Report No. 41036-MN Mongolia Promoting Investment and Job Creation An Investment Climate Assessment and Trade Integration Study November 2007 Poverty Reduction and Economic Management Department East Asia and Pacific Region Document of the World Bank - _iI. . . . . . . ~ P .....,I_ Table of contents Preface and acknowledgements ..................................................................................... i Executive Summary ...................................................................................................... ... iii What This Report Is About iii Where Things Stand V What The Main ObstaclesAre vi What NeedsTo Be Done X 1. Introduction ............................................................................................................... 1 a. What the report aims to do b. What the analysis is based on c. What the report does not do d. A road map P A R T I S C A N N I N G T H E L A N D S C A P E 4 2. The context, background and recent trends ............................................................ 5 a. The context: pre-existingconditions 5 b. The background:transition and transformation 5 c. Recenttrends: some reasonsfor optimism but also many causes for concern 7 d. The challenge: promotinginvestmentandjob creation bythe private sector 12 P A R T II M A P P I N G T H E T E R R A I N 13 3. The business environment ..................................................................................... 14 a. What businesseshaveto say 14 b. Bureaucraticand politicalcorruption is becoming entrenched 15 c. The cost of finance is high and access limited but scarcityof capital is not the main cause 17 d. Taxes are burdensomeand tax administrationinconsistent 21 e. The licensingand inspectionsregime imposes a bureaucraticburden without achieving its underlying public purpose 26 f. The court system,while improving,remainsa weakness while crime is not yet a major problem 29 g. Labor market flexibilityand human capital are strengths but skills shortagesare emerging 30 h. lnfrastructuralservices,though they could be improved,are not a pressingconcern 31 i. Regulatoryweaknesseslimitthe competitivenessandthreaten the sustainabilityof the meat, hidesand tourism industries 32 4. The setting for trade ............................................................................................... 35 a. The trade and foreign investment regime is remarkablyopen, but. .. 35 b. Customsvaluationsand exemptions have becomea locusfor rent-seeking 35 c. Transport options are limited,costlyand unreliable 37 d. Trade facilitation services are weak 40 e. Technical and other barriersto trade beyondthe border in China and Russia are serious impediments 41 f. Inefficienciesin transport and logisticsare particularproblemsfor the tourism and livestock- based industries 43 P A R T Ill C L E A R I N G T H E P A T H 4 5 5. The diagnosis and broad prescription ................................................................... 46 a. Corruptionand a lack of transparencyand accountability in government-business interactionsare the central impediments 46 b. But corruption is notthe only impediment-Mongolian firms face considerableobstacles getting goods to and from external markets 46 c. To tackle corruption, laws alone will not suffice-administrative processes needto be reformed 47 d. Public disclosure initiativesthat promotetransparencywill facilitate the administrativereform process 47 e. A two-part prescription 48 6. Improving the business environment ..................................................................... 49 a. The required anti-corruptionlaw has been passed but greater effort is necessaryto ensure that it is effectively enforced in an impartial manner 49 b. Addressingthe legal and institutionalgaps that make lending risky would lowerthe costs of finance and improve access 50 c. Reformof the tax code has rightly been on the top of the government's reform agenda 51 d. ...but reform of the tax administration is equally urgent 51 e. An "Open Government"taskforce to coordinatetransparency in government-business interactions is worth constituting 52 f. The licensing and inspections regime needs to be reviewed, rationalized,and appropriately resourced 53 7. Facilitating integration with regional and global markets ..................................... 54 a. Customs processes needto be reformedwith a view to reducing delays and reducing rent- seeking 54 b. Scarce resources and capacity for negotiating internationalagreements should be appropriatelyallocated 54 c. A (partial) open-skies policy is worth considering 55 d. In formulating trade and investment policy, it is importantto avoid misdiagnoses 55 References ................................................................................................................... 57 ....... . . . . . . ..... . . . . . . .- ..... . . . ..- Tables, figures and Boxes - - ~ ..,,,, ,,,,.. ..,., ,,., ,, L P ,, ..,.. . . . ......,,. . Executive SummaryTable 1:Corruptionpervades every sphere of business activity................................................... Executive Summary Figure 1:Perceptionsof Mongolianfirms regardingthe main investmentclimate impediments... iv iv Table 1.1: Mongolia Productivityand InvestmentClimate Survey, 2004 ....................................................................... Table 1.2. Mongolia Rural InvestmentClimate Survey,2004 ........................................................................................ 1 2 Table 2.2:GDP growth in recent years........................................................................................................................... Table 2.1:The make-up of the Mongolian private sector................................................................................................ 