89342 MONGOLIA Ulaanbaatar Financial Self-Assessment The World Bank East Asia and Pacific Region April 9, 2014 © 2014 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org 1 2 3 4 15 14 13 12 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. 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Ulaanbaatar Financial Self-Assessment Contents Acknowledgments .................................................................................................................................... v Abbreviations and Acronyms .............................................................................................................. vii Overview................................................................................................................................................. viii Summary .................................................................................................................................................... ix I. Financial Performance and Debt Profile .................................................................................... 1 Budget Finances ..................................................................................................................... 1 Capital Assets......................................................................................................................... 2 Debt Profile ............................................................................................................................ 3 II. Economic Fundamentals ................................................................................................................ 5 III. Institutional Framework and Governance ................................................................................. 7 IV. Extraordinary Support Considerations ....................................................................................... 9 V. Conclusions and Recommendations ........................................................................................... 9 Improvement of financial reporting ..................................................................................... 10 Strengthening of capital investment planning process......................................................... 10 Strengthening capital asset registry ..................................................................................... 11 Greater oversight role over municipal-owned enterprises and their debts .......................... 11 References................................................................................................. Error! Bookmark not defined. Appendix A. Financial Statistics .......................................................................................................... 13 Appendix B: Moody’s Rating Process for Local and Regional Governments ............................. 18 Figures Figure A.1: Moody’s Regional and Local Government Credit Rating Methodology .................... 19 Tables Table 1: Summary of External Debt of UB Enterprises, FY 2012 ......................................................... 4 Table A.1: Key Economic Indicators...................................................................................................... 13 Table A.2: Debt Statement (MNT millions) .......................................................................................... 14 Table A.3: Financial Operations (in MNT millions) ............................................................................ 15 Table A.4: Financial Trends (percent) ................................................................................................... 16 Table A.5: Balance Sheet (in MNT millions, as of 12/31/2012) ........................................................... 17 iii Ulaanbaatar Financial Self-Assessment Acknowledgments The note is part of a broader technical assistance program designed to assist the City of Ulaanbaatar (UB) to improve its financial management system, assess the quality of municipal services provision, and mobilize resources from the capital markets to fund urban infrastructure. This specific note is intended to prepare UB for a credit rating by first undertaking a self-assessment. This work was carried out by a joint UB and World Bank team. The UB team received guidance from Mr. N. Bataa, Vice Mayor for Economy and Finance. The Finance and Treasury Department (represented by Ms. Sandang Solongo), the Property Relations Department (headed by Mr. Tumurbaatar Sharavdorj), and the Strategic Policy and Planning Department (headed by Mr. Bayaarbatar) provided all the required information. Findings from the self-assessment and debt management assessment were presented at a workshop in UB convening a wide range of stakeholders, including city administration, government agencies, and the press. The World Bank team consisted of Meskerem Brhane (Task Team Leader and Senior Urban Specialist, EASIN), Hernando Garzón (Senior Public Finance Economist), Huong Mai Nguyen (Urban Governance Analyst, EASIN) and Erdene Ochir Badarch (Operations Officer, EASCS). Hernando Garzón provided technical assistance to the UB team and guided the counterpart team in applying a methodology for preparing a draft financial performance of Ulaanbaatar’s creditworthiness and debt profile. Peer reviewers Matthew Glasser (Advisor, WBCKO), Lili Liu (Lead Economist, ECSP4), Abha Prasad (Senior Debt Specialist, PRMED), Taehyun Lee (Senior Economist, PREM), and Pat O’Connell (Resident Debt Advisor for Mongolia, U.S. Department of Treasury) provided valuable guidance throughout the study. The work also benefitted from the close guidance of Abhas Jha, Sector Manager (EASIN) and Coralie Gevers, Country Manager for Mongolia. This work received funding and advisory support from the Public-Private Infrastructure Advisory Facility. Vice President Axel van Trotsenburg Country Director Klaus Rohland Country Manager Coralie Gevers Sector Director John Roome Sector Manager Mark R. Lundell Task Team Leader Meskerem Brhane v Ulaanbaatar Financial Self-Assessment Abbreviations and Acronyms BL Budget Law CIP Capital investment planning CPI Consumer Price Index GDP Gross Domestic Product IDA International Development Association LDF Local Development Fund LG Local Government MNT Mongolian New Tugrik MoF Ministry of Finance MTFF Medium Term Fiscal Framework O&M Operations and Maintenance OSNAAK Ulaanbaatar Housing and Communal Services Company PIT Personal income tax TA Technical Assistance UB City of Ulaanbaatar WB World Bank CURRENCY EQUIVALENTS (As of February 2014) Currency Unit = Mongolian New Tugrik MNT 1 = US$ 0.00057 US$1 = MNT 1,762.00 vii MONGOLIA Overview City of Ulaanbaatar (UB) leaders recognize that capital expenditure requirements to support continued economic growth and current urbanization trends are enormous. Like many national and local governments around the world, UB is closely weighing the benefits and costs of using borrowed money to build the infrastructure needed for more and better municipal services. Borrowing from the capital markets on a long-term basis could provide large