ADB Project on Governance Reforms in Mongolia-Terminal Report Part-3 by Tarun Das

8/8/2019 ADB Project on Governance Reforms in Mongolia-Terminal Report Part-3 by Tarun Das

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ADB Project Terminal Report -Part-3 by Tarun Das ________________________________________________________________

Adviser. Thus the Financial Adviser/ Financial Control Officer helps the line ministry for the following functions:

(a) allocating appropriations(b) approving financial commitments(c) holding tenders and concluding contracts

(d) overseeing purchase of goods or services(e) overseeing execution of public works(f) approvals for payment orders

Such Ex ante control mechanism is based on the principle that compliance audit is performed before the payment is made at various stages of the spending process. It isunderstood that the government of Mongolia does not have a system of FinancialAdviser/ Financial Controller/ Internal Auditor. It may be advisable for the Mongoliangovernment to adopt such a system for ex ante financial control and internal auditor. Tostart with, MOF may appoint Financial Advisers/ Financial Control Officer/ InternalAuditors for the major ministries like MOF, MOECS, MOSWL and MOH.

3. Relation Between Financial Planning and Budget Planning

3.1 Budget Planning and Strategic Planning

Financial planning is an integral part of a sound and transparent budgeting exercise.Table-1 summarizes the major characteristics of modern budgets as compared with thoseof classical budgets.

3.2 Public Sector Management and Finance Act (PSMFA June 2002)

It is well known that the Government of Mongolia enacted the Public Sector Management and Finance Act (PSMFA) on the 27 June 2002 in order to modernize budget planning and budgeting systems as per international best practices. We haveoutlined a seven year action program to complete these activities in a phased manner.

4. Methodology for Financial Planning for 2009-2011

4.1 Macro-economic framework

In this section we describe a methodology for Financial Planning for the MongolianBudget. However, it must be kept in view that there is no unique methodology which can

be applied at all times. Financial Planning depends on the macroeconomic prospects andon the budgetary and fiscal framework already approved by the Parliament. We make our fiscal projections on the basic of macro-economic prospects for the years 2008-2011 asdescribed in the chapter on strategic planning.

MOF, Govt. of Mongolia Glocoms Inc. (USA)163


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Table-1: Characteristics of Modern Budgets Compared with Classical Budgets

Classical Budgets Modern Budgets

Unbalanced budget with reliance on monetized

deficit financed by the monetary authority withcreation of additional money supply.

Balanced budget without any monetized deficit.

Fiscal deficit is financed by market borrowingsfrom either domestic markets or from externalsources including bilateral countries andmultilateral funding agencies.

Sectoral financial planning focusing basically onshort-run or sectoral gains

Strategic business planning keeping in view broader objectives, vision, mission, strengths andweaknesses

Input based budgeting- Budgeting in terms of wages and salaries, purchases of goods and services

Activity based budgeting- costing and budgetingof activities required to produce desired outputs

Inputs/ resources budgeting budgeting for labor, energy, transport, goods and services

Output/ Outcome budgeting- budgeting for specific outputs and outcomes

Cash accounting- accounting revenues andexpenditures when cash is received or paid

Accrual accounting- accounting revenues andexpenditures when commitments are made or liabilities are created it does not matter whether cash is received or not.

Project budgeting- focusing on completion of individual projects

Program budgeting- f ocusing on integrated program for a specific purpose such as employmentgeneration or poverty reduction

Expenditure based budgeting- allocation of money on the basis of expenditures

Performance based budgeting- allocating financeon the basis of performance

Annual budgeting- budgeting for a year Multiyear budgeting- budgeting for a number of years, generally for the budget year and twoforward years

Non-Transparent budgeting budgets are prepared in top secretary Transparency based budgeting l ess secretary in preparation of budgets, experts and stakeholders areconsulted, governments objectives are announced.

