Mongolia - Economic Transition Support Credit Project

Do_umo of The World Bank FOR OMCiAL USE ONLY lpwt No. P-6127-WOG XEKORANDUK AND RECONMDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMET ASSOCIATION TO THE EXECUTIEVE DIRECTORS ON A PROPOSED CREDIT OF SDR 14.2 NILIN TO MONGOLIA FOR M ECONMC TRANSITION SUPPORT PROJECT OCTOBER 1, 1993 MICROGRAPHICS Report No: P- 6127 MOG Type: MOP TVis docment has a rsticted distribution ad may be used b recipients only In te performance of -theirofficia duties Its contets asy not otebise be disclosed withu Wrld BDak authorization.  CURRENCY EQUIVALENTS (As of September 27, 1993) Currency Unit - Tugrik (Tug) Before November 1991: $1.00 - Tug 7 (barter rate) As of June 30, 1992: $1.00 - Tug 40 (for official transaction) $1.00 - Tug 250 (for free market transaction) Av of April 30, 1993: $1.00 - Tug 150 (for official transaction) $1.00 - Tug 420 (for free market transaction) As of May 31, 1993: $1.00 - Tug 398 (unified free market exchange rate) FISCAL YEAR January 1 to December 31 WEIGHTS AND MEASURES Metric System ACRONYMS AND ABBREVIATIONS AsDB Asian Development Bank c.i.f. Cost, insurance, and freight CIS Commonwealth of Independent States CMEA Council for Mutual Economic Assistance EAP Environmental Action Plan ERC Economic Rehabilitation Credit ESAE (IMP) Enhanced Structural Adjustment Facility GDP Gross Domestic Product ICB International Competitive Bidding IMF International Monetary Fund METS Mongolia Economic Transition Support MIS Management Information Systems MR Mongolian Railways MIi Ministry of Trade and Industry PFP Policy Framework Paper  FOR OMCIAL USE ONLY MONGOLIA ECONOMIC TRANSITION SUPPORT PROJECT Credit and Proiect Summary Borrower: Mongolia Amounts SDR 14.2 million ($20 million equivalent) Terms: Standard, with 40 years maturity Financing Plan: Local Foreian Total ------ ($ million) End-users 5.4 - 5.4 IDA - 20.0 20.0 Total 5.4 20.0 25.4 Economic Rate of Return: Not Applicable Staff Appraisal Report: Report No. 11954-MOG Poverty Categorv: Not Applicable lien: IBRD 22982 IThis docolment has it otricted dstjibution and may be used by tecipicrnts only in the pertonnance Iof their offcial dutios. Its contonts may not othetwise be dissb#4 wit' out World Bank authofation.  MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF TME INTIRNATICVJL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO MONGOLIA FOR AN ECONOMIC TRANSITION SUPPORT PROJECT 1. I submit for your approval the following memorandum and recommen- dation on a proposed credit to Mongolia for SDR 14.2 million ($20 million equivalent), on staidard IDA terms with 40 years maturity, to help finance an economic transition support project to assist in the operation, maintenance and development of the mining and transport sectors. PART I: COUNTRY POLICIES AND BANR GROUP ASSISTANCE STRATEGY A. Country Policies 2. Qgneral Background. With a land area of about 1.6 million kim2 and a population of only 2.2 million, Mongolia has one of the lowest population densities in the world. Moreover, the geography and infrast-ucture of the country make access to foreign markets difficult and costly. Since its inde- pendence in 1921 until the late 1980s, Mongolia remained isolated from the broader international scene. External trade was heavily integrated with that of the former USSR, with copper exports accounting for over half of the total. Mongolia followed the Soviet model of a centrally planned command economy, with emphasis on the development of industry and energy. With Soviet assis- tance equivalent to 30 percent of the GDP, high rates of growth in investment and output were achieved for a while but serious economic problems emerged by the second half of the 1980s. Possibilities for further economic growth under a command economy appeared exhausted by the turn of the decade. GDP has declined since 1990 with the total decline for the 1990-92 period reaching almost 20 percent. The most important reasons for this decline are the sharp contraction of trade with the former Soviet Union and other members of former Council for Mutual Economic Assistance (CMEA), decline in export prices, and the prevailing economic distortions. 3. Followin6 political reforms in early 1990, an elected coalition Government embarked on a program of economic tr- -formation to a market econ- omy. Mongolia expanded relations with market ecor.-;mies and became a member of various international organizations. A whole host of broad-ranging reforms were initiated. For example, many prices were liberalized or sharply increased, a program of privatization initiated, and legal and institutional reforms introduced. Most small- and medium-size public enterprises and shops were transferred to private owners under a privatization program using vouch- ers, and privatization of large public enterprises under this system was ini- tiated. 