capital sums for immediate use, and enable intergenerational equity, where those who benefit from the asset will also contribute to repaying long-term debts for long-lasting urban infrastructure. This note is part of a Technical Assistance program provided by the World Bank at the request of UB. This financial self-assessment is a joint effort by the City of Ulaanbaatar and the World Bank to guide UB in preparing for a credit rating. A credit rating is an opinion by an assessor on the chances that a borrower will repay a loan on time and in full as agreed. The rating enables potential investors to decide whether to invest in the borrower’s business, based on the underlying risk assumptions and uncertainties underscored by the rating. In other words, the credit rating is useful for investors to assess the long-term performance and stability of a municipality when they are considering partnerships in infrastructure development programs. The primary reason for obtaining a credit rating is to lower the cost of borrowing, as higher ratings tend to have a positive correlation with lower interest rates. Obtaining a credit rating also increases the marketability of the borrower, thus opening up more financing options and enhancing the municipality’s ability to choose the most cost-effective source of funding at a given time. The objective of this note is to assist the UB government in identifying the critical issues that would affect a future credit rating. The note reviews factors that may support or constrain the rating, ultimately impacting the UB’s creditworthiness. Moody’s methodology for subnational government credit rating has been applied to form the basis for the assessment. (See Appendix B for Moody’s methodology). This assessment comprises of a comprehensive review of the city’s economic fundamentals, institutional framework, fiscal performance, debt profile, and governance system. A key component of a credit rating comprises a review of the institutional framework that governs the city’s financial system. This includes evaluating the legal framework, regulations, and procedures. The review also elucidates the jurisdictional parameters across levels of governments regarding debt raising and financing, and evaluates the overall quality of decision-making. As in a formal rating, the assessment also examines the operating environment, which is underlined by the sub-sovereign credit rating, and the support range, or the sovereign guarantee available to UB, if any. The exercise aims to reveal capacity gaps and potential areas for strengthening, as well as proposing concrete steps to improve the city’s creditworthiness. viii Ulaanbaatar Financial Self-Assessment Summary The finances of the City of Ulaanbaatar (UB) reflect a fairly stable financial position on the basis of a well-diversified economic structure, a historical trend of surplus and cash flow liquidity, and fiscal resilience against cyclical macroeconomic factors. There are concerns regarding the insufficient clarity and transparency of the current financial reporting system, which does not accurately reflect total assets and total liabilities. The city’s consolidated balance sheet indicates moderate long-term debt liabilities of UB’s public enterprises. There is also an apparent lack of legal clarity in cases of debt distress. These aspects raise concerns regarding UB’s role and any implicit financial obligations it may be obliged to undertake. Capital and real estate assets in UB, which could potentially be used as collateral for municipal borrowing, are currently not properly inventoried and valuated. This exposes city finances to vast opportunity costs on the incomes and market values that could potentially be generated from their effective management and usage. Central government guarantees are moderate, given the role of UB in the national economy. They may not be equal to the short-term macro-fiscal readjustments, underlined by a large amount of off-budget spending, burgeoning credit growth, unsustainably high fiscal deficits, and inflationary pressures on the horizon. For UB to improve its credit quality and prepare for an official rating from a credit rating agency, it the city should consider the following actions:  Improving its financial reporting system. This should include audited financial statements indicating basic classifications such as own revenue sources, fiscal transfers, operating and capital revenues, as well as current expenditures. Current expenditures should differentiate between expenses in general administration, operations and maintenance of each municipal service, and capital expenditures.  Strengthening its capital investment planning process. This should comprise three- to five-year capital investment budgets prioritizing capital spending by services/programs. Budgets should also indicate specific sources of financing, such as own-source revenue, proceeds from debt, capital transfers, local development fund, PPPs, and any other capital sources.  Improving its capital asset registry. This registry should differentiate, among other things, between land and buildings devoted to services and fixed commercial assets including land not assigned to municipal services.  Greater oversight role over municipal-owned enterprises and their debts, identifying UB’s contingent liabilities, both explicit and implicit. ix MONGOLIA Credit Outlook Based on recent sovereign ratings, the credit outlook for UB would have been stable or positive. However, Standard & Poor’s has revised its credit outlook for the sovereign rating from stable to negative. A negative outlook on the sovereign rating would have unfavorable implications for UB’s credit outlook. As of April 3, 2014, although Moody’s rated Mongolia as B1 stable, it concluded that policy laxity and uncertainty are constraining the quality of its credit, resulting in a sharp spike in Moody’s External Vulnerability Indicator. The rating agency notes that in the absence of greater policy discipline and given the recent rise in government debt and system- wide foreign-currency borrowing, government finances and the economy at large would remain susceptible to boom-bust economic cycles. x Ulaanbaatar Financial Self-Assessment I. Financial Performance and Debt Profile This section analyzes the key indicators of UB finances as a whole, which include the UB government budget as well as the budgets of the nine districts. It also presents findings on local public debt and their implications for the city’s creditworthiness. Budget Finances Ulaanbaatar’s stable financial position has benefitted from a relatively diversified economy, which generated MNT 401.4 billion (equivalent to US$227 million) in own-source revenue in 2012. This represents about 63 percent1 of GDP, which supported a relatively stable revenue base. UB has a strong record of balancing its annual budgets, and has consistently maintained operating surpluses that have enabled the city to acquire new financial obligations. In the last five years,2 UB has closed yearly operations with balanced budgets and average surpluses of about 6.5 percent