetable. It will be important to link the pace and sequencing of the privatization program to reforms in other  - xii - areas, in particular price and marketing reforms. Marketing reforms must precede privatization, not follow it. A particularly difficult issue is how to treat the enterprises' Tug 10 billion of domestic debt. Clearly, enter- prises will have to be valued on a net basis, and debt may have to be con- verted into long-term bonds. Care will also be needed in addressing the pos- sible macroeconomic impact of privatization, especially the distributional effects of the ownership transfer. xvi. Considerable effort has gone into the price reform and privatization programs, but less attention has been given to promoting new private sector activities. Good progress has been made on the enabling environment, but this will need to be backed by supportive institutions. Sufficient credit, for example, must be available for new private enterprises so that they do not get squeezed out of the market by state-owned ones. Similarly, a significant num- ber of enterprises (in terms of asset value) will remain in public hands indefinitely and others for some time prior to their privatization; early thought will need to be given to how such enterprises will be managed and regulated and how the state's ownership role will be exercised. xvii. These reform issues--especially price reform and privatization--will be crucial for medium-term sectoral development. In agriculture, privatiza- tion of the herds and a full role for market forces are the main issues. Industry is hampered in particular by inefficiency and locational issues deriving from the central planning system. The energy sector has suffered from poor pricing policies, and from lack of access to modern technology, which has had an adverse impact on the urban environment. xviii. As reforms take hold, government will have to assume new roles. Preparation for this shift needs to start soon. For example, the government will continue to have a role in providing agricultural services; industrial retraining, and especially management development, will be required; and pub- lic investment will need to be refocused away from production and toward financing essential economic infrastructure. The latter is especially impor- tant in transport and energy, where capacity constraints could pose serious obstacles to economic diversification, especially in terms of external trade. There are perhaps two key roles for government. First is to reorient the government itself and the civil service to managing an economy indirectly instead of by the old administrative means. It is evident, for example, in the program to promote small business, that the government still thinks in terms of direct actions rather than enabling policies. xix. The second is to focus resources on the sociaLl safety net. The socialist system made notable achievements in terms of health, education, housing, and poverty alleviation. In the rush to discard the old structure, these functions of government should not be forgotten. During stabilization, special efforts need to be made to protect the most vulnerable groups from the effect of output declines and relative price shifts. At the same time, long- term gains in human resource development need to be maintained and improved. Development Prospects xx. Mongolia's medium-term development prospects include its well- educated labor force, abundant agricultural and natural resources, and the  - xiii - traditional resilience of its rural economy. However, the country also faces a number of basic developmental constraints, in addition to its serious short- term problems. In 1991, the economy was hit by severe external shocks, and the authorities responded with a strong stabilization program and simultaneous structural reforms. The program was designed to limit the decline in GDP to 5 percent in 1992 and, after a year of zero growth in 1993, to resume average growth of 3 percent annually thereafter. [As in other socialist economies in transition, GDP growth rates can be seriously understated during reforms because of large relative price shifts and unmeasured activity.] xxi. This scenario was based on two critical assumptions: that Mongolia's external environment would not deteriorate further; and that the government's reform program and policies would be effectively implemented on schedule. The greatest risk to the government's program is the prospect of a further collapse in trade with Russia and other former Soviet republics. Given Mongolia's high import dependence and harsh climate, this breakdown in trade could have potentially devastating consequences on its economy and people, although its rural sector may provide some resilience and security. Even in the absence of further external deterioration, the government's tar- gets may not be achieved because of policy failures, either in design or implementation. The program's realization may therefore require bolder and firmer reform measures by government and a strong response from the private sector. xxii. Throughout the period of stabilization, Mongolia will have to rely heavily on external financing if it is to have an acceptable minimum level of imports to maintain production and begin a modest recovery. Nevertheless, the balance of payments is subject to considerable risk, implying that Mongolia should obtain external financing primarily on concessional terms, with restricted access to commercial sources. If such terms can be achieved, related debt service should not be a problem, provided that the servicing of Mongolia's debt to the former Soviet republics remains manageable.   I. GEOGRAPHY, DEMOGRAPHY AND HISTORY Geographv 1.1 Mongolia is a large but sparsely populated country, landlocked between the Commonwealth of Independent States (CIS) to the north and China to the east, west, and south.1/ Its total land area (1.6 million km2) is about half the size of India and four times larger than Japan. It is 2,400 km long from west to east and 1,250 km from north to south. With an average elevation about 1,600 meters above sea level, the climate is semiarid continental. Mongolia's winters are long and severe, with average temperatures below freez- ing from October to March. The average temperature in January is about -25