4. Recent Developments. Mongolia's economy has suffered from external shocks (notably the breakup of the CMEA trading system and of the former USSR in 1991), from difficulties in transforming domestic institutions, and from some domestic policy slippage. Following a decline of 9.9 percent in 1991, real GDP fell by a further 7.6 percent in 1992. Notwithstanding a pickup in activity in the emerging private sector, industrial and agricultural produc-  -2 - tion has been constrained by shortages of intermediate goods and spare parts and, in the case of agriculture, also by adverse weather. 5. Inflation accelerated to over 300 percent by end-199?, reflecting liberalization of most official prices and relaxed monetary and credit poli- cies during the first half of the year. Monetary policies have tightened since the fourth quarter of 1992. The Bank of Mongolia's (the Central Bank) lending rates were raised to positive real levels and reserve requirements were doubled. The composition of credit is shifting in favor of the private sector. 6. The overall fiscal deficit reached about 10 percent of GDP in ID92, and was mainly financed by external resources. Currant expenditures were sharply reduced in real terms during 1992, primarily through the elimination cf most direct budgetary 4ubsidies to state enterprises and thrvugh zestra:lt in salary increases. Goverement savings had been negative until 1991. In 1992, savings of 1.3 percent of GDP were attained. On the external front, meanwhile, after a sharp decline of almost 50 percent during 1990191, exports recovered in 1992 as a result of the increase in practically all noncopper exports. 7. There are some positive indications for the first semester of 1993. Nominal exports (in US dollar) increased by 21 percent over the same period of 1992. Volume of exports for almost all goods increased, showing a broad-based response to policy incentivest appropriate exchange rate policies (including the unification of the exchange rate at the free market level in May 1993), introduction of interest rates that are positive in real terms, abolition of import licensing procedures (there are no export taxes and import duties are relatively low--15 percent--and uniform), enactment of a new foreign invest- ment law that allows transfers of benefits and assets abroad, etc. Another positive development is the clear trend towards trade diversification. 8. The Stabilization and Transformation Program. The Government has been implementing measures to stabilize and transform the economy since 1990 (i.e., privatization, price liberalization, changes in laws and regulitions, etc.). Those efforts were supported by a standby arrangement with the IMP in 1991. Performance under the standby was mixed. Progress was made in estab- lishing the legal framework for a market economy, banking and tax reforms, simplification of the exchange system, and price liberalization. Slippages in policy implementation, however, occurred, particularly in monetary policies. Performance criteria for end-June and end-September 1992 were not observed. Subsequently, an informal program was adopted by the newly elected Government and monitored by the IMF staff. During the last quarter of 1992, the Govern- ment tightened its monetary policies, adjusted interest rates, increased fis- cal revenues, controlled expenditures, introduced a new sales tax, raised administrated prices, adjusted the exchange rate, etc. Reflecting these mea- sures, the targets of the informal program were met. Meanwhile, discussions took place between the Government and staff from the IMF and the bank on a Policy Framework Paper (PEP). As a result of those discussions, a PFP was agreed in June 1993. An IMP Enhanced Structural Adjustment Facility (ESAF) was also approved in June 1991.  - 3 - 9. The main macroeconomic objectives of the Government articulatsd in the PFP are to reduce inflation and to reverse the decline in output. to support the stabilization efforts and provide scope for adequate expansion of credit to the productive sectors, the Government vill aim at financing the budget deficit from external sources. Expansion in domestic credit is being restrained to a level consistent with inflation targets and external objec- tives. The Bank of Mongolia is taking steps to improve the monitoring of monetary developments and the supervision of coamercial banks. Interest rates are basically free. Key structural reforms include: further privatization, supported by measures to improve the legal and regulatory framswork and mea- sures to strengthen corporate governance; the completion of the process of price liberalization; and the removal of remaining restrictions on production and trade associated vith the old system of state orders and rationing. Finally, improvements in public resource allocation are in progress: invest- ment expenditures are now subject to more critical scrutiny; and a rolling three-year public investment program is under preparation. B. External Environment 10. Given its geography and economic