of total revenue. The reduction of cash financing surplus from 6.5 percent in 2008 to 3 percent in 2009–10 was due to the global economic slowdown, which had a negative impact on tax collection both at the local and national level. Nonetheless, the city has recovered in subsequent years, recording cash surpluses of 10.2 percent and 8.9 percent in 2011 and 2012, respectively (see Table A.1). In absolute terms, yearly cash surpluses have ranged from MNT 9.5 to MNT 78.6 billion, equivalent to US$5.4 to US$44.6 million (Table A.3). Between 2008 and 2012, an average of 48.7 percent of total revenues came from own-sources, which have been fairly stable. UB’s main revenues are underpinned by taxes on incomes and wages, which represent about 58 percent of its total revenues and have been growing in both nominal and real terms, as well as in real per capita terms. During the five-year period of this analysis UB’s annual real revenues have grown at an annual rate of 36.4 percent. However, the city has no authority to set its tax rates. These are established by the central government’s Ministry of Finance (MoF). In addition, UB also draws revenues from a land payment/tax, property tax, vehicle tax, user fees for underground water extraction, an inheritance tax, and stamp duties. Other service charges and tariffs are collected by UB enterprises and reported in their own budgets. However, the enterprises and UB do not have full rate-setting autonomy on some of these charges and tariffs, which compromises revenue flexibility and sustainability. 1 This figure should be treated as a rough estimate (which is most likely overestimated by the national regional accounts), considering the inherent difficulties in calculating local/regional GDP, particularly the nation’s capital, which is the most interlinked with the rest of the Mongolian economy. 2 The fiscal year is defined as the period between January 1st and December 31st. 1 MONGOLIA Beginning in 2012, intergovernmental transfers through the MoF’s Local Development Fund (LDF) for infrastructure are being made on the basis of a formula and are likely to range between US$50 to US$100 million. UB is now also being allowed to retain all revenue collection surpluses, which will incentivize the city to improve its collection efficiency. Fiscal transfers equal to 51.3 percent of UB’s total revenue are earmarked for specific public programs, such as health and education, from corresponding line ministries.3 Note that fiscal transfers cannot be used to cover debt service obligations or any type of recurrent operating expenditures. LDF transfers are for investment financing only, and transfers from line ministries are earmarked for expenditures in health and education or corresponding sectors. Therefore, changes in transfers do not affect UB’s fiscal capacity associated with its operating budget. They may only affect UB’s capital budget. While earmarked transfers from line ministries could be characterized as fairly stable, transfers from MoF had historically been fairly erratic and hence, unpredictable. However, with the passage of the Budget Law, which established the LDF and a formula-based transfer system, discretionary capital transfers appear to have finally stopped. On the expenditure side, both current and capital expenses recorded significant expansion of 132 percent and 128 percent, respectively, between 2010 and 2011. These increases reflected huge public spending in response to the economic downturn, as well as intensifying pressure for rehabilitation and expansion of urban infrastructure and services. Some of these expenditures have been partly financed by recurrent revenues, yearly surpluses, and by accumulated cash balances, as reported under “Cash and Bank Deposits” in the UB’s balance sheet (Table A.5). As a sign of financial resiliency and fiscal discipline, the city still managed to close yearly operations with cash financing surpluses, despite the increase in investments in public works (Table A.4). Capital Assets4 International experience suggests that cities use their recurrent revenue to cover both interest and principal of debt service obligations. In practice, immovable capital assets, such as land and buildings, are rarely used as collateral for borrowing. Bond buyers expect timely payment of principal and interest, and know that liquidation of government-owned capital assets cannot typically be accomplished to ensure timely payment if default looms. Even in revenue- generating projects, only the corresponding revenue streams are usually pledged for the financing of debt service obligations. Most cities use a general obligation pledge, which promises the bondholder that interest and principal will be the first recurrent expense paid from all available revenues. For UB, the Budget Law Article 62.4 establishes that the Capital City is prohibited from using its revenue as collateral when it incurs debt. As would be 3While UB manages these funds, they cannot be used to cover its financial obligations, including debt payments. 4Capital assets include movable and nonmovable property. Movable property refers to tools, machinery, equipment, and motor vehicles; nonmovable property comprises lands and buildings. 2 Ulaanbaatar Financial Self-Assessment expected, the law does not say that general revenues cannot be used to cover debt service obligations (interest and principal). However, the law does not explicitly prohibit UB from pledging its general revenues to secure bonds during is normal operations, which is quite different from using general revenues (or part of them) as collateral in case of default. The Budget Law also specifies that municipal assets designated to provide services cannot be used as collateral. The current value of UB’s non-movable assets is recorded under “Tangible assets” in its balance sheet (Table A.5). However, no distinction is made in the balance sheet between nonmovable assets devoted to services and those commercial fixed assets not associated with service provision. This distinction would be useful because the non-service-related commercial assets could potentially be used as collateral. Note that if pledging revenues were explicitly adopted as part of normal operations, the actual need for collateral would become much less important and fairly remote. If the current Securities Market Law, which requires collateral, is not reformed through the proposed draft law on Debt Management, it should be noted that UB owns some land and buildings that are not used for service provision, and could potentially be used as collateral for municipal debt.5 For other objectives, UB has started an asset registry system of public infrastructure, which does not report on vacant and undeveloped public land. The valuation for commercial lands and buildings is not based on market price, but on construction costs, adjusted for depreciation, excluding the value of land. Consequently, UB’s capital assets stock is significantly undervalued and not fully reflected in its balance sheet. Additionally, land and (indirectly) public buildings may be quite unattractive for