Mongolia - Economic Transition Support Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 11954-MOG STAFF APPRAISAL REPORT MONGOLIA ECONOMIC TRANSITION SUPPORT CREDIT OCTOBER 1, 1993 Country Operations Division China and Mongolia Department East Asia and Pacific Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS 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) As 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 400 (unified free market exchange rate) FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank CES (Mongolia) Central Electricity System C.i.f. Cost, insurance and freight cIS Commonwealth of Independent States CMEA Council for Mutual Economic Assistance DP Direct Purchases EAP Environmental Action Plan ERC Economic Rehabilitation Credit ESAF Enhanced Structural Adjustment Facility FOB Free on Board GDP Gross Domestic Product ICB Intemational Competitive Bidding IDA Intemational Development Agency IMF Intemational Monetary Fund JICA Japan International Cooperation Agency KfW German Development Agency LIB Limited Intemational Bidding MIS Management Information Systems MR Mongolian Railways MTI Ministry of Trade and Industry OECF Overseas Economic Corporation Fund PFP Policy Framework Paper PIC Petroleum Import Concern TAC Technical Assistance Credit TR Transferable rubles UNDP/OPS United Nations Development Program/Office of Project Services USAID United States Agency for Intemational Development  FOR OFFICIAL USE ONLY CREDIT AND PROJECT SUMMARY Borrower: Mongolia Amount: SDR 14.2 million ($20 million equivalent) Terms: Standard, with 40 years maturity Project Objectives: The Project would finance imports and technical assistance urgently needed by Mongolia to maintain and develop key sectors of its economy. This would help the economic stabilization and adjustment program currently underway and would contribute to the resumption of growth. Project Description: The Project would finance the critical import of equipment, spare parts, and other essential inputs needed for the coal and copper mines, including technical and operational assistance to the coal and copper sectors. The Project would also finance essential imports for Mongolian Railways (MR), and would provide resources for the import of lubricants and the replacement of old, inefficient gasoline pumps for the Mongolian Petroleum Import Concern (PIC). Project Benefits and Risks: The Project would help maintain and increase output in each of the sectors identified during the next 12 to 18 months. Assistance to the coal mines would be critical for improving the energy supply; the assistance to the copper sector would provide long term production improvements. While a more detailed transportation sector project is being prepared, urgent imports and maintenance needs of the MR are being addressed in this Project. The high speed lubricants to be financed under this Project would help save energy and improve productivity of the machinery. Finally, changing the old gasoline dispensing pumps would minimize leakages, protecting the environment and contributing to energy conservation. There are essentially three types of project risks. First, performance in the implementation of the stabi- lization and reform program agreed with the IMF and the IDA, and reflected in the Policy Framework Paper (which this project intends to support), could be less than satisfactory given the complexity and comprehensiveness of the program. This risk This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - however seems low given the authorities' performance and commitment to reforms to date. Second, payment of local currency counterpart funds by the end-users may be delayed or insufficient. (Payment of the Tugrik equivalent by end-users is important to create incentives for the efficient use of the imported goods and or technical assistance rendered.) This risk is minimized by the authorities' commitment to: (a) implement appropriate price/tariff reforms that would improve cash flow of end-users; and (b) improve management of public expenditures, using already allocated budgetary funds for financing counterpart funds. Third, there are some risks connected with the sectoral components (delays in coal price adjustments, lack of implementation of the conclusions of the TA components). These risks appear minimized by the government commitments to proper price adjustments and by the clear desire shown in taking advantage of the TA components. Poverty Category: Not Applicable Estimated Project Costs: Local Foreign Total ----------- ($ million) ----------- Goods Copper 1.2 4.1 5.3 Coal 1.2 4.0 5.2 Railways 1.3 5.0 6.3 Lubricants 0.6 2.0 2.6 Gasoline Pumps 0.5 1.0 1.5 Total Goods 4 8 16.1 20.9 Technical Assistance Copper - 0.9 0.9 Coal - 1.0 1.0 Total Technical Assistance - 1.9 19 Contingencies 0 2.0 2.6 Total 4 20 0 25.4  - 111 - Financing Plan: Local Foreign Total ----------- ($ million) ----------- IDA - 20.0 20.0 End-users 5.4 - 5.4 Total 5 4 20.0 25.4 Estimated Disbursement: FY94 FY95 Annual 15.0 5.0 Cumulative 15.0 20.0 Economic Rate of Return: Not Applicable Map: IBRD 22982   - iv - CONTENTS 1 Background ........................................ 1 A. The Economy ..................................... 1 B. Recent Developments ................................. 1 C. The Stabilization and Transformation Program ................ 3 2 The Project ....................................... 7 A. Project Objectives ................................... 7 B. Lessons from Previous Bank/IDA Operations ....... . . . . . . . . . . 7 C. Project Description and Justification ......... . .. . . . .. . . .. . . 7 D. Rationale for IDA Involvement ........... .. . .. .. .. . .. .. . 8 E. Detailed Project Features .............. .. ... .. ... .. .. . 9 3 Project Cost, Financing and Implementation ....... . . . . . . . . . . . . 19 A. Project Cost and Financing ............. .. .. ... .. .. ... . 19 B. Project Implementation ................. ... ... .... ... . 20 C. Procurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 D. Disbursements, Accounts and Audits ........ .. . . . . .. . . . . . . 24 4 Project Benefits and Risks ............... ... ... ... ... ... . 25 A. Project Benefits .............................. .... . 25 B. Project Risks ..................................... 25 5 Agreements Reached and Recommendation ....... ........ . . . . . 27 This report is based on an appraisal mission in June/July 1993, comprising Carlos Elbirt (Task Manager), Hongjoo Hahm, Christopher Wardell and J. Chanmugam (Consultant). The peer reviewer was Paul Cadario. The Division Chief is Zafer Ecevit and the Country Director is Shahid Javed Burki.  ANNEXES Annex A. Procurement Planning Timetable ....... . . . . . . . . . . . . . . . 28 Annex B. Government of Mongolia: Statement of Economic Strategy for the Medium Term ........ . . .. . . . . . . . . . . . .. . . . 30 Annex C. Project Import Components ........ . . . . . . . . . . . . . . . . . . 42 Annex D. Stock, Import and Consumption of Lubricants ..... . . . . . . . . . 44 Annex E. Ministry of Fuel and Energy, and Ministry of Geology and Natural Resources-Terms of References ...... . . . . . . . . . . 47 TABLES iN TEXT 2.1 Consumption of Gasoline, Diesel and Lubricants .16 3.1 Estimated Project Cost ............... . . . . . ... . .. . . . 19 3.2 Project Cost by Category of Expenditure .20 3.3 Financing Plan .20 3.4 Procurement Arrangements .23  1. BACKGROUND A. THE ECONOMY 1.1 With a land area of about 1.6 million km2 and a population of only 2.2 million, Mongolia has one of the lowest population densities in the world. Moreover, the geography and infrastructure of the country make access to foreign markets difficult and costly. Since its independence 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 assistance 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), the virtual cessation of new financial assistance from the former Soviet Union, declines in export prices, and the prevailing economic distortions. 1.2 Following political reforms in early 1990, an elected coalition Government embarked on a program of economic transformation to a market economy. Mongolia expanded relations with market economies 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-sized public enterprises and shops were transferred to private owners under a privatization program using vouchers, and privatization of large public enterprises under this system was initiated. By mid-1993, 95 percent of small enterprises, over 400 large enterprises, and almost all the livestock herds are in private hands. B. RECENT DEVELOPMENTS 1.3 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 production has been constrained by shortages of intermediate goods and spare  - 2 - parts and, in the case of agriculture, also by adverse weather. Domestic investment has fallen sharply since 1990, partly reflecting a curtailment of projects financed by the former USSR. Savings have also declined because of a fall in real income, accentuated by a deterioration in the terms of trade that reflected a weakening of world prices for copper and cashmere, the country's main exports. 1.4 Inflation accelerated to over 300 percent by end-1992, reflecting liberalization of most official prices and relaxed monetary and credit policies during the first half of the year. Monetary policies have tightened since the fourth quarter of 1992. Domestic credit expanded by 52 percent and broad money by 34 percent, during that year. Efforts to shift from direct to indirect methods of monetary control and to complete the transition to a two-tiered banking system are underway. Payments clearing mechanisms were introduced in mid-1992. The Bank of Mongolia's (the Central Bank) lending rates were raised to real positive levels; reserve requirements were doubled to an average of 17 percent; minimum deposit rates were established; and credit ceilings were set on commercial bank lending to nonbanks (as a temporary mechanism). The composition of credit is shifting in favor of the private sector (from 7 percent of the total in 1990 to 48 percent at present). 1.5 The overall fiscal deficit reached about 10 percent of GDP in 1992, and was mainly financed by external resources. Current expenditures were sharply reduced in real terms during 1992, primarily through the elimination of most direct budgetary subsidies to state enterprises and through restraint in salary increases. As a result, Government expenditures declined from 64 percent of GDP in 1990 to 33 percent in 1992. Government current savings had been negative until 1991. In 1992, savings of 1.3 percent of GDP were attained. Although budgetary capital expenditures were constrained, substantial outlays were incurred on a number of large off-budget projects initiated in prior years and financed partly through external commercial borrowing. 1.6 After a sharp decline of almost 50 percent during 1990/91, exports increased by 1 1 percent in 1992. Imports fell by 17 percent in 1992 as the changes in relative prices made the country more import-efficient and, also, because the virtual cessation of new assistance from the former USSR was only partly offset by assistance from nontraditional sources. The deficit on the external current account declined from 29 percent of GDP in 1990 to 5.6 percent in 1992. Net official reserves fell from 3 weeks of imports at end- 1990 to 1.9 weeks of imports at end-1992. External payments arrears were reduced somewhat to $52 million by end-1992. Mongolia's medium- and long-term external debt in convertible currencies rose rapidly to about $340 million (87 percent of gross current account receipts) at end-1992, reflecting new commercial borrowing as well as new aid inflows. Medium- and long-term debt to the former CMEA (denominated in transferable rubles) amounts to TR 10.6 billion. This debt is presently under discussion between Mongolia and the interested parties (mainly Russia). I 1.7 There are some positive indications for the first semester of 1993. Nominal exports increased by 21 percent over the same period of 1992. Volume of exports for almost all goods ircreased showing a broad-based response to policy incentives. This  - 3 - growth in exports is most likely the result of the important progress made in the implementation of the stabilization and reform measures: exchange rate unification at the free market level, introduction of basically free interest rates, 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 investment law that allows transfers of benefits and assets, etc. Another positive development is the trend towards trade diversification: exports to G-7 countries increased from 3.7 percent of the total in 1990 to 8.7 percent in the first semester of 1993; exports to China were negligible in 1990 (0.7 percent), but now account for 25.7 percent of the total; exports to "other countries" increased from 14.8 percent of the total in 1990 to 28.6 percent in 1993. Exports to Russia, on the other hand, accounted for 37 percent of the total in 1993, down from 81 percent in 1990. The direction of imports shows the same trend. C. THE STABILIZATION AND TRANSFORMATION PROGRAM 1.8 Mongolia continues to face severe economic difficulties that reflect deep- rooted structural weaknesses, inexperience with new indirect methods of macroeconomic management, and the magnitude of the external shocks since 1990. The Government has been implementing measures to stabilize and transform the economy since 1990 (i.e., privatization, price liberalization, changes in laws and regulations, etc.). Those efforts were supported by a standby arrangement with the IMF in 1991. Performance under the standby was mixed. Progress was made in establishing 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 in June 1992 and monitored by the IMF staff. During the last quarter of 1992, the Government tightened its monetary policies, adjusted interest rates, increased fiscal revenues, controlled expenditures, introduced a new sales tax, raised administrated prices, adjusted the exchange rate, etc. Reflecting these measures, the targets of the informal program were met. Meanwhile, discussions took place between the Government and the IMF and the Bank on a Policy Framework Paper (PFP). As a result of those discussions, a PFP was agreed in June 1993. An IMF Enhanced Structural Adjustment Facility (ESAF) was also approved in June 1991. This report includes the Government's Statement of Economic Strategy for the Medium Term (Annex B). 