ties, Mongolia is highly vulnerable to external events, particularly from Russia and/or China. The country depends almost totally on Russia for the provision of petroleum. However, as the reform program progresses and external political and economic relations are diversified, this vulnerability is being somewhat reduced. A diversifica- tion of trade has been taking place since 1990. For example, exports to G-7 countries increased from 4 percent of the total in 1990 to 9 percent in the first semester of 1993; exports to China, negligible in 1990, now account for about 25 percent of the total; exports to "other countries" increased from 15 percent of the total in 1990 to 29 percent. Exports to Russia, on the other hand, accounted for about 80 percent of the total in 1990, but represent only about 40 percent at present. 11. Even under a scenario of complete commitment to reforms, Mongolia's short and medium-term balance of payments prospects are subject to consider- able weaknesses and risks, due to its heavy dependence on copper exports to Russia as well as the import-intensive nature of the economy. However, these weaknesses are diminishing gradually as nontraditional exports continue to grow, as changes in relative prices result in a less import-intensive economy and as new markets develop for both imports and exports. Needless to say, improvements in the domestic situatior within Russia would have a positive impact on Mongolia. By the same token, further development of relations with6 China would reduce Mongolia's balance of payments vulnerability. 12. Mongolia's debt in convertible currency amounted to $340 million at the end of 1992. Debt in nonconvertible currency is owed mostly to Russia, some of which is not due until the year 2000. An agreement has been reached with Russia, in principle, that future debt service would not be such as to impede Mongolia's economic development. In any case, debt negotiations with Russia are ongoing, covering more than 10 billion Rubles. The way this debt is settled will be a key determinant of Mongolia's balance of payments posi- tion in the future, and is an additional reason for Mongolia to be very con- servative in contracting loans on commercial terms as stipulated in the PEP. Debt service in 1993 is projected to account for about 22 percent of export  - 4 - earnings, reflecting large short-term and trade-related credits previously contracted. However, it is estimated to decline to about 7 percent over the medium term. In order to keep a serviceable external debt, Mongolia should avoid contracting new loans on commercial terms. Given its vulnerable balance of payments position, its need for large amounts of external capital for the foreseeable future (over $150 million per year), and the expected difficulties of the transition process, the country will need to continue to rely on grants, concessional assistance and direct foreign investment. Creditworthi- ness is not anticipated over the medium term. C. Country Assistance Strategy 13. Recent Performance and Bank's Resoonss. As mentioned before, the country has unified its exchange rate at a free, market level and most prices have been liberalized. Government participation in trade and production is falling. In response to the present liberalization program, most exports increased substantially during the first semester of 1993. 14. When Mongolia announced its political decision to transform itself into a market-oriented economy in 1991, the country was suffering from exter- nal shock due to the turmoil in (and subsequent dissolution of) the former Soviet Union. Moreover, the knowledge of the authorities and civil servants about the way a market-oriented economy operates and about its institutional requirements was extremely limited. Consequently, the Bank's strategy at that juncture was to: (a) provide financial assistance for critical imports needed to ameliorate the impact of the external shock; (b) provide technical assis- tance to help the country create the institutions required by a market-ori- ented economy and to assist the authorities design appropriate policies in key sectors (mining, agriculture, trade, public investment, etc); and (c) help coordinate broader bilateral and multilateral efforts to assist Mongolia. 