6 Table 2.3:Sector-wise contributions to GDP and employmentgrowth ........................................................................... 7 Table 2.4:Key financial indicators,................................................................................................................................. 8 9 9 Table 2.6:Have Mongolianfirms been creating jobs? What the aggregate data suggest ............................................ Table 2.5:Domestic private investment,......................................................................................................................... Table 2.7:Have Mongolianfirms been creating jobs? What the micro evidence suggests........................................... 10 Table 3.1: Government procurement:the importance of gifts...................................................................................... 11 Table 3.2:Real interest rates in Mongolia and selected other countries, 2001-05,....................................................... 16 Table 3.3 : How does bank-based financial intermediationin Mongolia compare:....................................................... 18 Table 3.4 : The evidence on access to credit............................................................................................................... 18 19 Table 3.6 : The structure of government revenues in Mongolia................................................................................... Table 3.5 : Collateral requirementsare more stringent in Mongolia than elsewhere ................................................... 20 21 Table 3.8 : Labor taxes are high in Mongolia,.............................................................................................................. 23 Table 3.7 : Corporatetax rates in Mongolia relativeto other countries in the region................................................... 22 Table 3.9 :The burden of tax inspectionsin Mongolia relativeto other countries........................................................ Table 3.10 :Corporatetax filings in Mongolia.............................................................................................................. 24 24 Table 3.11 :Perceptionsof businesses regarding registration,licensing and inspections in Mongolia and other .................................................................................. ...................27 Table 3.12 : The experience of Mongolianfirms in obtaining the permits neededto start and continue operations....29 countries........................ , ..#.. 28 Table 3.14 : The legal system and the crime situation: Mongolia relativeto others..................................................... Table 3.13 : The consistency and compliance burden of regulations in Mongolia....................................................... 30 Table 3.15 : Delays and reliability of basic infrastructureservices............................................................................... 31 Table 4.1 : Facts about customs processes in Mongolia............................................................................................. Table 3.16 : Delays and reliability of basic infrastructureservices............................................................................... 32 Table 4.2 : The extent and value of import duty exemptions in Mongolia .................................................................... 36 Table 4.3 :Transport options to/from Ulaanbaataralong the major trade corridors..................................................... 37 Table 4.4 :Costs and reliability of surface trade transport corridors to/from Ulaanbaatar............................................ 38 Table 5.1 : Corruption pervades every sphere of business activity.............................................................................. 39 46 Figure2.2:Which firms have been creatingjobs? ........................................................................................................ Figure2.1:Which firms have been investing.and how much?..................................................................................... 10 Figure 3.2: Perceptionsof corruption as a severe obstacle are more widespread in Mongoliathan elsewhere.........15 Figure 3.1:Perceptionsof Mongolianfirms regardingthe main investment climate impediments................................ 12 14 Figure 3.3:Firms' perceptionsof government procurementprocesses ........................................................................ 16 Figure 3.5 : The availability of medium and long-term credit in Mongolia (2001-2004)................................................ Figure 3.4: Politicalconnections are more importantfor doing business in Mongoliathan elsewhere......................... 17 19 Figure 3.7 : Cross-countryperceptionsof tax rates and tax administration ................................................................. Figure 3.6 : Mongolianfirms avoid taxes by staying artificiallysmall ........................................................................... 23 Figure 3.8 :The effectivetax rate faced by firms varies widely..................................................................................... 24 Figure 3.9 : Evasionof social security taxes is widespread ......................................................................................... 26 25 Box 4.2:The Mongoliantourism industry's harsh summer of 2005 .............................................................................. Box 4.1: Inspectionof wool and cashmere .................................................................................................................. 