investors as collateral, due to the legal risks associated with ownership of public land. Under the current system of restricted land tenure, land is not a very liquid asset (that is, not easily tradable) and thus ineffective as collateral. This limitation seems to be aggravated by the lack of valuation of public land and buildings, which currently makes the market value of such potential collateral unknown, or at best uncertain. Debt Profile Until 2012, UB was prohibited by law from borrowing. The debt report for the period of analysis (2008–12) does not report any direct debt, and thus UB’s ratio of debt service to total revenues is zero, as reported in Table A.1. Nevertheless, some municipal-owned companies currently hold internal and external debts. Some of these debts are guaranteed by the central government, others by the assets of the enterprises. It appears some concessional loans have 5 Article 62.4.1 of the 2012 Budget Law states that the capital city is prohibited from using “capital city property, which is required to fulfill its responsibilities.” The only viable options would be city property that is not related to the provision of services, such as vacant lands not involved in a program of land distribution, or real estate property owned by UB’s own enterprises that are not being used or meant for the provision of city services. 3 MONGOLIA been made in the form of on-lending agreements through the city to the enterprises by the MoF. The consolidated debt for FY 2012 reported long-term external debts of about MNT 130 billion (or US$73.4 million), and internal debts in the amount of MNT 44 billion (equivalent to US$23 million). These debts, as reported by the city, belong to UB’s municipal enterprises (see Table 1 and Table A.2 in Appendix A). In 2012, these debts (MNT 173 billion) comprised 19.7 percent of UB’s total revenue—not an unmanageable proportion in the event of a potential contingent liability. This debt is equivalent to 1.2 percent of Mongolia’s GDP (Table A.2). In the event that the city would have to assume the debt service obligations of its enterprises, the yearly financial obligations of the city would be less than a half a percent of its total own revenues. The repayment of this debt is in principle the responsibility of the companies themselves. According to UB’s debt report, the city government and its nine districts have no legal obligation for the payments of interest and principal. Nonetheless, over-borrowing by UB enterprises could lead to operational deficits, and potential default on their debt service obligations. This situation is more likely considering that some of these enterprises do not enjoy full financial autonomy. For example, city enterprises are not able to set their own rates and tariffs for the services they provide, which may compromise their financial sustainability. In addition, given that most of these enterprises provide essential services, UB may be forced to bail them out in the event of insolvency. As such, there are implicit contingent liabilities that could have a negative effect on UB’s financial stability and possibly in its future credit rating. The largest debt of MNT 88 billion (about US$50 million) belongs to the water utility. This debt represents 22 percent of UB’s own revenues in 2012, which suggests that current implicit contingencies could be manageable, but still significant. Table 1 Summary of External Debt of UB Enterprises, FY 2012 Loan amount Enterprises (MNT million) Share of total debt (%) Borrower 1 Water supply & sewers 88,005 67.36 MoF 2 Meat processing factory 6,286 4.81 MoF 3 Public Transport (Bus 3) 6,341 4.85 MoF 4 Public Transport (Bus 1) 6,715 5.14 MoF Subtotal 107,347 82.16 MoF 5 Tsalhilgaan teever 3,664 2.80 UB Ent. 6 Water pre-treatment plant 30 0.02 UB Ent. 7 Baganuur Water & Heating 209 0.16 UB Ent. 8 OSNAAK (Housing offices) 19,407 14.85 UB Ent. Subtotal 23,310 17.84 UB Ent. TOTAL AMOUNT 130,657 100.0 Source: UB Treasury Department. Note: Ent. = Enterprises. OSNAAK = Ulaanbaatar Housing and Communal Services Company. 4 Ulaanbaatar Financial Self-Assessment Note that the loan to the water company originated in July of 2004 from a loan provided by the World Bank Group (IDA) to the government of Mongolia through MoF to improve services in UB. This loan, as it appears, was on-lent by MoF to UB, which in turn passed it on the water company. This lack of clarity for financial responsibilities illustrates the critical importance of full transparency in debt management. Records on debt need to be systematized so that new local administrations are fully aware of the debt situation, as well as the corresponding legal responsibilities between UB, its enterprises, and MoF. After passage of the 2011 Budget Law on January 1, 2013, UB was authorized to borrow and issue bonds. The law specifies the central government approvals and disclosures required prior to borrowing. It also sets limits on the size and duration of debt. Specifically, “government” debt (that is, public debts) may reach ceilings of 40 percent of GDP; debt service for local governments is capped at 15 percent of base revenue of the previous year. The total debt of a local government cannot exceed its base revenue of the previous fiscal year and debt can only be held up to four years. Note that empirical findings of UB’s financial performance, including its yearly cash financing surpluses of about 6.5 percent of revenue, suggest that the city has capacity to borrow (within the specified limits) from either financial institutions and/or through the securities markets. Prevailing laws do not require a central government guarantee for UB’s borrowing. This means that the city would need to back its debt with its own creditworthiness based on the stability of its net revenue flow. If the city acquires debt, then it must be fully prepared to make the corresponding yearly budgetary appropriations to cover debt service obligations. In addition, it is advisable that UB pledges yearly revenues to a reserve fund, and makes mandatory annual deposits to a sinking fund, so that it can periodically redeem its bonds. Investors in bonds, in contrast to bank lenders, rely more on the stability in revenue sources (for servicing debt on a timely manner), than on a city’s own commercial assets that could serve as collateral in the event of default. Since UB would be fully responsible for the payment of its future financial obligations, a credit rating should be required by either law and/or corresponding regulations. II. Economic Fundamentals As the capital and largest city of Mongolia, Ulaanbaatar has roughly 1.3 million inhabitants, or 46 percent of the total population. People have migrated to the city in droves, attracted by growing economic and job opportunities and better public services. They have also been forced from the rural areas by the loss of livestock and livelihoods due to persistent harsh winters. The average income per household in UB is 21 percent higher than the national average, and income per capita is 35.6 percent higher. With 67.2 percent of the inhabitants in the