1.9 The main macroeconomic objectives of the Government articulated 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 will aim at financing the budget deficit from external sources. Expansion in domestic credit is being restrained to a level consistent with inflation and external objectives. The Bank of Mongolia is taking steps to improve the monitoring of monetary developments and the supervision of commercial banks. Interest rates are basically free. Key structural reforms include: further privatization, supported by measures to improve the legal and regulatory framework and measures to strengthen corporate governance; the completion of the process of price liberalization; and the  - 4 - removal of remaining restrictions on production and trade associated with the old system of state orders and rationing. Finally, improvements in public resource allocation are in progress: investment expenditures are now subject to more critical scrutiny; several large (and possibly uneconomic) projects are to be reassessed; and a rolling three-year public investment program is under preparation. 1.10 The authorities' principal objectives over the next 18 months are: to hold the decline in real output below 2 percent in 1993, with a recovery of 2.5 percent in 1994; to reduce inflation to about 50 percent in 1994; to eliminate external arrears and build up net international reserves to $21.5 million (equivalent to 2.5 weeks of imports) by end-June 1994. Specific targets and policy actions have been agreed as part of the PFP and ESAF. A prominent one is the adoption of a unified floating exchange rate system which took place in May 1993. 1.11 As noted before, there is some evidence that reform measures are having some positive impact on export growth. They should also contribute to a positive supply response in agriculture/livestock. The service sector is already showing good potential for gains in private employment in areas such as tourism, external and internal trade, business and professional services, and distribution. Some export-oriented industries (i.e., garments) and small, import-substituting consumer goods industries initiated with private capital have began contributing to growth. However, output of many traditional industries is expected to remain stagnant or decline as a more rational price structure and hard budget constraints force nonviable entities to close and other entities to undergo rehabilitation and restructuring. More foreign investment is expected with the enactment in July 1993 of a revised foreign investment law that aims at reducing existing impediments to investment, clarifying legal ambiguities, and streamlining approval procedures. Declines in the price of copper have been hurting Mongolia's balance of payments position. Improvements in the balance of payments will depend, to a large extent, on the development of an efficient and more diversified export sector. Growth in noncopper exports, including those of cashmere, textiles, leather products, and meat and meat products will greatly depend on the continuation of an appropriate exchange rate policy, the removal of restrictions on private trading, and increased investment in infrastructure. 1.12 The Government's program also addresses crucial sectoral policies. They include: (a) Agriculture/livestock. Most state farms dedicated to cultivation have been divided into smaller private plots through privatization and land leasing. Modalities for ownership and transfer of land will be determined with the passage of the land law. As part of the first phase of privatization, equipment and buildings have been made available to the private sector through leasing or purchase. Procurement prices for agricultural products, held at inadequate levels for some time, were liberalized in 1992. (b) Industry. The Government is establishing hard budget constraints on state enterprises through the removal of remaining indirect subsidies, the phased  - 5 - elimination of directed bank credit, and requirements that state enterprises pay market-determined prices for imported inputs. The Government will begin this year to identify and close down state enterprises that cannot be restructured into viable units in the new market environment. (c) Energy. For the coal-based power plants, priority has been given to increasing coal supply and production in the mines through donor-financed technical assistance and imports of new equipment needed for mining and coal transport. Further upstream, a system of energy audits of major enterprises to identify additional methods of conserving energy is being developed, for introduction in 1994. As the more urgent sectoral problems are overcome, the Government intends to produce a comprehensive energy assessment, including the development of an integrated tariff structure. (d) Minerals. A new mining law, drafted under the IDA-financed Technical Assistance Credit (Credit 2321-MOG), is being considered by Parliament. The law aims at improving the environment for domestic and external investment. The Government is formulating a plan to address long-term technical, management, and environmental problems in the copper sector, supported by technical and operational assistance provided under this project. (e) Transport. There is a rapid increase in private transportation. Privatization of some Government-owned transport corporations will be considered. Agreement has been reached to secure access to the port of Tianjin in China. However, difference in gauges and lack of empty wagons in China for the predominantly north-south traffic are the chief reasons for delays and congestions at the border with China. There are air links only with China, Russia and, more limited, Kazakhstan. Negotiations have been initiated to establish air links with other countries in the region. A Road Master Plan is being developed with assistance from the ADB. (f) Enviromnental Issues. The Government is preparing a country-wide Environmental Action Plan (EAP) for submission to IDA in early 1994. The EAP will focus on measures to: protect the environment from the negative aspects of mining; combat soil erosion; and reduce air and water pollution in urban areas. To maintain and protect pasture lands, the Government intends to restore exhausted areas through the growth of protective vegetation, reintroducing more traditional forms of livestock breeding, and restricting the expansion of crop cultivation on fragile pasture land. A rangeland management study to be initiated this year will address these environmental issues. With external assistance, efforts are also underway to foster improved use of forestry resources through the promotion of reforestation and better forestry management. To reduce air pollution, "scrubbers" will be installed in coal-fired electricity plants by end- 1993.  - 6 - (g) Social and Human Resources. 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 transfer the equivalent of five months' salary of dismissed workers to the Social Security System, which in turn uses these funds to pay modest unemployment benefits and to provide job information, job training, and job creation services. 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. Some nongovernmental organizations, for example the Mongolian Red Cross, contribute to relief work.  -7- 2. THE PROJECT A. PROJECT OBJECTIVES 2.1 The Project's principal objective is to finance imports and technical assistance urgently needed by Mongolia in order to maintain and develop key sectors of its economy. Specifically, the Project will finance the import of equipment, materials, spare parts and other inputs needed in coal and copper mining and the transport sector during the next 12 to 18 months. The goods and services to be financed under the Project have been selected from a list of critical imports prepared by the user agencies concerned. The Project's scope and content have been designed to take into account assistance planned, or already underway, by other bilateral and multilateral agencies, in particular the Asian Development Bank (AsDB), German Development Agency (KfW), Overseas Economic Corporation Fund (OECF) and the United States Agency for International Development (USAID). The Project includes technical and operational assistance to the coal and copper sectors that is critical to their long term viability. B. LESSONS FROM PREvIOuS BANK/IDA OPERATIONS 2.2 The proposed project draws and builds on the experience gained through the Economic Rehabilitation Credit (ERC) which also financed critical imports (equipment, materials, spare parts, and vehicles) needed for the key agriculture, energy (electric power, coal mining and petroleum products), and transport sectors. Experience under the ERC, approved in December 1991 and now almost fully disbursed, confirmed the utility of the short-term technical assistance provided to facilitate international competitive bidding, the advantages of a well-prepared procurement plan and monitoring system, and the need to ensure that local currency counterpart funds for project-financed goods and services are paid by user agencies when the goods and/or services are received. Another important lesson was that timely implementation of technical assistance is crucial to secure the expected positive impact of some components (i.e., coal and copper). C. PROJECT DESCRIPTION AND JUSTIFICATION 2.3 The proposed Project would finance: (a) equipment, materials and spare parts for the Baga Nuur and Sharyn Gol coal mines, which together account for two thirds of Mongolia's coal output; technical assistance required to undertake (i) a coal pricing study; and operational assistance needed to enhance (ii) coal sectoral planning and mine management and operating practices;  - 8 - (b) materials and spare parts for the Erdenet copper mine; and technical assistance for (i) metallurgical testing to improve Erdenet's copper grades; (ii) modernization of Erdenet's cost and financial accounting systems; and (iii) a review of the environmental aspects of Erdenet's operations; (c) materials, spare parts and maintenance and servicing of locomotives for the Mongolia Railways; (d) gasoline dispensing pumps for the Mongolian Petroleum Import Concern to reduce leakages and waste of petroleum products, mitigating environmental hazards in the domestic distribution system; and (e) lubricants for agricultural and transport machinery to meet Mongolia's import requirements in this area and to improve the productivity of the machinery involved. 2.4 Financed items are regarded as very important for resuming economic growth. User agencies will receive imported equipment, materials and spare parts against payment in local currency (Tugriks) of their c.i.f. cost at the prevailing unified, free market exchange rate. These payment arrangements will also apply to the technical assistance. Tugrik funds to pay for the imports, technical assistance and local costs will derive from three sources: from the beneficiary agency's own resources, from the use of domestic credit, and/or from state budgetary allocations. End-users would be required to pay for the import of goods at the time they are cleared by customs and for the services when they are paid for by IDA. The unified interbank floating exchange rate would be applicable. Assurances on these arrangements were obtainedfrom the Government during negotiations. D. RATIONALE FOR IDA INVOLVEMENT 2.5 With the approval of the IMF ESAF, and the related PFP in late June, the rationale for IDA involvement in the proposed project is as follows. First, the ESAF program assumes a continuing flow of quick-disbursing concessional resources required to restore and improve the efficiency of Mongolia's economic and social infrastructure. Such resources are also needed to expedite timely implementation of the authorities' structural reform efforts, while preparation of the medium and longer-term sectoral strategies (including priority development projects) provided for in the PFP is underway. Second, IDA involvement through this project would help Mongolia finance its overall balance of payment requirements for 1993-95 which include the goods and services under this proposed project. The PFP identified the overall financing requirements for 1993-96, amounting to $226 million for 1993, $203 million for 1994, $170 million for 1995 and $155 million for 1996. Most of the financing sources for 1993 and 1994 have been already identified. Third, IDA involvement, together with that of AsDB, is expected to catalyze similar assistance to Mongolia from several bilateral agencies, as manifested during the third Mongolia Assistance Group meeting, co-chaired by the Bank and the Government of Japan, held in Tokyo in September of this year.  - 9 - E. DETAILED PROJECT FEATURES 2.6 The proposed project would finance the essential import requirements in the coal, copper, and transport sectors (Annex C). In addition, the project would finance the installation of new petroleum dispensing pumps as well as the import of high-speed lubricants for use in agricultural and transport machinery. A brief summary of the concerned sectors and details of the items to be financed are given below. Coal ($5.0 million IDA financing) 2.7 Coal accounts for almost all the primary energy production in Mongolia, providing the fuel for power plants in Ulaanbaatar, Darhan, Dornod and Erdenet, and for industrial and domestic use. The key Baga Nuur and Sharyn Gol coal mines (capacity 4.0 and 1.5 million tons of coal per year) continue to provide approximately 70 percent of total coal production. 