42 43 Box 6.1:Debt recoverytribunals in India...................................................................................................................... Box 4.3:The role of logistics in the decline of meat exports: the story of one exporter................................................. 43 Box 7.1:Pakistan'sfailed experiment with export taxes on raw cotton......................................................................... 50 56 ~~Preface and acknowledgements The planning for this study was initiated in the summer of 2003 at the request of the Government of Mongolia. In its Economic Growth Support and Poverty Reduction Strategy (EGSPRS) paper released in July 2003, the government recognized the critical role of a dynamic private-sector as the driving force behind sustainable growth and poverty reduction (Government of Mongolia, 2003). Accordingly, it adopted as one of the central pillars of the EGSPRS the aim of establishing a sound institutional and regulatory environment to complete the transition to a market economy and enable the private sector to become an engine of growth. This report is meant to assist in the process of translating the government's broad policy statements regarding the intention to encourage private sector led growth into a coherent private sector development strategy, underpinned by a prioritized set of specific policies to be developed and implemented, in partnership with the private sector and international development partners (World Bank 2003). The findings and recommendations of this study are based on the primary data collected in 2004-05 and analysis undertaken subsequently. Some of the policy measures being proposed through this work have since been adopted, for example regarding the anti-corruption law and some improvements to the tax code-all in 2006-07. These are early steps in the right direction. Despite these reforms, Mongolia's global ranking with respect to the Ease of Doing Business has remained static according to the latest report in this area. In 2007 the country was ranked 52"dout of 178 countries surveyed, compared to 2006 when it was ranked 48'h out of 175 countries. In the area of taxation, it is worth noting that in Mongolia it takes on average more than five weeks to prepare, file and make the 42 annual payments required. By contrast, in top- ranked Singapore, an average of only 5 tax payments are to be made each year, requiring little over one week of time to prepare, file and pay. Similarly it takes an average of 5 days to go through the required official procedures to export goods in Singapore but in Mongolia this process takes an average of 58 days. These simple comparisons of a few aspects of doing business serve to highlight the challenging and dynamic nature of the reform agenda. A large number of individuals and organizations contributed substantially to the production of this report. The cooperation and help of the Mongolian government-in particular, the Macroeconomics Department of the Ministry of Finance, the General Department of National Taxation (GDNT), the Customs Authority, the State Professional Inspections Agency, the Bank of Mongolia, the National Statistics Office, and the Ministry of Industry and Trade are gratefully acknowledged. In addition, representatives of private sector firms, financial institutions, and industry associations as well as a number of donor agencies were extremely generous in sharing their insights and perspectives. The Mongolian National Chamber of Commerce and Industry, the Asian development Bank (ADB), and the Economic Policy Reform and Competitiveness Project of the United States Agency for InternationalDevelopment(USAID) deserve particular mention. 'Doing Business,2008,World Bank,Washington DC, 2007. i The main contribution and value-added of the report derives from the firm and household-level data on which the analysis is based. A number of Mongolian organizations were critical to the data collection effort. The Sant Maral Foundation painstakingly implemented the Productivity and Investment Climate Survey (PICS) of 393 private firms in Ulaanbaatar and 4 other cities. The Macroeconomics and Business Statistics Department of the National Statistics Offices was responsible for the survey of 500 rural households engaged in non- agricultural household enterprise activities. The Mongolian Alternatives Center (MAC) organized the survey of firms at all points in the supply chain of the tourism industry, while the Mongolian Veterinary Association (MVA) undertook the survey of supply chain participants, from herders to traders to processors and retailers, in the meat and hides industries. Profiles of the tourism industry by MAC and of the meat and hides industries by MVA provided detailed and useful background information. The primary data collection and analysis undertaken for this report was done in 2004 and 2005. A draft version of the report was discussed in June 2006 in a day long workshop attended by nearly 150 participants from the private sector, government, and donor community, who debated the main findings and recommendations of the report and discussed ideas for translating these into concrete actions that the government, in partnership with the private sector and donors could implement. The report was written by Shubham Chaudhuri based on the contributions of a number of World Bank staff and consultants. Robin Carruthers and Robert Wallack wrote a background piece on the transport and trade facilitation challenges faced by Mongolia. Remco Oostendorp and Martin Cumpa undertook the statistical analysis of the PlCS and Rural Investment Climate Survey data and cogently summarized