working age group, 5 MONGOLIA UB has a reported unemployment rate of approximately 5.6 percent, and the monthly average salary of workers increased by 170 percent between 2008 and 2012. The local economy is relatively well-diversified. Local output is mostly (99 percent) comprised of construction, mining, and transportation services; light manufacturing and processing; and retail. In 2011, the mining industry, commerce, wholesale and retail, transportation, and real estate accounted for 15.7 percent, 11.0 percent, 9.74 percent, and 8.10 percent of GDP, respectively. Between 2008 and 2012, Ulaanbaatar’s average real GDP growth was around 13.3 percent, compared to the national growth rate of 8.76 percent. In spite of the global economic downturn (when national GDP decreased by 1.3 percent), Ulaanbaatar’s GDP grew by 6.4 percent, reflecting a high degree of economic resiliency. Construction and maintenance works in UB accounted for US$421 billion in 2011, 75 percent of total national output. Similarly, the retail and wholesale industry in UB produced 2.88 billion, also about 75 percent of total national sales. As these two sectors continue to drive growth and generate employment in UB, diversification of the tertiary sector, including hotel management, restaurants, and the development of financial services, will expand economic opportunities to UB’s inhabitants. The city also benefited from having domestic and foreign mining enterprises registered in its jurisdiction and receives 5 percent of royalties on minerals as part of the shared taxes system. Economic and revenue bases in UB have been broadening due to the demographic dividends. However, increasing pressure for municipal services has compounded a host of existing urban challenges, including air and soil pollution, solid waste management, water and energy (heating and electricity) provision, affordable housing, and transport. In the past two years, the real estate sector has grown significantly, driven mainly by increasing demand (rapid in- migration, rising disposable income, and interest rate subsidies), as well as boosted supply resulting from the direct government funding to construction companies, producers of construction materials, and real estate developers to support new construction.6 Strong demand for both housing and service delivery associated with this population growth will continue to put pressure for infrastructure spending in the future. In the face of mounting financial pressure on the municipal budget, UB is constrained by its restricted authority to set new tariffs and fees and limited adjustment flexibility. However, incentives to improve collection efficiency have expanded as UB has gained the authority to manage its own operating surpluses. 6This effort is part of the recent Monetary Stimulus Programs of the Government of Mongolia, which seeks to reduce inflation and spur economic growth. The program is well intended and embeds important social objectives. However, it is being implemented in an uncertain macroeconomic policy environment, through inappropriate channels of off-budgetary schemes, and therefore has the potential to exacerbate unfavorable macro trends. Furthermore, there is a perception that Ulaanbaatar’s public works projects are far beyond the capacity of local contractors, who simply don’t have the human resources, technological know -how, or experience to properly undertake many of the necessary infrastructure projects. 6 Ulaanbaatar Financial Self-Assessment III. Institutional Framework and Governance The democratically elected city leadership came into power in June 2012. It has since then moved towards a governance system that allows for greater public participation in the decision- making process through inclusion of voices from the neighborhood level, and introduction of a complaints system for better accountability and improvement in services provision. The city management has made major efforts to demonstrate visionary leadership to tackle enormous municipal challenges more effectively. Nevertheless, UB faces institutional constraints to manage its growth and development. The capital city is currently managed through a complex institutional structure, which renders effective cross-sectoral collaboration and data sharing particularly challenging. The UB municipal administration is comprised of 6 key departments, 32 agencies, and 53 municipal- owned enterprises overseen by a mayor (also governor of the UB Capital City), 6 vice-mayors, and 45 council members. This structure leads to institutional fragmentation, with overlapping roles and responsibilities among city departments and agencies, especially with regards to financial management, planning, and execution. The Finance and Treasury Department is in charge of producing financial statements, while the Property Relations Department provides data on city-owned enterprises’ debt record. However, it is unclear which departments would be responsible for providing crucial information regarding cash flows and liquidity, plans for municipal borrowing, comprehensive debt levels, and debt management strategy. The internal auditing function has not been set up yet. This self-assessment recommends (as does the debt management assessment) the creation of a financial and planning coordination mechanism and a debt management unit in the Finance and Treasury Department to be in charge of cash flow projections and liquidity, borrowing strategy, and debt management. Significant progress has been made in improving budget reporting formats. The dual reporting obligation requires that UB submit a budget report that is in line with MoF’s format and uniform with the rest of the country. Meeting this obligation, while trying to align its own budgeting system closer to international standards, severely hinders UB’s ability to report on relevant municipal finance elements; it also hinders reporting of key standard ratios from the budget reports for credit rating purposes. Budget reports from 2013 onwards have reported on actual services provided. There is still room for improving this service- or program-based reporting to be closer to international standards. Furthermore, the UB’s financial data and budget information are not managed or reported in an integrated manner that follows international standards. Following such practices would facilitate effective financial analysis, planning, and forecasting. UB’s budget format still does not record the yearly balance between 7 MONGOLIA revenues and expenditures, as it should. Even in the revised format prepared for this assessment, distinctions between capital and current revenues are not made. Finally, there is no systematized reporting (or a yearly balance sheet) on assets and liabilities. Since any future credit rating would need to review budget data for the previous five years, the rating agency would not be able to do this assessment for the years prior to 2013. This self-assessment exercise took 11 months; the majority of the time was spent in identifying the relevant financial data. Recently, UB has adopted recommendations on key principles