15. In implementing this strategy, the Bank has taken the following steps: (a) two operations were approved in FY 1992 (the Economic Rehabilitation Credit--ERC--and the Technical Assistance Credit--TAC). The ERC for $30 million provided foreign exchange for critical imports in min- ing, transportation, agriculture, power and petroleum. After one year and a half, it is almost completely disbursed and it has had a direct impact in ameliorating the impact of external trade disrup- tions on Mongolia. The TAC for $5 million was designed to improve public sector management through institutional strengthening of the Ministries/Agencies of Justice, Trade and Industry, Finance, National Development Board, Customs, Central Bank and the Statistics Office. The TAC is also providing advisory services (including sectoral assessments), equipment and training. Several sectoral studies (mining, coal, transport) have been completed or are close to completion and are being used intensively in our policy dialogue. Advisory services for project evaluation, trade policies, petroleum exploration promotion, and improvement of statistical systems (including social indicators) are being provided under the TAC. Over 25 percent of the TAC has been disbursed. Overall, this credit is also proceeding satisfactorily; and  - 5 - (b) the Bank has been co-chairing with the Japanese Government an annual Assistance Group Meeting in Tokyo. The meetings have mobilized short-term assista.ace required by Mongolia to overcome urgent needs created by the external trade disruptions and to provide financing for new investments. Three meetings have taken place since 1991. 16. Country's Development StrateSX. The medium-term macroeconomic objectives are to reverse the decline in output, restore financial stability, and make progress toward external viability. The Government program articu- lated in the rFP aims to limit the contraction of economic activity to less than 2 percent in 1993 and restore real GDP growth thereafter. The rate of inflation is targeted to be reduced from about 320 percent at end-1992 to single digits by 1995. The external current account deficit is to be con- tained to 17 percent of GDP over the medi7m term, gross international reserves are to be rebuilt to a level equivalent to two and a half morths of imports and external payments arrears are to be eliminated. These are recognized as ambitious but achievable targets, the realization of which will require satis- factory external conditions and full implementation of stabilization measures and structural changes outlined in the PFR and in the Statement of Economic Strategy for the Medium Term. 17. Restoration of economic growth will depend on recovery in the agri- cultural, industrial, and services sectors, especially in export-related activities. Priority is being given inter alia to reversing the decline in food supplie3 in recent years. A positive supply response in agriculture is expected from the improvement in the terms of trade for the sector resulting from the establishment of market-determined producer prices, appropriate exchange rate, elimination of trade barriers, and a simplified import system consisting of a low, uniform import duty (15 percent). The services sector offers potential for gains in private employment in areas such as tourism, external and internal trade, business and professional services, and distribu- tion. Some industrial subsectors, such as small, import-substituting consumer goods industries initiated with private capital, should also begin contrib- uting to growth. Howevex, output of many traditional indus ries is expected to remain stagnant or decline as a more rational price struoture and hard budget constraints force nonviable entities to close and other entities to undergo rehabilitation and restructuring. 18. The Government is committed to the continuation of the privatization program, with future asset sales projected to include activities/sectors such as retail gasoline, housing, and communications. The Government has also emphasized that measures to improve the quality of public expenditures will continue. The initial elimination of most subsidies will be extended and a public investment program containing priority projects is being formulated. 19. The difficulties of the transition have resulted in significant declines in living standards for the population and have contributed to rising unemployment. To mitigate the effects of unemployment, the Government, in 1990, instituted unemployment grants for civil servants retrenched as a result of rationalization of government agencies; and, in 1991, introduced a system of severance pay financed by employers. All employers are required to trans- fer the equivalent of five months' salary of dismissed workers to the Social Security System, which in turn uses these funds to pay modest unemployment  - 6 - benefits and to provide job information, job training, and job creation ser- vices. The Government intends to restructure its current system of social benefits to improve targeting and to provide support for self-employment, job creation, and expanded job training. In order to identify vulnerable groups, the Statistical Office has developed a measure of minimum living standards and established an objective measure of poverty. A number of nongovernmental organizations, such as the Mongolian Red Cross and Save the Children, also contribute to poverty alleviation. Women have equal access to education than men and that is reflected in the enrollment rates. There is also some evi- dence, yet to be confirmed, that women participation in the formal sector labor force is increasing. 