the main findings. Batshur Gootiiz and Giulia Ferrari analyzed the data from the supply chain surveys and produced reports on the competitiveness of the tourism, meat, and hides industries. Saha Dhevan Meyanathan, Tsolmon Bat-Ochir, and Altantsetseg Shiilegmaa of the World Bank's Ulaanbaatar office provided invaluable perspectives on the local context. Chris Finch, Xiaofeng Hua, Shabih Mohib, Genevieve Boyreau, Giovanna Dore, Salvador Rivera, Charlie Abelman, Vera Songwe, Bert Hofman and Sudarshan Gooptu-all current or former members of the World Bank Mongolia country team based in Washington, DC-provided much useful feedback, while Philip Schuler and Vincent Palmade provided many useful comments as peer reviewers. Cyrus Talati was instrumental in updating the report to reflect recent developments. The work was done under the guidance of Homi Kharas (former Sector Director and Chief Economist, EASPR), David Dollar (Country Director, Mongolia) and lndermit Gill (former Sector Manager, EASPR). ii What This Report Is About The aim of this report is to identify a set of concrete steps that the government of Mongolia-in partnership with the private sector and the international donor community-might take to promote private-sector activity and greater integration with the global economy in a way that leads to job creation, broad-based growth and most importantly, poverty reduction. It does this by combining an assessment of the investment climate faced by firms (through analyses of firm and household surveys and supply chains in selected sectors) with a diagnostic trade integrationstudy. As in many transition economies with limitedtraditions of market-oriented private- sector activity, the obstacles to private-sector development in Mongolia are numerous. There has been no shortage of studies and surveys documenting the challenges that the Mongolian private sector faces. From the burden of taxes, bureaucratic harassment and corruption, to the high cost of and limited access to finance, and the logistical and infrastructural difficulties of getting goods to markets (especially export markets), there is little disagreement about the range of impedimentsthat Mongolian businessesface. Where there is less consensus, however, is on what needs to be done and on which, of the many things that need to be done, ought to be done first. This report aims to contribute to the ongoing debate and to building a consensus. Two things distinguish the analytic approach adopted in this report. First, to a greater extent than most past studies, the analysis is based on quantitative data, not just on the perceptions of businesses but also on their actual practices and performance. Second, wherever possible, reference is made to comparable data from other countries, which serves to benchmark the investment climate in Mongolia against international standards. By doing so the hope is that more diagnostic insights can be obtained into the underlying causes of the range of impediments that have been well-documented over the years. And that, in turn, should help to prioritize what needs to be done, and in what order. The diagnosis: The basic diagnosis, which results from this analysis, is this: corruption and the corruption and a lack of transparency and lack of transparency and accountability in government-business interactions that accountability in allows corruption to flourish are the central impediments to the development of a government-business robust and dynamic private sector in Mongolia. interactionsare the central impediments,but not the only ones This basic diagnosis does not mean that other impediments are unimportant or that corruption is the only problem confronting the Mongolian private sector. On the contrary, it is clear from the study that Mongolian firms face considerable The transport options obstacles-logistical, infrastructural and institutional, within Mongolia, at the Mongolianfirms havefor getting goods to and border and beyond the border in China and Russia-in getting goods to and from from external markets areexternal markets. As in other land-locked countries, and perhaps even more so limited, costly and than most, the transport options that Mongolian firms have are limited, costly and unreliable. unreliable. But these "natural" difficulties, which stem from Mongolia's geography and location and which undoubtedly need to be addressed, are overshadowed by the "man-made" obstacles that Mongolianfirms face. iii The evidence indicates that corruption and a lack of transparency and accountability pervade almost every sphere of business activity. Mongolian businesses recognize this, and corruption is the most frequently cited impediment to doing business in Mongolia (Table 1). The analysis further suggests that the consequence of this has been the growth of a culture of operating in the "shadows", which has gotten in the way of firms accessing finance, building market relationships, enhancing productivity, growing and creatingjobs. ... 26.0 ~~" major or severe obstacle ",,...~-"....~I__ 56.5 connection _I Value of gift expected to secure % of firms paying bribes for telephone E%of~firms s r C c ! ! s o s.ok?ofcontrE%,.. 4.3 23.0 indicatingthat politicalties '7" of firms paying bribes for waterll^..-_l"--l_ll_-. line ~ are importantfor business 15.0 % of cases""where unofficial payments "1111 " _ 47.' connection_-....^_-.~",._."_I_.-" YOof exporters paying bribes for __I__ ~~~ needed for "... registration 15.2 customscl!~~ra~~.,~exp-orts . 25.0 % of cases where unofficialaavments % of imaorters aavina bribes for needed to obtain licenses and permits 22 2 customs clearance oiimports 22 6 Source.Mongolia Productivity and Investment Cl/m