for capital investment planning (CIP), with a goal of preparing a pipeline of projects to be financed with municipal bonds and other capital sources. These principles are: multi-year capital investment planning, establishment of an interagency CIP working group to provide inputs and oversee the prioritization of investment projects, and inclusion of life-cycle costing to account for operations and maintenance. Given the significant infrastructure investment needs in UB, and under current CIP practice, financial planners are overwhelmed with review requests from 9 districts, 50 government entities, and 70 municipal enterprises and joint ventures; each may request a dozen to over 100 projects. The key challenges and recommendations relate to the providing the human resources and expertise needed for project supervision. Staff and expertise shortages pose several challenges for UB, from independence in its investment decision-making to effective procurement of public works. Because of the role of UB as the economic, social, and political center of Mongolia, the institutional framework governing subnational governments is subject to national laws. It has gradually evolved towards deconcentration of fiscal powers and expenditure responsibilities. Several laws provide the broad legal framework for debt management,7 although inadequacies across these laws introduce rigidities and create significant uncertainties in the legal mandate that UB would have to follow to issue bonds. These laws need to be carefully reviewed, adjusted, and clarified in order to ensure legal and actual viability of these expected debts. 8 Hence, it is recommended that UB, as main stakeholder, actively advocate for technical revision of some crucial articles in these laws, as discussed in this note. 7 This body of laws includes: the Public Sector Management and Finance Law (2002); Securities Law (2002); Law on Coordination of Foreign Loans and Grants in Aid (2003); Making Payments for Treasury Securities (2005); Fiscal Stability Law (2010); Budget Law of 2011; and Securities Market Law (2012). 8The lack of clarity in some key elements of the laws may expose them to different interpretation by implementing agencies and could generate discretionary actions that may be against the law. The concepts of “debt” and “debt instrument” are defined in Articles 4.1.45/46, while the concept of “Public Debt” is defined in Provision 4.1.8 of the Fiscal Stability Law. When incurring public debt, local governments must adhere to the legal mandates established in Articles 57.4 and 62.2 of the 2011 Budget Law (BL). The first article refers to central government short-term loans, while the second one alludes to medium-term debt. Regarding short-term government loans, Art. 41.5 of the BL establishes that short-term loans can be allocated from upper-level budgets for financing revenue shortages in lower-level budgets as specified in the Provision 41.4 of the BL. 8 Ulaanbaatar Financial Self-Assessment IV. Extraordinary Support Considerations Extraordinary support is defined as the likelihood that a higher tier of government would aid a local government that faced acute liquidity stress or help local government avoid default on its debt obligations. Support could take different forms, such as a one-time cash infusion or any action facilitating negotiations with lenders that enhances access to interim financing for the local government. For UB, there is a moderate likelihood of extraordinary support from the national government. This conclusion reflects, at the jurisdictional level, the national government’s willingness to address any major financial problems that may be experienced by UB, in view of its strategic importance for the Mongolian economy. Legally, it is not explicitly stated whether the national treasury will provide timely bailouts, given the lack of precedent for municipal borrowing. Regarding bond issuance, best international practices strongly suggest that UB’s ultimate policy goal should be a legal framework that incentivizes local governments to be financially transparent, balanced, and solvent. In this way, central government guarantees would not be needed. Note that central government guarantees inherently induce moral hazard; that is, if a local government defaults, then the central government will bail it out. In a number of cities, moral hazard can be avoided by banning central government guarantees. Furthermore, following best practice transparency and accountability principles, bond issuance regulations must explicitly state the procedures to be followed in case of delays of interest payments, default, or bankruptcy. This gives investors a measure of confidence that they will recover their investments through liquidation of city assets, or other means. V. Conclusions and Recommendations UB has favorable economic fundamentals and a strong history of balanced budgets and cash financing surpluses. Despite a relatively diversified revenue base, UB’s expen diture assignments are not matched by flexibility in raising revenues. Nor is there a clear mandate to set fees, taxes, tariffs, and service charges, which are a common source of revenue for recurrent costs and capital expenditures. While there have been significant improvements in financial reporting, clearly understanding the extent of UB’s capital asset stocks and the city’s financial situation is challenging. Finally, the legal and regulatory framework on borrowing and debt management is incomplete. There is still a need to develop the guiding regulations, norms, and procedures for debt management, especially of city-owned enterprises. 9 MONGOLIA In order for UB to enhance robustness in financial governance and credit quality, prepare for a formal credit rating, and achieve creditworthiness, a number of measures are proposed for the consideration of the city’s leadership. The following measures build on the achievements of the ongoing partnership and technical assistance with the World Bank. Improvement of financial reporting Investors and creditors base their decisions to purchase bonds or to lend primarily on the financial strength of the issuers, and the associated guarantees to ensure the expected returns and minimize financial risks. The self-prepared and audited financial statements of UB would legally need to include information on cash flow, surpluses in operations, liquidity, sources of collaterals, and current holding levels of different debt types. UB would also be expected to highlight its sources of collateral, generally its commercial assets that should be reported in financial statements. However, UB’s reporting systems do not make such statements timely and easily available. Financial statements for the year 2013 are closer to international standards because they use a revised format that reports on the basis of outputs or services provided. Statements of prior years and those for 2014 are reported in a complex and nontransparent manner. As a result, producing the five-year statement for this self-assessment was an arduous task for UB technical staff that took a number of