20. Main Obiectives of the Bank's Program of Assistance. With Mongolia having absorbed the initial external shock and now moving towards implementing systemic transformation, the central thrust of the Bank's country strategy is to assist the country in transforming its economy (as articulated in the PFP and explained before), in improving the quality of its public investment pro- gram and in developing its private sector. To pursue this strategy, the Bank is concentrating its efforts on the following fronts: (a) First, since the effects of the external shock continue to affect the economy, there is still a need for financing some critical imports. Consequently, the present Mongolia Economic Transition Support (METS) Credit ($20 million) intends to provide financing for some of those critieal imports. The further implementotion of the reform program should reduce the need for import-financing credits such as the PY 1992 Economic Rehabilitation Credit (ERC) and the proposed METS, and no future operation of this type is currently envisaged. (b) Second, the Bank will continue to monitor the economic events and the balance of payments requirements of Mongolia to examine whether a quick-disbursing, policy-based operation is required to complement the assistance of the international community to the country. Should a policy operation be necessary, it would be based, inter alia, on the policy parameters included in the Policy Framework Paper discussed by the Committee of the Whole on June 23, 1993 and on the Statement of Economic Strategy for the Medium Term that is part of this proposed operation. Any eventual policy-based opera- tion most likely would finance imports to the private sector. This strategy of envisaging a policy based operation only on a contingent basis results from observing the present situation of Mongolia, whereas the continuation of the reform process and the consolidation of the free foreign exchange market should lead to a sustainable balance of payments situation, with requirements for external capi- tal inflows mainly associated with new developmental projects or private investment. In line with this, a shift to traditional in estment and technical assistance operations is envisaged. (c) Third, the areas of the public sector requiring priority investments are being identified by the Goverment with assistance provided under the TA Credit. Taking into account such identification, as well as other donors' programs of assistance, the Bank has identi-  fied three areas where it expects to be able to make a substantial contribution to the development of the country through investment projects in the near future (FY 1994 and FY 1995)s namely, transpor- tation, agriculture (mainly crop development) and petroleum explora- tion. Advanced preparation of the transportation ($30 million) and agricultural ($10 million) projects is underway. The Board presen- tation of a petroleum exploration project ($5 million) is envisaged for PY 1995. The preparation of such a project would start as a part of the functions of a petroleum advisor financed under the TAC. Possible areas of lending after 1995, for which necessary identifi- cation work will be carried out over the near future, include energy/power and noverty alleviation. In the case if energy, given the magnitude (4 the investment seqvirements, it is likely that a cofinancing arrangement with other donor(s) will need to be sought. In this regard, contact is being maintained with Asian Development Bank (AsDB) which is conducting studies and preparing projects in this sector. (6) Fourth, future donor coordination will continue to be very impor- tant. However, such coordination will increasingly focus around Mongolia's long term investment and technical needs rather than balance of payments and critical import requirements. For the time being, an annual meeting in Tokyo has been identified by donors as the most suitable format for such coordinat'on. 21. The envisaged lending program is linked to the implementation of the reform program. The proposed METS Credit is, to some extent, linked to a satisfactory progress of the reform program. This is so because one of the conditions of the credit would be the continuation of a free, unified exchange rate system as the basis for counterpart payments by user agencies. As explained above, the unification of the exchange rate represents a crucial component of the reform program. Some of the sectoral conditions that would be part of the investment projects are also linked to fundamental aspects of the reform program. For example, the transport project is expected to include agreements on tariff reforms which most likely would be part of the reform program in the second year. The agricultural credit would depend on the con- tinuation of satisfactory pricing policies for the agricultural sector. This- is also a key aspect of the reform program. A possible Poverty Alleviation Project, yet to be fully identified, would help the Government address the negative side-effects of the reform program: unemployment and lack of access to some social servicpe resulting from the restructuring of the economy and the drastic cuts in public expenditures. 