2.8 With the IDA-financed Economic Rehabilitation Project (Credit 2320-MOG) approved in December 1991, and with support from other donors (Japan, USA) over the 1991-93 period, fleets of mining equipment (dump trucks, bulldozers etc), spare parts and consumables have been supplied to the Mongolia coal industry, primarily to Baga Nuur and Sharyn Gol. An additional $2 million is currently being used from unallocated Credit proceeds to procure additional critical needs (dump trucks and related spare parts). The objective of the combined donor support is to increase production to about 7.0-7.5 million tons of coal per year, thus securing a reliable supply of coal to power plants and other consumers (production in 1992 was about 6.0 million tons). In the past, sizeable amounts of donor assistance were provided for the coal sector. This assistance helped the country to avoid an even sharper decline in production but did not solve some managerial and technical issues. These technical and managerial issues are addressed by present USAID assistance and would also be addressed in this Project (in the T.A. component, para. 2.2). 2.9 Overburden materials continue to increase in the coal mines. This reduces the quantity of coal exposed for excavation and, therefore, the coal production. In addition, continued financial problems in Mongolia have prevented the Government from mobilizing sufficient funds to import all required items. Furthermore, difficulties are continuing to be faced in acquiring adequate spare parts (excavators and dump trucks) and consumables (fuels, lubricants and explosives) from original suppliers in the former Soviet Union. A Coal Workshop held in April 1993 in Mongolia reviewed key issues in the industry based on studies financed by USAID and IDA. The workshop, in which Bank staff actively participated, identified management (operations and maintenance) deficiencies that contribute to the continuing poor performance of the coal mines. 2.10 The Government is making good progress in addressing coal pricing issues. Following the latest increase in July 1993, prices are now in the range Tugrik 3,000-3,800 ($7.5-9.5) per ton coal. This represents a cumulative increase of 300-400 percent in relation to mid-1991 coal prices, after adjustment for local currency devaluation and inflation (it should be noted, however, that coal transport is still substantially subsidized).  - 10 - It is estimated that coal prices now represent over 50 percent of long-run marginal costs and the Government appears committed to further price increases. Agreement was reached with the Government during negotiations that, until the coal pricing study planned under the proposed credit is completed in mid-1994, coal prices will continue to be increased, at least on a quarterly basis, to keep pace with inflation, using the estimates of CPI produced by the State Statistical Office. 2.11 Import Needs. The Ministry of Fuel and Energy has developed a list of critical equipment, spares and consumables to operate through 1993 and particularly the severe 1993/94 winter months. This list, which amounts to about $11 million, remains relatively large, but its financing is considered to be realistic. It provided the basis for the identification of possible IDA financing under this Project. The identified financing would be as follows: USAID, $3.5 million; Government funds, $3.0 million; and IDA-METS, $5.0 million. This Project would finance, specifically: (a) graders, loaders and bulldozers ($2.6 million); (b) mine vehicles, explosive trucks, and tire trucks ($0.5 million); (c) excavator, dump truck and bulldozer spare parts ($0.9 million); and (d) critical technical assistance ($1.0 million). 2.12 Under the technical assistance component of the proposed credit, operations assistance (35-40 man-months) would be provided to the mines' management at Baga Nuur and at Sharyn Gol to upgrade mine management, operating and maintenance practices. Coal mines' efficiencies (equipment and labor productivity) would be improved and mine production costs reduced. This operations assistance, together with equipment, spares and consumable procurement under the METS credit and the USAID program, is expected to secure a sizeable production increase in 1994. A coal pricing study would be undertaken (estimated 3-4 man-months) to develop options for a rational and economically efficient coal pricing mechanism. This study should be completed by June 30, 1994. Afterwards, its results and recommendations would be discussed with IDA; steps would be taken for their implementation. Assurances regarding the implementation of the study were received from the Government during negotiations. Terms of reference for the operations assistance and coal pricing study were agreed with the government during appraisal-and ratified during negotiations-and are included in Annex E. A proposal for the operations assistance will be solicited by the government on a sole-source basis. A shortlist of consultants for the proposed coal pricing study has been submitted and agreed with the government. 2.13 Benefits. The component would help restore the production capacity of the key Baga Nuur and Sharyn Gol mines and thus provide for a reliable source of coal supply to the power, industry and domestic subsectors. With additional financing for extensive spare parts and consumables from USAID and auxiliary mine equipment and important mine vehicles from the proposed IDA credit, supported by critical operations assistance under the technical assistance component of the credit, improvement of the performance of the coal subsector would be obtained. The coal pricing study component of the credit would provide the technical basis for formulating appropriate policy decisions on coal pricing. This, in turn, would enable the coal sector to develop a financially stable and  - 11 - healthy base from which to provide for equipment-and capital needs in general-in the coming years, thereby reducing the need for donor assistance. Copper ($5.0 million IDA financing) 2.14 The mining sector in Mongolia is dominated by the Erdenet copper mining and processing operation, which generates about $200 million annually in foreign exchange earnings. The mine and concentrator were developed in 1978 on a 51/49 percent joint venture basis between the Mongolian Government and the former Soviet Union (now the Russian Federation) government, and have been in full production operation for 10 years. The open-pit mine produces 20 million tons per year of copper porphyry ore (0.75-0.80 percent copper) which is processed (by traditional crushing, grinding and flotation) into copper concentrates (30-35 percent copper) which are then exported. Molybdenum concentrates are produced as a minor by-product and exported also. Ore grades are forecast to deteriorate down to 0.5 percent copper (see below) and thus, ore production is planned to be expanded to 25 million tons per year and further, at a later date. Present proved ore reserves are sufficient for operations well into the 21st century and probable reserves suggest a mine life of 50-60 years. 2.15 Historically, Erdenet has produced and exported consistently some 340- 350,000 tons copper concentrates per year, representing about 110,000 tons of contained copper metal. In 1991, production of copper concentrates dropped markedly to 275,000 tons concentrates due to serious interruptions in the power supply from the Mongolian Central Electricity System (CES) grid. In addition and following the cessation of technical and economic assistance from the former Soviet Union, Erdenet has faced difficulties in procuring needed equipment replacements, spare parts and consumables from the Russian Federation and CIS, all of which are necessary to maintain operation of the mine and copper concentration facilities. In 1992, copper concentrate production recovered some 10 percent to a little over 300,000 tons. There are concerns about the predictability of regular power supply and the availability of equipment, spares and consumables. 2.16 Copper ore is mined at the Erdenet open-pit. The concentrator plant is of Russian origin and although equipment component specifications are not comparable to western equivalents, it appears to be close to 1970s international technology. The concentrates are transported directly by rail to international copper smelters, primarily in Kazakhstan and Japan, and to China. Sales of the concentrates are on the basis of FOB border international prices, denominated on a US dollar basis. However, much of the sale of copper concentrates remains on a barter basis with the Russian Federation, with respective commodity movements being balanced with reference to international-dollar denominated prices. Payment problems seem to continue and Erdenet is still not totally free from periodic cash flow difficulties. 2.17 Production costs at the Erdenet operation are difficult to analyze due to the company's cost and financial accounting systems which are still based on the old Soviet accounting system. Production costs appear higher than those in North and South American and Pacific operations due to the higher cost of grinding the very hard Erdenet  - 12 - ore. However, this is somewhat offset by the higher grade of the concentrates produced in Mongolia. Cash flow and profitability are not defined on any basis that can be easily interpreted but annual profits appear to be positive. At present international prices, the operation appears to be competitive with other international copper producers. 2.18 Under the Technical Assistance Project, IDA-financed consultants undertook a detailed review of the minerals sector in Mongolia, focusing on the Erdenet operation. Three key issues were defined. First, from a technical/operations viewpoint, it has been identified that the grade of copper concentrates produced has declined from the original (start-up) level of 35 percent to 29 percent in 1992 and is forecast to decline further to 21 percent over the next 5-10 years. This is a very serious issue, not only because of its impact on the overall economy and on the revenues of the Erdenet Corporation, but because international smelters would not be prepared to purchase for processing concentrates containing such low concentrate grades. The problem of deteriorating grades is due to increasing difficulty in depressing insolubles (impurities) in the ore feed. This is not an uncommon problem in processing copper porphyry ores worldwide and would normally be solved by metallurgical testing to identify depressants that could be introduced at the flotation stage to elevate copper yields. Second, cost and financial accounting systems are poorly developed. Not only does this interfere with production cost and profitability analysis, but it has not permitted a meaningful management information system (MIS) to be developed. As a result, Erdenet management is not in a position to identify accurately its competitiveness in the international market place and to prepare a business plan accordingly. Third, environmental protection falls short of international guidelines in a number of areas. Water and air pollution are not closely monitored and controlled, and of particular concern to the health of workers and livestock are the airborne particles from tailings pond beaches which may contain harmful metal content. Reservations have also been raised regarding the long-term stability of the 60 meter tailings pond dam, particularly in connection with the proposal to progressively increase the dam height to 92 meters. Erdenet is recognized as an area with historical seismic activity and it remains unclear whether the original dam construction took account of this factor. Any failure of the dam would have very serious consequences to the downstream town site. 2.19 Import Needs. Erdenet requires annually some $95-100 million imports of replacement equipment, spare parts and consumables to support its mining and copper processing operation. A list of critical import needs has been identified. Erdenet recognizes the need to diversify its equipment and spare parts procurement sources. Recognizing the importance of the Erdenet operation to the overall economy and the periodic cash flow constraints facing the company, items suitable for IDA-financing, totalling $4.1 million, have been identified. These include: (a) dump trucks for $1.8 million; (b) front-end loaders for $0.65 million; and (c) bulldozers for $1.7 million. Procurement of this equipment would proceed under international competitive bidding and would provide an opportunity for Erdenet to initiate the introduction of equipment with highly efficient technology. 2.20 Under the technical assistance component of the proposed credit, arrangements would be made for international experts to assist to (a) undertake and  - 13 - supervise a metallurgical testing program to identify options to preserve copper concentrate grades and recovery and to assist Erdenet to implement the test program findings and recommendations; (b) upgrade cost and financial accounting systems that can provide good assessments concerning cash flow, profitability and liquidity of Erdenet. Similarly, assistance would be provided for upgrading the management information systems; and (c) undertake an assessment of environmental degradation resulting from the mining and copper processing operation and develop and assist to implement, specific measures to ensure that the production operates within international environmental guidelines. Terms of reference for these technical assistance components have been agreed with Erdenet management and the Ministry of Geology and Natural Resources during appraisal and are included in Annex E. A proposal for the expert services for the metallurgical test program will be solicited by government on a sole source basis. Short lists of consultants for the other areas of technical assistance have been submitted by government and agreed during appraisal. 2.21 Recognizing the need to modernize and rehabilitate the Erdenet operation, aid is being provided currently by the Japan International Cooperation Agency (JICA), which is financing an 18-month study program to review existing technical, operational, financial and general business management arrangements at Erdenet. The Erdenet component of the proposed credit would complement the JICA initiative, focusing on critical imports and on key areas of required technical assistance. 