months. A credit rating agency would not have the time or the insider knowledge to dedicate the same degree of attention as the self- assessment team. As a result, it is likely that the city may not receive the rating it merits. Therefore, in preparing for a formal credit rating, UB could consider having the statements produced for this assessment formally audited as an interim measure to provide a degree of confidence to the rating agency. UB should internally undertake projections of revenues and expenditures, taking into account the expected financial obligations that would result from bond servicing. This information will help the city in its overall financial management. Specifically, it would help UB anticipate any possible negative trends in the balance between revenue sources and expenditure responsibilities. These projections would also be particularly relevant in the event that a specific revenue-generating project was expected to help finance debt service obligations of a revenue bond. Strengthening of capital investment planning process The city needs to strengthen its investment planning capacity. UB should strive to convince potential private investors of its ability to make a good and efficient use of public credit. UB should also develop its capacity to prioritize investment projects through a multi-criteria ranking methodology and cost-benefit analysis. UB should also build confidence with timely 10 Ulaanbaatar Financial Self-Assessment execution of its new capital budget. New regulations can establish a threshold below which a project is not financed through the CIP but instead funded from the current budget. This would reduce the backlog of project review requests. Strengthening capital asset registry In UB, not all land and buildings can be used as collateral for borrowing, depending on their current use. Current practices of asset inventorying only apply to public infrastructure in service and neglecting potential income-generating assets is not efficient or bankable. A public capital asset registry would help the city manage its assets inventory, and derive values and incomes from assets. The registry would also be a mechanism to help keep the costs of owning, operating, and maintaining assets at acceptable levels. Based on international best practices, government property and assets are owned by the government as a whole, with specific institutions or agencies as “users” of the assets. The registry will enable UB to duly reflect these assets on its books and value them accordingly. Greater oversight role over municipal-owned enterprises and their debts Municipal-owned enterprises have debt payment obligations and assets that are under the oversight of UB, as sole owner of such enterprises. Hence, UB would be obliged to intervene in case of enterprises’ default. Effective oversight over enterprises operat ions is crucial, particularly given the implicit and potential burden on the finances of the capital city in case of debt distress. Therefore, it is recommended that for each city-owned enterprise, UB officials exercise a systematic and thorough review of (i) annual operating and capital budgets, including a review of the justifiable number of staff; (ii) monthly statements of revenues and expenditures, with explanations of any variances from approved budgets; (iii) annual audited financial statements; (iv) assessments of the adequacy of current rates and charges; and (v) requests for any new borrowing and any disposition of assets beyond those justified by the normal course of business. In addition, for the eight enterprises that have loans, a comprehensive debt management system should be put in place. There is also a need to strengthen the legal framework that ensures effective enforcement of loan agreements. For example, as proposed in the draft Debt Management Law, a fiscal intercept could be introduced to withhold transfers to the city if it defaults on debt service obligations. A similar enforcement mechanism is needed to ensure UB enterprises comply with their debt service obligations. This will reduce uncertainties and credit risks, providing investors and lenders greater confidence that there is oversight and an effective enforcement system in place for debt repayment. 11 MONGOLIA Bibliography Brhane, Meskerem, Hernando Garzón, and Ariunaa Lkhagvadorj. 2013. “City Finances of Ulaanbaatar.” World Bank, Washington, DC. Chilkhaasuren, Bayanchimeg, and Batbayar Baasankhuu. 2012. “Population and Economic Activities of Ulaanbaatar.” Ulaanbaatar, Mongolia. Available at: http://www.ubstat.mn/upload/reports/ub_khotiin_khun_am_ediin_zasag_angli_ulaanba atar_2012-08.pdf M.A.D. Investment Solutions. 2013. “A Brief Analysis of the Mongolian Economy: Shifting the Focus from Short-term Instability to Long-term Sustainable Growth.” Ulaanbaatar, Mongolia. November. Moody’s Investor Services. 2010. Credit Analysis of the Municipality of Lima. December. Available at: https://www.moodys.com/ Moody’s Investor Services. 2013. Credit Analysis for Mongolia. Singapore. September. Available at: https://www.moodys.com/. 12 Ulaanbaatar Financial Self-Assessment Appendix A. Financial Statistics Table A.1 Key Economic Indicators 2008 2009 2010 2011 2012 Population ('000) 1,067 1,107 1161.8 1,207 1,227 UB Nominal GDP (MNT billions) 3,595 3,914 5,226 7,194 8,785 As % of Nominal National GDP 54.8 59.4 62.1 64.9 63.0 UB Real GDP, 2005 (MNT billions) 2,174 2,324.1 2,585.3 3,173.7 3,515 % of Change 16.7 6.9 11.2 22.8 9.0 National Nominal GDP (MNT billions) 6,556 6,591 8,415 11,088 14,013 National Real GDP (MNT billions) 3,964 3,913.6 4,162.7 4,891.8 5,492.7 % of Change 8.9 −1.3 6.4 17.5 12.3 UB’s Nominal GDP per capita (MNT thousands) 3,368 3,536 4,498 5,961 7,308 As % of National 129.0 136.3 139.3 142.1 135.6 Interest Payment/Total Revenue 0 0 0 0 0 Debt Service/Total Revenue 0 0 0 0 0 Cash Financing Surplus (Requirement)/Total Revenue 6.5 3.7 3.0 10.2 8.9 Own-Source Revenue/Total Revenue 45.6 58.0 46.7 47.5 45.5 GDP per capita/National average 129 136 139 142 135 Implicit Inflation Rate 23.2 1.8 20.0 12.1 12.6 Source: Computed for this report based on UB’s data provided by the Treasury and Property Relations Departments. 13 MONGOLIA Table A.2 Debt Statement (MNT millions) 2008 2009 2010 2011 2012 Internal debt for UB’s public enterprises 1,364 1,808 1,445 22,537 44,194 Securities 0 0 0 33 11 Other 1,364 1,808 1,445 22,504 44,183 External debt 247 488 488 123,474 129,784 Central government’s implementing projects 247 488 488 123,474 129,784 City 0 0 0 0 0 Internal and External debt (public enterprises) 1,612 2,296 1,932 146,012 173,978 Int. & Ext. Debt as % of GDP 0.002 0.03 0.02 1.32 1.24 DEBT TRENDS (as of 12/31) Internal and External debt 1,612 2,296 1,932 146,012 173,978 as % of Operating Revenue 0 0 0 0 0 as % of Total Revenue 0 0 0 0 0 Foreign currency debt 247 488 488 123,474 129,784 as % of Internal and External debt 15.3 21.2 25.2 84.5 74.9 Local currency debt 0 0 0 22,537 44,194 as % of Internal and External debt 0 0 0 15.4 25.0 Short-term debt 1,373 504 759 17,992 22,086.6 as % of Internal and External debt 84.7 21.8 37.9 12.3 12.8 Source: Computed for this report based on data provided by the Treasury and Property Relations Departments. 