22. To sum up, there are two projects currently under preparation: Transport Rehabilitation (appraisal already completed); and Agriculture (appraisal envisaged for 1994). The possible petroleum exploration project is envisaged for FY 1995. Possible areas of lending for FY 1996 onward include power and poverty alleviation. 23. Economic and Sector Work. Our Economic and Sector Work (ESW) has included tasks necessary to deepen our understanding of Mongolia's development issues and to support the lending program. Following the first Country Economic Memorandum (Mongolia: Toward a Market Economy) in 1991, several work-  ing documents have been produced and shared with the Government of Mongolia: Financing Education during Transition, Development of the Private Sector in an Economy in Transition, Developing the Private Sector and Rationalizing Public Expenditures, and Assessment of Vulnerable Groups in an Economy in Transition (in cooperation with Save the Children), Review of Civil Service Remuneration Policy (in cooperation with ODA-UK), Some of these working dosuments are being processed for publication as DWecussion Papers. In addition, aeveral studies have been conducted with support from the Technical Assistance Credit: Management of the Mineral Sector of Mongolia, Engineering Review of the Coal Industry of Mongolia, Orvanizational and Management Review of the Coal Indus- try. 24. Envisaged ESW tasks for the three forthcoming years are: (a) an annual updating of the PFP for, at least, two years in collaboration with the IMF; (b) an update of the CEM, with emphasis on supply response, poverty and public investment issues; (c) a Public Expenditure Review to complement pre- sent efforts and to provide additional elements for the identification of future lending operations; (d) an Energy Review to analyze both policy an- investment priorities in the sector; and (e) a Review of the Social Sectors (Health, Education, Social Security) to take stock of the social situation as the reform program advances and to suggest concomitant policy responses. 25. Policy Dialoaue. The Bank's strategy has also been based on an active policy dialogue. As mentioned before, a PFP has been produced and discussed recently. As is usually the case, annual PFPs would follkw for, at least, two consecutive years. The Bank will contribute to the PPPs, particu- larly in the areas of public expenditures and private sector developments, on vhich some informal CESW has been already carried out. The Bank has partici- pated in IMP Stand-By and ESAP missions while the IMF has similarly partici- pated in Bank missions for the preparation of the METS. There has been broad donor coordination, especially with the AsDB. 26. Cofinancina. The Bank will actively seek opportunities for cofinancing with other donors. The Technical Assistance Project has already received cofinancing from the Japan Grant Facility. The proposed METS would finance critical imports in parallel with the already approved AsDB Industrial Program Loan. The envisaged Transport Rehabilitation Project would proceed in parallel with financing from Japan for improvement of Mongolian Railways for which funds have been already committed. 27. IFC/FIAS. After the first IFC/FIAS mission visited Mongolia in 1991, several longer term investment opportunities and privatization possibil- ities vere identified. At this point, however, the Genghis Khan Hotel is the project with best chance of going forward. The Government has now agreed to IPC's conditions for involvement: privatization, market valuation (rather than historical cost), and replacement of the Yugoslavian contractor. IPC staff believes that the project has a good potential and will assist Mongolia in identifying a new developer and new equity sources in order to create a pro- posal that IFC can consider financing. 28. MIGA. Mongolia signed the MIGA Convention in June 1991 but has not ratified it yet. MIGA can thus register investment projects in Mongolia, thereby maintaining eligibility for coverage once Mongolia becomes a member,  but cannot issue guarantees for investments until all membership requirements are fulfilled. There are no investment projects in Mongolia registered with MIGA at this time. 29. Key Policy Issues for Conaideration. The thrust of the Bank's stra- tegy is to support Mongolia's stabilization and transformation program. An IDA lending program for an average of about $30 million per year is proposed. The proposed METS would be the last credit to finance import requirements. A future policy-based operation would take place only in the event that balance of payment requirements make it imperative. A shift to traditional invest- ments and te