2.22 Benerits. The component would initiate the introduction of high-efficiency mobile mining equipment to the Erdenet operation, diversifying supplier sources and reducing dependency on equipment and spare parts that have become difficult to obtain and to service. The familiarization of the company with International Competitive Bidding procedures should be considered an important side-benefit. Reliability of the copper mining operation should be increased and, concomitantly, production costs decreased. The technical assistance component would help to ensure that: copper concentrate grade and recovery is maximized; modern cost, financial, and management information systems are introduced; and Erdenet develops action plans to ensure that the mine and processing facilities operate within environmentally acceptable guidelines. Discussions regarding the corporatization and the possible privatization of Erdenet have been initiated, and the credit will permit the Association to maintain a dialogue with Erdenet and government on this important corporate development program. Rail Transport ($5.0 million IDA financing) 2.23 The Mongolian rail system reflects the evolution of the economy over the past seventy years and its overwhelming dependence on trade with the former Soviet Union. A railway line built after the Second World War south from the trans-Siberian line, initially to Ulaanbaatar and later to the Chinese border, provides Mongolia's main connection with the outside world. Mongolia serves as an important transit corridor for traffic between Russia and China through its main north-south section. The Mongolian track width is the same as the Russian (1,524 mm), as against the international standard gauge width (1,435 mm) that is used also in China. The gauge difference and the lack of  - 14 - wagons in China for the predominantly north-south traffic create delays and congestions of freight and passenger traffic at the border with China. Mongolian Railways (MR) is a joint venture between Russia and Mongolia. It services the Russia-China corridor and provides direct rail access to Ulaanbataar, Darhan, and Erdenet. MR has a rolling stock of 111 diesel locomotives (Russian), 227 coaches (East German), and 1,736 wagons (Russian). All of Mongolian Railways' equipment, including servicing and repairs of engines and rolling stock, require support from the Russian system. Originally, full support from Russia was inexpensive and readily available. But, now, payments are required in convertible currency. This makes servicing of locomotives and purchase of spare parts difficult for MR. Around 50 percent of the locomotives are nonoperational due to lack of spare parts and overhaul. A sizeable part of the coaches and wagons are also nonoperational for lack of spares and timely repair. All these reduce the efficiency and long-term viability of the railways. 2.24 During the last two years, there has been a significant drop in rail traffic, both freight and passenger. A large proportion of the freight is domestic (around 50 percent). The freight and passengers carried by MR are well below capacity and revenue levels necessary to sustain regular, reliable service. They are contributors to the weak financial position of MR. 2.25 Recent shifts in freight traffic patterns have resulted in a serious drop in railway traffic and revenue for MR, making regular maintenance of critical rolling stock and rails even more difficult. MR carries almost all the coal from the mines to the thermal power plants and this accounts for almost half the freight ton/km in freight traffic. While traffic patterns have shifted with decreased freight transport, coal freight demand is increasing (current demand for 1,020 freight cars surpasses the 990 cars available for coal transport). Coal transport demand is forecasted to increase substantially. 2.26 While the capacity of the railway system is adequate, maintenance of tracks and rolling stock has become a serious problem. The government of Japan is providing assistance to address some of the issues affecting MR. Allocation of funds from this Project would be coordinated with the Japanese assistance, to avoid duplication and to ensure complementarity. 2.27 IDA is preparing a transport sector rehabilitation project. The railways component would provide assistance to address the medium-term issues faced by MR. Since it will take some time for both the IDA and Japanese projects to materialize, certain priority spare parts and servicing requirements of MR have been identified for IDA to provide advance financing under the METS project. 2.28 Import Needs. MR has a fleet of 111 diesel locomotives of four different Russian designs. The backbone of the fleet is the 64 4,000 hp locomotives, of which more than half are nonoperational at this time for lack of spare parts and maintenance. Shortages of foreign exchange have resulted in a backlog of replacements of fatigued and worn out parts and a backlog of locomotives to be sent to Russia for a major overhaul. Periodic overhauls are necessary, but they have not been observed. As a result, there has  - 15 - been an increase in operational failures of locomotives, and deterioration in overall performance. A similar problem affects the freight and passenger cars. In addition, some rail tracks need prompt replacement due to wear and tear. Through Japanese grant financing, MR was able to acquire, via UNDP/OPS procurement, 2,450 tons of R-50 rails (Russian standard), but for reasons unclear, the associated track accessories (e.g., base plates, fish plates, washers, insulating butts, nuts, bolts, and washers) were left out inadvertently. These accessories are essential to lay the new tracks. 2.29 Maintenance of tracks and rolling stock is a major problem. The list of items for possible financing under the METS Project thus consists of $4 million for critical spare parts and other maintenance needs, and $1 million for railways accessories such as spikes and fishplates. Specifically, the METS project would finance: (a) spare parts for locomotives ($1.45 million); (b) spare parts for freight and passenger wagons ($0.88 million); (c) overhaul of locomotives ($1.55 million); (d) overhaul of wheel sets ($0.12 million); and (e) rail track accessories ($1.00 million). Most of these material/services are manufactured in the CIS and accessible through the same rail system. Therefore, direct purchases for about $4.5 million would be procured. 2.30 Benefits. This component would help to reduce the backlog in servicing locomotives and in availability of spare parts. This, in turn, would allow MR to prevent further decline in capital utilization and to improve efficiency, positively affecting the earnings of the company. The impact of improved railways services on the transport of coal could also be very important for improving the energy situation of Mongolia. This credit component would be in anticipation of the transportation project which would address the medium term issues of MR. Petroleum Products/Lubricants ($2.0 million IDA financing) 2.31 Traditionally, all petroleum products requirements of Mongolia were met by imports from the former USSR. The dislocations in Mongolia's external trade with the former Soviet Union since late 1990 have, in particular, affected the flow of petroleum products severely. The annual consumption of gasoline and diesel oil declined from a high of 685,000 tons in 1988 to about 391,000 tons in 1992. The fall in consumption has been attributed to, on the demand side, decreases in military/govemment requirements, slowdown in the economy, and shortages in foreign exchange to finance the petroleum products imports. Increased energy efficiency resulting from shortages and more realistic prices is also responsible for the decline in gasoline consumption. On the supply side, the inability of CIS countries to deliver agreed quantities of petroleum products also contributed to the reduced consumption. Lubricants of all kinds, totalling 25,600 tons in 1988, and 9,960 tons in 1992, were consumed for use in agriculture, aviation, industry, mining and transport. Table 2.1 shows the steady decline in gasoline, diesel oil and lubricants consumption since 1988. 2.32 Russia has already indicated that, owing to production constraints, they are no longer able to supply Mongolia's minimum annual requirements for lubricants of various types. In response, the Petroleum Import Concern (PIC) has been attempting to  - 16 - Table 2.1: CONSUMPTION OF GASOLINE, DIESEL AND LUBRICANTS (in metric tons) 1988 1989 1990 1991 1992 Gasoline 343,567 336,560 315,721 237,918 178,799 Diesel oils 341,323 335,695 322,638 282,022 212,127 Lubricants 25,600 26,500 23,000 15,100 9,960 Source: Petroleum Import Concern. procure vital lubricants from other sources since early 1991. These attempts have been constrained by a lack of foreign exchange on the part of PIC. Using $2 million of IDA funds (from the previous Economic Rehabilitation Project, Credit 2320-MOG), $4.4 million in Japanese grant assistance, and $2.8 million of PIC's own money, Mongolia was able to import about 11,200 tons of lubricants in 1992. In 1990, 1991 and again in 1993, PIC has been using the government's reserve stock of lubricants to satisfy domestic demand. Annex D shows the stock, import and consumption of lubricants, by types, during 1990-92. 2.33 Import Needs. The demand for lubricants in 1993 (i.e., during the next six months) and first half of 1994, is estimated to cost over $10 million. Of that amount, almost $3 million will be required for high speed lubricants. Good quality, high speed lubricants should be available at all times since they improve the efficiency of the machinery. The UK has provided some funds for lubricants imports. 2.34 The high level of lubricants consumption, especially diesel lubricants (i.e., engine grease), is attributable to the use of obsolete and inefficient industrial equipment and vehicles. There has been an increase in the number of new imported machinery especially from Japan and western countries. This machinery requires "high speed" lubricants. Therefore, the demand for "high speed" lubricants is increasing. 2.35 Benefits. The project will finance $2 million of high speed lubricants. The use of imported (advanced standards) lubricants will increase the productivity of the machinery concerned. This was the case with lubricants imported under the Economic Rehabilitation Credit: interviews and data suggest that turbines and engines using imported, advanced lubricants have increased efficiency and productivity. The demonstration effect of the improved lubricants has been enormous, and partially as a result, request for additional lubricants imports was made by the Mongolian authorities. PIC passes through cost increases in gasoline and lubricants to the consumers. Assurances were obtained from the government during negotiations that this policy would continue.  - 17 - In this regard, a formula to adjust domestic prices of gasoline and lubricants to reflect international prices and exchange rates was agreed during negotiations. Petroleum Pumps ($1.0 million IDA financing) 2.36 Mongolia has traditionally relied on Russian petroleum products imported under barter arrangements in exchange for copper and molybdenum concentrates. Although the barter deal system was officially eliminated in 1992, most petroleum contracts continue on a barter basis. The Angarsk and Achinsk Russian refineries provide most of the supply of petroleum products, which are delivered via rail and/or road tankers to Mongolia's main import depots. In the northwest, road tankers supply Ulaangom and Tsagaanuur. In the northeast, rail transport reaches Choibalsan. Other import depots such as Ulaanbaatar, Darhan, and Erdenet are fed by railway from Angarsk via Sukhbaatar. 2.37 Each import depot controls a geographical area based on consumption and population distribution in order to minimize import and transportation costs. A depot's operating area typically overlaps aimak (local government) boundaries (there are 17 depots). Road tankers (50 m' unit capacity each) are used for distribution to the pumping stations within each jurisdiction. 2.38 Excess capacity was particularly evident at Baruunharaa and Hentii import depots where some stations are used infrequently. However, they were operated in that fashion because of the policy that each aimak capital should have its own pumping station. Excess capacity also exists in Dornogobi, Bayanhongor, and Gobi-Altay located in the south where pumping stations were constructed for then existing military functions. Seasonal fluctuations also result in excess capacity, particularly in the agricultural regions during the nonsummer months. Some aimaks, serving remote hilly areas, maintain extra pumping stations with minimal velocity for supply safety reasons in the winter months. 2.39 While some pumping stations are underused, other are heavily used, some doubling as fuel stations for trains en route to Russia. In terms of industrial production, Darhan depot's three pumping stations carry heavy volume, but a lack of capacity at Darhan's import depot has forced authorities to use Darhan's three pumping stations as secondary depots/holding facilities. Ulaanbaatar depot's stations are critical since it also supplies the broad area surrounding the capital. 2.40 Each pumping station currently uses outdated pumps of 1950s Russian design that are extremely worn down. The pump nozzles are connected to the pump hoses by steel wires and consequently have significant leakages. Further, the gauges at the pumping stations are obsolete, making precise measurement of petroleum use problematic. Consequently, fraud by pump station attendants is said to be common. Annex D shows the level of consumption at each pumping station, calculated on the basis of petroleum products delivered to each station, and the level of waste at each station that includes leakages from the outdated pumps as well as for alleged siphoning of petroleum products by station attendants. The underground petroleum tanks at most stations, installed and/or replaced in the 1970s, appear to satisfy environmental concerns with minimal leakages.  - 18 - 2.41 Import Needs. The Mongolian Petroleum Import Concern has developed a list of high volume pumping stations that require urgent pump replacement. Out of 300 existing pumps, 113 pumps are at stations where consumption exceeded the 1992 average of 2,136 m3. Some 63 additional pumps, of which 15 are part of the 113 mentioned before, are not included in the list of replaceable pumps because their utilization is not intensive: pumps which were mostly used in the past for military purposes, or only during the agricultural season, etc. This information as well as data on the volume carried by each pumping station helps the Government determine which pumping stations are critical enough to justify new pumps. Consequently, the Petroleum Import Concern has identified 96 pumps that need replacement. At an approximate cost of $10,000 per pump, financing of about $1 million would be required. The Petroleum Import Concern would bear the cost of installing the new pumps. 2.42 Benefits. By replacing 96 pumps, this component would help reduce some 921 tons of waste (see Annex D). Further, by eliminating leakages, this component would reduce the adverse environmental effects of petroleum evaporation into the air and on the ground, while mitigating safety hazards to consumers and station attendants alike. In this regard, the Ministry of Environment will be actively involved in supervising the installation of the new pumps with periodic checks to ensure adherence to government environmental standards and to conduct environmental waste impact assessments in conjunction with PIC. The new pumps will also have precise measuring gauges that would substantially reduce the possibility of siphoning petroleum products by petroleum station attendants. This will have a positive impact on the finances of the company.  - 19 - 3. PROJECT COST, FINANCING AND IMPLEMENTATION A. PROJECT COST AND FINANCING 3.1 The project has an estimated total cost of $25.4 million equivalent, of which $20.0 million would be in foreign exchange. Foreign costs are based on international procurement prices, recent prices in other Asian countries and the historic cost for goods bought in the former Soviet Union under barter arrangements (prices are estimated at June Table 3.1: ESTIMATED PROJECT COST ($ million) Local Foreign Total Goods Coal 1.2 4.0 5.2 Copper 1.2 4.1 5.3 Railways 1.3 5.0 6.3 Lubricants 0.6 2.0 2.6 Gasoline/diesel pumps 0.5 1.0 1.5 Total Goods 4.8 16.1 20.9 Technical Assistance Coal - 1.0 1.0 Copper 0.9 0.9 Total T.A. 1.9 1.9 Contingencies 0.6 2.0 2.6 Total 5.4 20.0 25.4 1993 levels). Local costs include: expenditures on domestic transportation and storage of the imported goods, installation costs (in the case of the gasoline pumps), and import duties of 15 percent. The cost of consultants' advisory services are based on typical current costs for such assignments. Contracts for all imported items are expected to be signed during the next six months. About $2 million of the credit is unallocated to allow  - 20 - for contingencies on foreign costs, including transport cost overruns, and in the event of cost overruns in any particular category, quantities would be adjusted accordingly. International inflation would be covered by the unallocated amount. Table 3.2: PROJECT COST BY CATEGORY OF EXPENDrrURE ($ million) Local Foreign Total Imported goods plus freight and duties 4.8 16.1 20.9 Consultant services 0.0 1.9 1.9 Other local cost/unallocated 0.6 2.0 2.6 Total 5.4 20.0 25.4 3.2 Local costs of this project would amount to $5.4 million. Most of this amount is the duties (15 percent plus, in some cases, an additional 10 percent of sales tax) and domestic freight for transporting the goods. Foreign costs would amount to $20.0 million; that would include the import of goods, consultant services and unallocated amounts to be financed under the IDA credit. 3.3 The proposed IDA credit would be made to Mongolia on standard IDA terms. End-users would advance the local currency equivalent of imported equipment, specialized vehicles, spare parts, materials, petroleum products, and technical services. Table 3.3: FINANCING PLAN Local Foreign Total IDA - 20.0 20.0 End-users 5.4 - 5.4 Total 5.4 20.0 25.4 B. PROJECT IMPLEMENTATION 3.4 The Ministry of Finance would have overall implementation responsibilities for the project. Procurement/disbursement matters for goods would be handled by the Ministry of Trade and Industry (MTI). MTI's performance during implementation of the Economic Rehabilitation Credit, now almost completely disbursed, was satisfactory and  - 21 - its project unit and staff are still in place. The technical assistance components of the project would be handled by each user agency, in coordination with the line ministry and IDA. 3.5 Since this project would finance critically needed imports, and would contribute to the success of the stabilization and reform program under implementation, agreement was reached during appraisal on advancing procurement so as to expedite disbursements once the credit is approved and effective. Consequently, an understanding was reached during appraisal on starting, immediately, the process of International Competitive Bidding (ICB), Limited International Bidding (LIB), and Direct Purchases (DP). Moreover, the Government decided to use proceeds from the IDA-TAC to finance the services of an agency to assist the Government in the preparation of the documentation leading to the selection of the companies from which goods will be procured. This assistance will include the training of local personnel from MTI and the participating end- user agencies, on procurement procedures and policies. 3.6 The overall impact of the project will depend, particularly for the copper and coal components, on the effective implementation of the TA components. For this reason, the selection of consultants is already advanced. 3.7 The Ministry of Environment will inspect the replacement of the gasoline pumps to make sure that the work is done properly. The Ministry of Environment would be kept informed on the studies pertaining to the tailing pond and the dam stability (at Erdenet). C. PROCUREMENT 3.8 All goods and services will be procured in accordance with IDA Procurement Guidelines. All new equipment items were grouped according to their characteristics into five bid packages. Three procurement modes were selected after careful scrutiny of the requirements and taking into account the best interests of the project: Four of the bid packages were considered appropriate for purchase by international competitive bidding (ICB), for approximately $12.2 million or 61 percent of the credit. * The fifth bid package involves highly specialized equipment under small contracts, most efficiently purchased using limited international bidding (LIB) procedures, for $0.5 million or 2.5 percent of the total. * All the remaining goods to be purchased under the project are urgently needed spare parts for existing equipment manufactured in the CIS and for major overhaul of locomotives and wheel sets by CIS contractors (readily accessible through the same rail system) specialized in this sort of work. Since there is no other practical alternative, these spare parts would be  - 22 - purchased directly from the CIS vendors of the original equipment. Similarly, sole source contracting for the overhaul work of the locomotives would be followed. Goods and services to be purchased directly amount to about $5.4 million, or 27 percent of the credit. 3.9 The ICB package includes: graders, front-end loaders, bulldozers, wheel dozers, explosives, high-speed lubricants, rail track accessories, and fuel dispensing pumps. All the items are commercially available worldwide, traded internationally and do not need to be specially manufactured. The bidding documents used successfully in the previous Economic Rehabilitation Project would be used again. They were prepared following the Bank's standard bidding documents for procurement of goods. In bid evaluation under ICB, goods manufactured within Mongolia may be granted a margin of preference of 15 percent of the c.i.f. cost of competing imports or the relevant prevailing level of customs' duties to be paid by the beneficiary agencies, if they are not exempted from import duties, whichever are lower. 3.10 The only LIB package is for special vehicles used in the mines to transport explosives, fuels, lubricants, and personnel. There are only a few manufacturers of such vehicles. Since the total amount is estimated at about $500,000 for the six special vehicles (two of each kind), the different suppliers well known in the mining trade would be contacted directly (i.e., without advertisement) to submit bids but following all other ICB procedures. 3.11 The detailed lists of spare parts for the two coal mines (Baga Nuur and Sharyn Gol) and for Mongolian Railways have been extensively reviewed by IDA's sector technical specialists as to their proprietary nature, urgency and quantity needed. Particular attention was given to the extent and quality of the overhaul work on the locomotives and wheel sets. For the coal mines, direct purchase contracts would amount to about $0.9 million and for the railway, about $4.5 million. Therefore, the total would amount to $5.4 million equivalent of the credit. 3.12 Draft technical specifications have already been prepared for the ICB and LIB bid packages. Similarly, the direct purchase contracts have been drafted, in a format acceptable to IDA. These would be reviewed and finalized by MTI in collaboration with the user agencies. All contracts would be subject to prior review by IDA. Up to $2 million of the eligible imports for which expenditures were made after completion of appraisal (July 8, 1993) would be eligible for retroactive financing. This would allow urgent procurement actions prior to effectiveness of the credit to proceed without delay. 3.13 MTI is responsible for coordinating all procurement work with the user agencies, undertaking the procurement transactions, monitoring the progress of procurement actions and supervising the delivery of the items contracted to be purchased or overhauled. MTI had a similar responsibility in the implementation of the ERC, which it undertook very satisfactorily. MTI's project unit is fully functional and staff who have gained considerable experience in IDA's procurement procedures and practices are still in place. Arrangements have been made to secure the expert services of the same  - 23 - procurement consultant who assisted the MTI project unit in handling IDA financial procurement work in the previous project. Table 3.4: PRoc uREMiENT ARRANGEMEENTS ($ million) ICB LIB Other Total Goods Equipment, spare parts and services for mining and railways; dispensing pumps and high-speed oil 12.2 0.5 10. 8/a 23.5 (12.2) (0.5) (5.4) (18.1) Consultancies Technical Assistance - - 1.9/b 1.9 (1.9) (1.9) Total 12.2 0.5 12.7 25.4 (12.2) (0.5) (7.3) (20.0) Note: Figures in parenthesis are the respective amounts financed by IDA. Contingencies have been prorated. /a Direct Purchasing of railways spare parts and overhauls. Local costs are also included. /b Consultants selected following Bank guidelines. 3.14 All the necessary steps are being taken to ensure that advance procurement and contracting actions are satisfactory and in conformity with the Procurement Guidelines. The borrower has been made fully aware of the risks entailed. The necessary procurement planning and scheduling of the various activities have been well organized by MTI with the cooperation of the beneficiary agencies (Baga Nuur and Sharyn Gol coal mines, Erdenet, Petroleum Import Concern and Mongol Railway). 3.15 Two sets of technical service contracts are presently envisaged for $1.9 million or 9.5 percent of the credit. The first set involves the assistance to the coal sector for: (a) outside expert services to upgrade mining operations in the Baga Nuur and Sharyn Gol coal mines; and (b) consultant services to undertake a nationwide coal pricing study. The second set is for the Erdenet copper complex involving three contracts for consultant services to develop: (a) a metallurgical testing program; (b) an environmental  - 24 - action plan; and (c) a cost and financial accounting system. Consultants would be selected in accordance with IDA's Guidelines for Consultants. 3.16 Based on the appraisal mission's assessment of the items proposed for financing and the advanced state of procurement planning, the arrangements described in the "Procurement Planning Timetable" (Annex A) are considered appropriate and feasible. D. DISBURSEMENTS, AccouNTs AND AuDITS 3.17 Disbursements would be made on the basis of Direct Payment to the suppliers. Direct payments would also be used for the consultants providing the Technical Assistance services. Payments would exceed $20,000 equivalent. Disbursements would be on the basis of 100 percent of foreign expenditures for equipment and services (CIF Ulaanbaatar or CIF at the site of goods requiring assembly and/or commissioning by suppliers); and, for consultant services, 100 percent. Full documentation would be provided for payments to be carried out. The Ministry of Trade would be responsible for making sure that each user agency makes the necessary arrangements for paying handling costs, duties (as applicable), and any local transport costs. The Ministry of Finance would be responsible for collecting from end-users all the local counterpart funds, and for enforcing the agreed upon conditionalities. 3.18 Project accounts would be maintained at MTI. The account for the counterpart funds, however, would be maintained at the Ministry of Finance. The project account would be audited by independent auditors acceptable to IDA. The annual audit report would be submitted to IDA within six months of the end of the fiscal year. The project completion date would be June 30, 1995; the Credit closing date, December 31, 1995.  - 25 - 4. PROJECT BENEFITS AND RISKS A. PROJECT BENEFTS 4.1 The project, designed to support Mongolia's stabilization and reform program, would help maintain and increase essential output and services in sectors of the economy that are crucial to the resumption of growth, particularly the minerals and coal sectors. Benefits expected from each component have been described before and are summarized as follows: Summary of Expected Benefits from the Project * Coal: (a) Increase in coal production; (b) formulation of a rational and efficient pricing mechanism; and (c) improvement in the financial position of the coal mines. e qCopper: (a) Diversification of supplier sources; (b) introduction of ICB at the copper company; (c) maximization of copper concentrate and recovery; (d) introduction of modem cost, financial, and management information systems; (e) development of a Plan of Action regarding environmental issues (at the tailing pond); and (f) policy dialogue on corporate development program. * Railways: (a) Increased efficiency of MR through improved availability of spare parts and reduction in backlog for servicing locomotives; (b) improved transport efficiency for coal thereby also improving the energy situation. * Lubricants: Increased productivity and longevity of machinery through the use of high-speed lubricants. * Changing Gasoline Pumps: (a) Elimination of leakages; (b) positive environmental impact; (c) reduction of safety hazards to consumers and attendants at gasoline stations; (d) reduction of possible siphoning of gasoline by attendants; thus, (e) improving the financial situation of the Petroleum Import Concern. B. PROJECTS RISKS 4.2 Project risks are essentially twofold. First, as is usually the case with countries undergoing deep adjustments, performance in the implementation of the stabilization and reform program agreed with the Fund and the World Bank and reflected  - 26 - in the PFP could be less than fully satisfactory. That would undermine the results expected from this project. The commitment and initial actions shown so far by the Government in the implementation of the program, however, provide assurance and are the basis for going ahead with this operation. Second, payment of local currency counterpart funds to the government by the user agencies concerned may be delayed or inadequate. This risk is minimized by Government's commitment to: (a) implement appropriate price/tariff policies that would improve the cash flow situation of user companies; and (b) improve management of public expenditure which would allow use of already allocated budgetary funds for priority uses, including the financing of counterpart funds. 4.3 In addition, there are some risks connected to various components of the Project. For example, in the coal sector, there is a risk that the authorities may delay implementing quarterly price adjustments which would adversely affect the financial viability of the coal mining companies. To the extent that price adjustments are associated with progress in the stabilization program (to which the authorities are committed), the risk of delaying coal price adjustments is minimized. In the copper sector, there is a small risk that the authorities will not take advantage of the TA results, including implementation of the cost and financial accounting and Management Information Systems. Efforts will be made during follow-up supervision missions to ensure the effectiveness of all TA- components. In the railway sector, there could be unexpected delays in the servicing and delivery of materials from the direct purchase source. However, with appropriate financing, this risk should be minimal. Finally, there could be some delays in installing the gasoline dispensing pumps since the supplier is only expected to install three to five pumps for demonstration purpose. The installation process is, however, a relatively simple procedure, and this should not pose a significant problem.  - 27 - 5. AGREEMENTS REACHED AND RECOMMENDATION 5.1 At negotiations, assurances were obtained from the Borrower that it will: (a) carry out its Economic Strategy for the medium term (Annex B) in a manner satisfactory to the Association (para. 1.8); (b) collect from the end-users the local currency equivalent of the foreign currency costs calculated for the costs of goods, on the basis of cost, insurance and freight (c.i.f.), and cost of services at the unified interbank floating exchange rate prevailing when delivered goods are cleared by customs or when the services have been paid for by IDA (para. 2.4); (c) starting in March 1994 and until the recommendations included in the coal pricing study are implemented, adjust the price of coal, on a quarterly basis, to keep pace with domestic inflation measured by the Consumer Price Index (CPI) estimated by the Borrowers' State Statistical Office (para. 2. 10); (d) undertake and, by June 30, 1994, complete a study on coal pricing in consultation with the Association. The results and recommendations of the coal study would be discussed with the Association and steps would be taken for their implementation (para. 2.12); and (e) adjust the domestic prices of gasoline, diesel and lubricants to reflect international prices and exchange rates, in accordance with a formula agreed with the Association during negotiations (para. 2.35). 5.2 With the above assurances, the proposed project would be suitable for an IDA credit of SDR 14.2 million ($20 million equivalent) to Mongolia, on standard IDA terms with a 40-year maturity.  - 28 - ANNEX A PROCUREMENT PLANNING TIMETABLE (As of Appraisal) 1. Appraisal mission receives: MTI; (a) technical specification for all ICB and LIB bidding July 8 (Coal mines, Erdenet copper mines, Petroleum Import Concern, Mongolian Railways); and (b) list all items in direct purchase contracts for IDA no objection. 2. Appraisal mission receives copy of: MTI; (a) model ICB documents; and July 8 (b) model direct purchase contract for IDA no objection. 3. Submit draft notices of advance ICB procurement to MTI; appraisal mission for IDA approval to appear in UN July 8 Development Business. 4. Request appraisal mission for IDA agreement to use LIB MTI; for procurement of ANFO trucks used in coal mines. July 8 5. Collaborate with Mongolian Railways and forwarding agents (Tuushin and Mongol Tekh) regarding likely MTI; Now until com- volume of freight and logistical arrangements needed to pletion of delivery ensure timely delivery. 6. Clarify arrangements, confirm selection and finalize MTI; contract for procurement expert; prepare with appraisal July 8 mission the letter of appointment. 7. Submit to IDA short list of consultants for 3 technical MoEnergy, assistance contracts; and sole source contracting for 2 Erdenet; consulting services (coal operation assistance; copper July 20 testing) for IDA comments and no objection. 8. Collect all necessary information and approvals; finalize MTI; all inputs for procurement implementation, preparation of July 25 final bid documents and direct purchase contracts, in time for procurement expert's arrival at end July.  - 29 - ANNEX A 9. Finalize LOI, TOR and draft contracts for the five MoEnergy, consulting services. Send out documents to consultants. Erdenet; August 8 10. Bid documents for ICB and LIB packages should be MTI; printed and ready for public purchase. Send copies of all September 15 bidding documents to IDA. 11. Send copies of final negotiated contracts for direct MTI; purchase of spare parts and sole source overhaul services September 30 to IDA for no objection. Such contracts should be valid for at least three months. 12. Receipt of final proposals from consultants for the 5 MoEnergy, technical assistance components. Evaluate the proposals Erdenet; for the 3 competitive TA services. Send evaluation report October 15 and award recommendation to IDA for no objection. 13. Answer bidder questions and provide clarification of ICB MTI; and LIB bid documents. October 1 14. Organize and arrange for receipt of ICB and LIB offers MTI; and public bid opening. October 15 15. Evaluate ICB and LIB offers, and send evaluation reports MTI; and award recommendation to IDA for no objection. October 30 16. Prepare letters to notify contract awards to selected MoEnergy, consultants, while awaiting IDA no objection. Erdenet; November 15 17. Prepare letters to notify contract awards to selected MTI; evaluated bidder for each ICB and LIB package, while October 30 awaiting IDA no objection. 18. Await telex from IDA confirming Credit declared MTI, MoE, Erdenet; effective and promptly send letters mentioned in 16 and Date of Credit 17 above. Send copies of letters to IDA. Effectiveness, Late-October ICB: International Competitive Bidding LIB: Limited International Bidding LOI: Letter of Intent TOR: Terms of Reference IDA: International Development Agency  - 30 - ANNEX B GOVERNMENT OF MONGOLIA: STATEMENT OF ECONOMIC STRATEGY FOR THE MEDIUM TERM Introduction 1. Mongolia has embarked upon a program of stabilization and economic transformation. We are convinced that the present emergency situation will be overcome with our policy actions and the help of the international community. Meanwhile, we intend to continue the path of economic transformation initiated in 1990. 2. Mongolia's stabilization and adjustment efforts have reached a new stage. We have reached agreement with the IMF on a Enhanced Structural Adjustment Facility (ESAF) program. The Policy Framework Paper (PFP) issued in conjunction with the IMF and IDA states our main policies and objectives for the next three years. Our Government believes that our efforts to speed up the establishment of a market economy will result in a gradual resumption of growth and improvement in the living standards of the population. We are committed to respect democracy, human rights and the rule of law. 3. Our central concern is to overcome the present critical situation, to stabilize the economy and to implement systemic and structural changes. Mongolia's transformation into a market economy is proceeding on three basic fronts: changes in ownership of assets, reduction and change in the nature of Government intervention, and institutional changes. Recent Developments 4. Mongolia's economy has suffered from disruptions in trade and payments with the former USSR and CMEA. Financial and technical assistance from the former USSR (amounting to almost 30 percent of GDP) disappeared almost completely. We still feel the impact of these events. However, our Government recognizes that policy slippage have also been partially responsible for the present high inflation and for the lack of sufficient supply response by the newly born private sector. 5. Real GDP declined by about 10 percent in 1992, following a decline of almost 8 percent in 1991. Although some expansion took place in private activities, industry and agriculture were constrained by shortages of intermediate goods and spare parts. Weather also played an adverse role in agriculture. Investments have fallen sharply since 1990 reflecting, to a large extent, the phasing out of projects financed by the former USSR and the fact that projects financed by new donors can only be designed and implemented gradually.  - 31 - ANNEX B 6. By the end of 1992, inflation exceeded 300 percent. While price liberalization is partly responsible for this development, the Government recognizes that lax monetary and credit policies added to inflation during the first part of 1992. The fiscal deficit was held at about 10 percent of GDP in 1992, financed mainly with external resources. 7. A highly overvalued currency prevailed during 1992. However, a free, unified foreign exchange rate market was introduced in May 1993. The medium and long- term external debt has risen rapidly to about $315 million by the end of 1992. It is made up of new commercial borrowing and new aid flows. This debt does not include the debt to the former CMEA, denominated in transferable rubles (TR), of TR 10.6 billion which is being negotiated at present. In addition, external arrears amounted to $52 million at the end of 1992. 8. Our external situation deteriorated further in 1992. Merchandise exports increased somewhat while imports declined as the reduction in external assistance from Russia was only partially offset by new donor assistance. The deficit in current account reached $32 million in 1992. This relative low level reflects an equally low level of imports rather than a good overall balance of payments performance. Net official reserves fell to $14 million, or 1.9 weeks of imports, by December 1992. Structural Reforms and Medium-Term Objectives 9. Over the past two years, we have initiated deep economic reforms. First of all, a program of privatization through vouchers distributed to the population was initiated. Over 95 percent of small- and medium-size public enterprises were privatized, and about 450 large public enterprises were transferred to private owners for vouchers, through the stock exchange. There are now more than 6,000 active private enterprises registered in the country. Second, practically all prices have been freed from administrative controls and a more realistic pricing policy is being applied to goods and services still subject to administered prices (energy, rents, and public utilities and services). Third, a two-tiered banking system was created with the establishment of a central bank and commercial banks. Fourth, steps were taken to create a modem tax system. Finally, several laws were enacted to provide the legal framework for a market- oriented economy. These include Privatization Law, Bankruptcy Law, Anti-monopoly Law, amendments to the Civil Code regarding property ownership, Consumer Law, Foreign Investment Law, Customs Law, Tax Laws, Law on Economic Entities, Labor Law and Banking Law. 10. As stated in the PFP, the medium-term macroeconomic objectives of the Government are to reverse the decline in output, restore financial stability, and make progress toward external viability. The program aims at limiting the contraction of economic activity to less than 2 percent in 1993 and restore positive real GDP growth thereafter. This program is recognized to be an ambitious, realization of which will require favorable external conditions and full implementation of the structural changes outlined in the PFP and in this statement.  - 32 - ANNEX B 11. The Government acknowledges that restoration of economic growth will depend on recovery in the agriculture, industry, and service sectors, especially in activities related to exports. A positive supply response in agriculture/livestock is expected from the establishment of market-determined producer prices and appropriate exchange rates, the elimination of barriers to agricultural exports (including mandatory state orders and export licensing), and access to foreign exchange for essential inputs. The service sector offers potential for gains in private employment in areas such as tourism, external and internal trade, business and professional services, and distribution. Some industrial subsectors, such as small import substituting consumer goods industries, initiated with private capital, should also begin contributing to growth. However, output of many traditional industries is expected to remain stagnant, or to decline, as more rational price structures and hard budget constraints force nonviable entities to close down and/or undergo rehabilitation and restructuring. The Govermnent Stabilization Program 12. Our Government is committed to continuing and reinforcing our initial stabilization efforts. Our goal is to decrease the inflation rate from over 320 percent at the end of 1992 to about 10 percent by 1995. This ambitious target will be achieved by a combination of tight monetary policies, realistic interest rate policies, increase in taxation, control in public expenditures, including elimination of direct subsidies to state enterprises, and the introduction of market-determined exchange rates. Specific measures to stabilize the economy are explained below. 13. Monetary and Financial Policies. Expansion in money supply and credit will be consistent with achieving the reduced inflation targets. The lending rate will be free of Government control, and interest rates charged by the Bank of Mongolia will continue to be positive in real terms. Reserve requirements have doubled (to an average of 17 percent). Credit ceiling were established on individual bank lending to nonbanks. This direct policy mechanism will be abolished as bank supervision and use of indirect policy tools, including the reserve requirements, becomes effective. 14. To restore confidence in, and to further develop, the commercial banking system, the Bank of Mongolia's supervisory capabilities are being strengthened significantly. The authority to conduct on-site supervision will be confirmed through passage of a permanent Central Bank Statute. The department of banking regulation and supervision is developing guidelines, requirements, and limits for capital adequacy (using risk-based assessment) and prudential liquidity connected to lending and management of foreign exchange operations. A review of commercial bank portfolios is being undertaken, and the commercial banks will be required to improve the overall quality of their loan portfolios. 15. To facilitate appraisal of credit risk, a system of national accounting standards will be developed with IDA technical assistance. These standards will be applied to selected public enterprises in 1994 and extended to all public enterprises thereafter. Commercial banks will be required to publish balance sheets and income statements by  - 33 - ANNEX B end-1994, and steps will be taken to reduce lags in booking transactions and in reporting to the Bank of Mongolia. 16. Budgetary Policies. The economic role of the Government is being redefined. The medium-term goal is to limit the role of Government to provision of basic public services, economic infrastructure, defense, and protection of the lowest income groups and the environment, with the private sector taking the lead role in productive activities. Budgetary reforms are focusing on: (a) continuing the process of modernizing the tax system and broadening the tax base; (b) strengthening the monitoring and control of budgetary revenues and expenditures; and (c) rationalizing budgetary expenditures, while improving the cost effectiveness in the delivery of government services. 17. New tax measures were introduced in early 1993. A 10 percent sales tax on domestic production and imports was introduced (replacing the temporary surcharge on imports adopted in late 1991), and the scope of customs duty exemptions was reduced. Measures to strengthen administration of these taxes will be adopted, based on technical assistance recommendations provided by the IMF, including the introduction in 1993 of a customs valuation code and the establishment of individual taxpayer identification numbers. 18. Expenditures will be restrained to levels consistent with the fiscal deficit targets. Measures to rationalize expenditure will concentrate on, but not be limited to, the areas of education, health, social security, and public investments while ensuring an adequate safety net for the truly needy. * Education. The Government has initiated a program to: (a) further reduce the ratio of administrative personnel to teachers; (b) increase the number of pupils per teachers, presently about 10 for higher education and 20 for primary and secondary schools; (c) reduce subsidies to students abroad; and (d) reduce the amount of stipends for students and introduce a policy of systematic targeting. * Health. The Government is pursuing a very active program to reverse the deterioration of health services suffered during the last two years. Home deliveries have been increasing due to the closing of maternal waiting rooms. As a result, an increase in mortality rates has been observed. Therefore, the Government will increase the allocation of funds for waiting room and, concomitantly. will reduce the construction of hospitals which are not a sectoral priority. The Government will minimize its involvement in drug manufacturing industries. * Social Security System. The social security system (SSS) required the largest Government subsidy, equivalent to 4.4 percent of the GDP in 1992. The Government is therefore pursuing measures to reduce the SSS deficit as a key requirement to reduce the budget deficit. The introduction of a new SSS will take place in parallel with some key measures aimed at  - 34 - ANNEX B reducing the subsidy of the SSS over the next two years. First, workers contributions of not less than 4 percent of wages and salaries will be introduced. Second, early retirement options will be reduced. Third, other benefits including extended matemity leave will be reduced. Transport Tariffs. The Government will implement, starting in 1994, a program of tariff rationalization, based on the actual cost of gasoline and diesel. This program will be based on the finding of a study financed under an IDA TA Credit. Prices of gasoline and diesel will be based on the intemational price at a realistic exchange rate. Any subsidy would be transparent and in line with a level of budgetary deficit consistent with the stabilization program; * Agricultural/Livestock Expenditures. The Govemment has recently initiated a program for phasing out subsidies to fodder transport. We will concentrate our efforts on the delivery of services to facilitate the supply response of the agricultural/livestock sector. Privatization of veterinary services will continue at a pace that will not disrupt their existing provision. * Public Sector Investment. We are undertaking a comprehensive review to identify an appropriate rolling, three-year public sector investment program. Investment criteria have been established based on the project belonging to the domain of the public sector, minimum rates of return (not applicable in all cases, however), and sectoral strategies. The Govemment will refrain from participating or financing projects falling within the domain of the private sector. Rate of return criteria will not be applicable in the case of projects within the social sectors (education, health, etc.). Based on the above-mentioned criteria, the Govemment will decide about new investments and the fate of projects under implementation. While new, sound projects are identified and implemented, we are taken measures conceming several controversial projects under implementation: (a) the Government is studying, in some cases with IDA assistance, available options regarding projects that appear to have low or negative rate of return (i.e., Minimetal project). Meanwhile, new investments in those projects will be minimized to maintain the assets in acceptable conditions; (b) during 1993 and 1994, a program of privatization of investments that belong to domain of the private sector will take place (i.e., Genghis Khan Hotel, Meat Plants); (c) as mentioned before, a reallocation of investments-from construction of hospitals to more waiting rooms-will take place in the health sector; and (d) new prospective projects will be carefully scrutinized before deciding on their implementation (i.e., Paper Plant, Sugar Factory). * Budgetary Management and Control. In addition to improving the quality of public expenditures, the management and control of govemment expenditures by the Ministry of Finance will be strengthened through the  - 35 - ANNEX B implementation of recent IMF technical assistance recommendations. These improvements cover budgetary classification, fiscal forecasting, treasury management, fiscal reporting and auditing. Private Sector Development 19. The Government will enhance and speed up the process of privatization through the introduction of secondary markets for vouchers and shares. The Government will initiate a program of privatization of buildings and urban land. To regulate stock exchange transactions, a Securities Law, under preparation, is expected to be enacted in 1994. To promote foreign trade, export licenses have been abolished (except for a limited number of commodities mostly for environmental reasons or when the import market is imposing quotas). The Government has also discontinued the practice of imposing minimum export prices and state orders. No export taxes will be maintained or introduced. The Government is fully aware that in order to avoid the negative impact of import taxes on exports, a simplified drawback system is necessary. Consequently, additional work will be undertaken during 1994 to implement a duty drawback system. 20. The Government has enacted a new Foreign Investment Law to make the country more open to direct foreign investment. Further, a draft of the Mining Law has been prepared with financing from the IDA TA and is expected to be enacted soon. 21. Only the price of utilities, rents, selected public services and petroleum products remain subject to Government control. Prices of petroleum products reflect their international cost. The ration system has been eliminated since August 1993, and the Government will compete with the private sector in buying and selling goods as state orders are abolished. 22. Private sector wages and salaries have been liberalized. For the public sector, the Government has established a minimum wage and regulate wages and salaries of budgetary agencies and agencies receiving budgetary transfers. A Tripartite Commission, consisting of representatives of Government, state enterprises and labor is guiding wage policies in the public sector. Increases in wages and pensions will be held below inflation levels. However, in the context of this general stabilization policy, efforts are underway by the Government to retain qualified personnel and to initiate a policy of retrenchment of redundant workers. Social Safety Net 23. The Government is very concerned about the drop in living standards associated with the transitional difficulties to a market-based economy. We acknowledge that the privatization process is likely to generate further unemployment as loss-making enterprises close down. Budgetary difficulties led to a reduction of services: heath, education, and transportation to some poor areas. In addition, some groups have become more vulnerable as a result of rising alcoholism, child neglect, and crime. Increased economic strain combined with limited training in family planning have resulted in a surge  - 36 - ANNEX B in abortions. This, in turn, is associated with high matemal mortality rates. As mentioned before, maternal mortality increased as some waiting homes, financed by now disbanded cooperatives, were closed down. Pensions have become, in some cases, extremely low. Government estimates of people living in absolute poverty was 16 percent of the population in 1992. 24. The Government is taking measures to tackle the above mentioned issues. First of all, it continues the severance pay system for redundant workers (for five months). Second, it has created a Fund for Poverty Alleviation that allows the provision of assistance to families (i.e., tools, animals, training programs for unemployed and small entrepreneurs). Third, a program for reopening maternal waiting homes is under consideration. Fourth, family planning programs are being strengthened (in cooperation with UNFPA). Fifth, special provisions for people unable to pay the cost recovery fees (for education and health) have been introduced. Sixth, minimum pensions will be monitored and increased as a way of reducing extreme poverty among their recipients. Finally, the Government will monitor poverty-related indicators as a way of anticipating problems and facilitating policy response. To assist the Statistics Office in identifying and compiling appropriate indicators, a program of TA has been agreed with IDA. Environment 25. The Government is committed to limiting the adverse environmental effects caused by economic activities. An Environmental Action Plan is being prepared and is expected to be completed in early 1994. It will focus on measures to protect the environment from negative aspects of mining exploration, to stop soil erosion, and to reduce soil and water pollution in urban areas. Assistance from IDA is being received to evaluate specific ways of preventing the tailings pond (close to Erdenet copper mine) from contaminating the surrounding area and to analyze the stability of the tailing ponds dam. A rangeland management study will be initiated in 1993 to address the effects of soil erosion. Sectoral Policies 26. External Sector Refonrs. As mentioned before, the Government has initiated a policy of decentralizing foreign trade activities and has abolished general export licensing except for a limited number of commodities. Steps have also been taken to eliminate government-imposed barriers to trade, including quotas, most export bans (except for bona fide purposes, e.g., environmental), and minimum export prices. Requirements to seek permission for, or conditions attached to, engaging in domestic procurement of exportable goods and marketing of imported goods have also been eliminated. The previous monopoly position of the foreign trade corporations has been abolished, and many have already been privatized. 