14 Ulaanbaatar Financial Self-Assessment Table A.3 Financial Operations (in MNT millions) 2008 2009 2010 2011 2012 REVENUE Taxes 13,550 86,849 110,747 163,655 239,973 Goods and services 15,789 5,560 5,947 10,809 14,263 Licenses, fees and permits 23,162 25,226 26,376 42,659 56,054 Non-tax revenues 18,983 26,813 25,500 69,165 82,919 Intergovernmental transfers 90,913 105,794 197,759 324,376 479,335 Operating revenues 162,398 250,243 366,329 610,664 872,545 Sales of assets 4,913 1,657 5,195 9,696 8,217 Capital revenues 4,913 1,657 5,195 9,696 8,217 Own-source revenue*** 76,398 146,106 173,766 295,984 401,426 TOTAL REVENUES 167,311 251,900 371,524 620,357 880,762 Total Revenue (in real terms) 101,168 149,584 183,799 273,699 345,237 Per capita Revenue (real terms) 94,780 135,162 158,202 226,835 281,367 EXPENDITURES Personnel and social obligations 7,035 10,239 13,467 29,531 36,392 Pension obligations 1,277 1,294 1,949 2,582 4,716 Goods and services 14,030 17,962 20,963 64,767 117,106 Interest 0 0 0 0 0 Other current expenditures 13,142 4,011 17,126 27,634 57,726 Current expenditures 35,484 43,506 53,505 124,520 215,941 Investment 43,724.5 47,756.5 74,914.8 170,975 180,113 Other capital expenditures 422 750 746 1,803 1,277 Capital expenditure 44,147 48,507 75,661 172,778 181,390 Transfers, Grants, Subsidies 76,729 150,365 231,117 261,574 404,785 TOTAL EXPENDITURES 156,360 242,378 360,283 558,872 802,115 Cash Financing Surplus 10,951 9,522 11,241 61,488 78,646 /requirements/ ** Source: Computed for this report based on data provided by UB’s Treasury Department. *** Own source revenue is total revenue minus intergovernmental transfers. ** Cash financing surplus is total revenue minus total expenditure. 15 MONGOLIA Table A.4 Financial Trends (percent) 2008 2009 2010 2011 2012 % Change in Own-source revenues 91 18 70 35 Intergovernmental transfers 16 86 64 47 Total tax revenues 540 27 47 46 Operating revenues 50 46 66 42 Total revenues (in nominal terms) 50 47 67 42 Total revenues (in real terms) 47.8 22.8 48.9 26.1 Personnel Spending 45 31 119 23 Current Expenditures 22 23 132 73 Capital Expenditures 9 56 128 5 Total Expenditures 55 48 55 43 As % Operating Revenues Own-source revenues 47 58 47 48 46 Intergovernmental transfers 55 42 53 53 54 As % Total Revenues: Cash Financing Surplus 6 3 3 10 8 Own-source Revenues 45 58 46 47 45 Intergovernmental Transfers 54 42 53 52 54 As % Total Expenditures Current Expenditures 22 17 14 22 26 Capital Spending 28 20 21 30 22 Personnel Spending 4 4 3 5 4 Source: Computed for this report based on data provided by the Treasury Department. 16 Ulaanbaatar Financial Self-Assessment Table A.5 Balance Sheet (in MNT millions, as of 12/31/2012) 2008 2009 2010 2011 2012 ASSETS Cash and banks 21,382 33,399 39,926 129,853 235,305 Receivables 4,736 1,816 2,357 13,877 44,035 Other receivables 2,905 1,021 1,284 1,260 31,374 Advance 0 0 829 2,876 3,484 Others 913 1,663 1,999 14,916 20,512 Total current assets 27,031 36,877 45,111 161,521 303,337 Tangible assets 33,231 71,496 97,297 297,378 399,642 Intangible assets 65 92 197 436 3,137 Total noncurrent assets 33,295 71,587 97,494 297,814 402,779 TOTAL ASSETS 60,327 108,464 142,605 459,334 706,116 LIABILITIES Short-term debt (enterprises) 0 0 0 32.7 10.5 Short-term payable (enterprises) 8.9 6.7 55.6 501.6 1,070 Other payable 1,364 497 703 17,490 21,737 Total short-term debt 1,373 504 759 18,025 22,447 Long-term debt 247 488 488 123,474 129,784 Deferred interest 0.3 1,311 741 5,014 21,884 Long-term liabilities 248 1,799 1,229 128,489 151,668 TOTAL LIABILITIES 1,620 2,303 1,988 146,513 174,114 Source: Computed for this report based on data provided by the Treasury and Property Relations Departments. 17 MONGOLIA Appendix B: Moody’s Rating Process for Local and Regional Governments Our ratings process is manageable and most information should be readily available to government officials. It generally starts with the provision of the following information: I. Document requirements  Three to five years of financial statements  Current year’s budget and projections  Breakout of expenditures by object and operating vs. capital  Off-budgetary revenues and expenditures and trends  Capital budget or multi-year capital improvement program  Debt statement for past five years detailing amount and structure, for direct/indirect/unconsolidated debts  Other contingent liabilities (pension funds, etc.)  List of major related companies, ownership stake and debt outstanding  Coverage of principal and interest of total debt  Economic data as available would be useful The next step is a face to face meeting with Moody’s that generally takes around one day. The city/province selects who should participate in the meeting—some suggestions are as follows: II. Suggested participation of city officials  Finance Bureau (Department of Budget, Treasury, Department of Exchequer, Intergovernmental Relationship)  Department of Debt and Capital Works  Economist/Economic Development Department City officials determine how the meeting will be run—questions can be provided in advance and dialogue may continue after the meeting if information is not available at the meeting III. Topics to discuss at rating meeting  Institutional framework: Relationship between City/Province and the central government including financial, legal and political aspects. Examples of central government support to the city/province. 18 Ulaanbaatar Financial Self-Assessment  Government Related Issuers: Financial interaction with GRIs including level of subsidies and dividends, importance of companies to the city, summary of financial performance of major profitable and unprofitable companies and future development plans.  Economic Factors: Size, structure and diversity of economic base: major economic sectors and their activities. Potential growth sectors, competitive pressures and importance of different industries. Planned large capital projects and potential impact.  Budget Structure and Policies: The structure of the city’s budget, key factors that have driven trends in major categories over the past five years, and degree of flexibility to raise revenues or cut expenditures if necessary. Review intergovernmental grant and loan programs.  Financial Performance and Position: Discuss past recent years of financial performance and projections and key factors driving outcomes. What are the major financial pressures addressed in the budget? How does the city manage its liquidity requirements?  Debt Position and Management: Review of total direct, guaranteed and non-guaranteed debt of state-owned companies. Debt management policies and limits. Financing plan including projections of government investment and future borrowing for the next three to five years. Figure A.1 Moody’s Regional and Local Government Credit Rating Methodology Source: As applied in Lima, Peru. Moody’s Investor Services. 2010. Credit Analysis of the Municipality of Lima. December. Available at: https://www.moodys.com/ 19