27. The Government will implement a realistic exchange rate policy. A unified market-determined floating exchange rate system has been introduced in May 1993. Foreign exchange surrender requirements for public enterprises, not exceeding 50 percent,  - 37 - ANNEX B will be applied on a transitional basis to provide foreign exchange for official purposes, including debt service, reserve accumulation and certain government imports. All surrendered foreign exchange proceeds will be channeled through the banking system. Importers with bona fide documentation will have unrestricted access to the foreign exchange market. 28. Rules covering dealing, risk exposure and portfolio management have been established for commercial banks holding a license to engage in foreign exchange operations. Under its permanent statute, the Bank of Mongolia will be granted the necessary authority and effective powers to enforce rules and regulations governing foreign exchange operations. 29. The major share of Mongolia's external debt obligations is owed to former CMEA members, mainly to the Russian Federation, and is denominated in transferable rubles. From January 1, 1991, all outstanding debt payments, as well as payments and clearing mechanisms through the IBEC, were suspended by mutual agreement. Agreement was reached, in principle, with the former USSR, and reconfirmed by the Russian Federation that future debt service will not be such as to impede Mongolia's economic development. In mid-1992, further agreement was reached with the Russian Federation on postponing debt service on medium and long-term debt falling due through 1995, until at least the year 2000. Proposals on modalities for valuation and future settlement of the Mongolian debt are under negotiation, and the Government is seeking to renegotiate outstanding IBEC balances owed to the Russian Federation. The Government has also undertaken discussions with other former CMEA members to settle outstanding IBEC balances. 30. The Government is seeking to renegotiate its major commercial debt obligations. To strengthen debt management, all external borrowing of the public sector and private sector enterprises will be monitored by the Ministry of Finance and Bank of Mongolia, and the authorization of the Minister of Finance will be required for all public and publicly guaranteed borrowing. Until Mongolia's external financial position is more firmly established, the Government and the Bank of Mongolia will refrain from short-term borrowing (credits with original maturity of one year or less) and/or guaranteeing of such loans, excluding normal import-related credits. The contracting of public and publicly guaranteed loans in the medium-term maturity range on nonconcessional terms will also be strictly controlled. 31. Agriculture/Livestock. A draft law will be presented to Parliament to establish long-term leasing of agricultural land. Only research farms will remain under public control. In keeping with nomadic tradition, pasture land will remain under state ownership but consideration will be given to a system of land leasing. 32. To encourage a significant supply response and to stimulate producers and traders of agricultural products to search for new and expanded export markets, all bans on private exports of agricultural products have been lifted, concomitant with giving private sector agents full access to the purchase of such commodities either directly from  - 38 - ANNEX B producers or through intermediaries. Over the medium term, improvement in agricultural incomes through these measures will permit an increase in the price of veterinary service charges to full cost recovery levels. 33. Industry. The Government has established hard budget constraints on state enterprises through the removal of remaining direct and indirect subsidies, the phased elimination of directed bank credit, and a requirement that enterprises pay market- determined prices for domestically produced and imported inputs. State enterprises that cannot be restructured into viable units in the new market environment will be identified and closed down. The Government has initiated a process of budgetary oversight of the financial position of public enterprises excluded from full privatization, even as subsidies and remaining centralized controls over prices, employment and other operating decisions are eliminated. 34. Energy. Enterprises in this sector will remain mainly under state ownership in the near term. For the mainly coal-based power plants, short run priority has been given to facilitating coal production through donor-financed imports of new equipment and spare parts and the rehabilitation of old equipment needed for mining and coal transport. The import costs for electricity procured from the Russian (CEA) grid will be passed on through energy tariffs. A system of energy audits of major enterprises to identify additional methods of conserving energy will be developed, with assistance from the ADB, for introduction in 1994. As the more urgent sectoral problems are overcome, the Govemment intends to undertake a comprehensive Energy Assessment, not later than 1994, to identify longer-term investments and policies in the sector. A study of power tariffs will be undertaken. Based on this study and improvements in accounting practices, power tariffs will be set in 1994 so as to cover fully operating and capital costs. Before an integrated energy tariff structure is implemented, the Government plans to introduce periodic tariff adjustments to increase the price of energy in real terms. In planning policies and investments, environmental considerations will play a crucial role. 35. The Government will undertake a strategic review of its petroleum supply and distribution system with a view of prioritizing the use of petroleum products and improving procurement, transport and storage to limit supply interruptions. Prices of petroleum products will be adjusted to fully cover costs, including full and immediate pass- through from exchange rate depreciation, in order to promote conservation and to provide resources for improving transport and storage facilities. 36. Mineral. The main objective of the Mongolian Government is to create an environment favorable to the growth of the mining sector, particularly by attracting investments by international mining companies. Proposed legislation, regulations and administrative procedures will be developed on the basis of the following principles: (a) The overall direction of legislation and regulations will be promotional and will reflect the objective of attracting private investors to the Mongolian mining sector.  - 39 - ANNEX B (b) Licenses for exploration and mining will be issued by the Ministry of Geology and Mineral Resources of Mongolia with a minimum of administrative requirements. (c) Mining rights will be issued for renewable periods of time and holders of concessions will be allowed to sell their mining titles to other investors provided the purchaser agrees to fulfill the obligations under which activities covered by the titles are to be carried out. (d) Sustainable mining development will be ensured through appropriate regulations and standards regarding environmental, health and safety aspects. Effective monitoring and enforcement capabilities will be established. (e) Gold mining will be generally subjected to the same rules as other minerals. However, as an exception to the general principle of equal treatment for Mongolian and foreign investors, priority will be given to Mongolian individuals and firms for the development of small placer mines. Such priority will not be given for hard rock and large placer gold mining. 37. Existing public sector mining operations will be commercialized. The shares of the new corporations will be assigned to the present owners (for example, in the case of Erdenet 51 percent of the shares will belong to the Mongolian Government and 49 percent to Russia). The question of possible future changes in the ownership of shares after commercialization will be addressed in the near future. The objective of the commercialization is to increase the busir,.ss orientation of the mines, so they would operate like a private corporation. In particular the corporations would introduce the following: (a) Cost accounting, budgeting by cost centers, management information systems. (b) Energy audits, metallurgical audits and other procedures to increase efficiency. (c) International bidding, shopping and other purchasing procedures designed to maximize efficiency and to obtain the full benefits deriving from the opening of the Mongolian economy to the international markets. (d) Financial accounting including the preparation of income statements and balance sheets to be audited according to usually accepted accounting principles. (e) Marketing plans and business plans including financial projections (income statement, balance sheet, cash flow projections).  - 40 - ANNEX B 38. The commercialization may also entail a renegotiation of the agreements with the foreign partners, which should be transformed into shareholders agreements, loan agreements, technical assistance agreements, contracts to provide equipment, contracts to provide specialized manpower, purchasing contracts for mineral products, etc. 39. Transportation. The bulk of foreign trade is transported over the rail network through Russia and China. Agreement has been reached to secure Mongolia's access to the port of Tianjin in China, but differences in gauges between Mongolia and China create bottlenecks at the border, and the intensive use of Chinese railways leaves little spare capacity for transit traffic. Investment in new technology to ease the difficulties caused by the differences in rail gauges is being sought, and railway rehabilitation is being financed by a concessional project loan from Japan. Mongolia has air links only with the Russian Federation and China, but has initiated negotiations to establish air links with other countries in the region. In April, Mongolia has successfully negotiated air links with Singapore. An ADB project will assist in improving the airport facilities in Ulaanbaatar. Nearly three fourths of domestic freight is carried over the existing road network. However, the condition of the network is poor with only 3 percent of the total paved. The rapid increase in private vehicles and the prospective privatization of some transport corporations should ease some of the constraints on the domestic transportation system. Assistance is being provided by the ADB for a Road Master Plan feasibility study and the ADB's project pipeline includes projects for road development. In addition, a prospective transport project financed by IDA would provide assistance to help Mongolia remove bottlenecks in road and rail transport. An action program to implement the recommendations of an IDA study on transport tariffs will be drawn up. 40. Communications. Weak communication links hamper Mongolia's efforts to expand commercial and other contacts with the outside world and delay the transmission of official, commercial, and personal information. To improve the institutional capacity of the Mongolian Telecommunication Authority (MTA), postal, telecommunication, and broadcasting transmission services have been separated, leaving the MTA as a policy making body. The Government is implementing some projects for the development of a modem telecommunications network. A medium-term strategy for the further development of the communications sector is being drawn up with ADB technical assistance as a basis for seeking further external financial assistance. Implementation 41. We are aware that in the course of implementing the structural adjustment program, there will be a need for close coordination between all agencies involved with economic and financial matters, in particular the Ministry of Finance, the Bank of Mongolia, the Ministry of Trade and Industry, and the National Development Board. To  - 41 - ANNEX B facilitate this coordination, the Government will establish an interagency committee. The implementation capacity of the economic agencies is being supported through the placement of long-term advisors from various international agencies and TA programs, including the IMF, UNDP and IDA. Mr. D. Davaasambau Minister of Finance  - 42 - ANNEX C PROJECT IMPORT COMPONENTS COPPER REHABILITATION COMPONENT 1. Equipment - Critical Needs (a) 5 x 110 T Dump Trucks $1,800,000 (b) Front End Loaders 1 x 8 cubic meter - 1 x 5 cubic meter $650,000 (c) Bulldozers 4-250 HP minimum $1,700,000 Subtotal $4. 150,000 2. Operations Assistance Program (a) Copper Grade Improvement International Laboratory Test Program (including supervision assistance) $250,000 (b) Development of Cost/Financial Accounting and MIS $500,000 (c) Environmental Protection Review of Pollution and Dam Stability Recommendations for Action Plan $100,000 Subtotal $850.000 Total $5