No public scrutiny- does not allow scrutiny byothers

Public scrutiny- allows scrutiny by the media andthe general public

No stakeholders consultation- stakeholders arenot consulted

Multi-stakeholders consultation- stakeholdersare consulted before finalizing the budget

Top-Down Approach- MOF first allocates theresources to line ministries who then allocate fundsunder various heads

Bottom-up Approach- Line ministries first prepare their budgets and sends requests to MOFwho makes adjustments on the basis of resourceconstraints and inter-sectoral equity

Complete secrecy in budget preparation Limited secretary and public consultation

Parliament of Mongolia has earlier approved major macroeconomic and fiscal parametersas medium-term objectives under the Medium Term Budgetary Framework (Table-2).



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For Financial planning during 2009-2011, we consider major macro-economic and fiscal parameters such that these parameters comply the basic targets under MTBF.

Table-2 Compliance with the 2008 MTBF targets(As percentage of GDP unless otherwise specified)

Major macro-economic and fiscalparameters MTBF Budget for2008 FinancialPlan 2 for2009-2011

1. Floor on GDP growth rate (%) 8.7 10.1 10.02. Ceiling on inflation rate (%) 5.0 5.5 5.53.Ceiling on total budget revenue 40.2 44.0 43.74. Ceiling on total budget expenditure 43.2 47.0 46.25. Floor on current balance 7.9 7.7 7.76. Ceiling on budget deficit -3.0 -3.0 -2.57. Floor on capital expenditure 8.0 8.8 9.0Source: Government of Mongolia Budget 2008 for MTBF and 2008 Budget, and the

authors estimate for the Financial Plan for 2009-2011.

It may be mentioned here that the Socio-Economic Development Guideline of Mongoliafor the year 2008 has an inflation target of less than 10 percent. This is significantlyhigher than the European Unions inflation target at 3 percent, and the inflation target of the most of the developing countries at less than 5 percent. Mongolian policy implies amajor departure from the neo-liberal macroeconomic framework that has dominated

policymaking in many developing countries. The neo-liberal model favors strict fiscaldiscipline that is pre-occupied with maintaining small fiscal deficits, monetary policy thathas low inflation targets and exchange-rate policy that is committed to be fully flexibleand market-determined. While the government of Mongolia also supports fiscal

discipline (with overall fiscal deficit targeted at less than 3 percent of GDP as in theEuropean Union) and flexible exchange rate, it is more liberal for the target of inflationrate. This is because the overall inflation in Mongolia is highly correlated with global

prices of minerals and petroleum products, which had witnessed significant increasesover the past few years.

Higher inflation rate also implies a more expansionary fiscal policy to encourage work efforts and production, to enhance buoyancy in government revenues and to foster privateinvestment. Monetary policy can be accordingly designed to support fiscal expansion andexport promotion by achieving low real interest rates for private investment and thealleviation of public-sector debts.

With higher inflation rate prevailing in the economy, monetary authority (i.e. the Bank of Mongolia) could take direct measures (such as selective credit controls and higher cashreserve ratios) to dampen the inflationary pressures resulting from supply shocks e.g.,sharp increases in food and energy prices. They should not hold back economic growth

by raising interest rates and trying to contain inflation at five percent or less. They couldmove aggressively to provide increased access to affordable credit, through offering loan2 Authors projections in this report. For details, see section 4.2.



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guarantees for productive activities and reviving development banks. They could also pursue appropriate foreign exchange management policies to reduce volatility inexchange-rates and to maintain stability in real interest rates.

4.2 Methodology for Financial Planning

Financial planning means forecasting different components of governments revenuesand expenditures for the financial planning horizon. In this exercise, the current budgetyear 2008 has been taken as the base year and the three forwarding years viz. 2009-2011have been taken as the planning horizon. Trends of different revenue and expenditureitems are examined during 2006-2008 and then one of the following methods, dependingon the pattern of past trends and underlying relationships, are used for projecting theseitems for the planning horizon:

(a) Growth method - Average growth rate of an item during 2005-2008 or growthrate during 2008 or average growth rate in the past excluding extreme values;

(b) Stability approach - Stable value for an item over the planning horizonimplying attainment of satiety or saturation level;

(c) Ratio or intensity approach - Average ratio of an item to GDP at currentmarket prices.

(d) Elasticity approach- Elasticity of an item with respect to GDP at currentmarket prices.

The methodology for specific items is described in details in Tables-3A and 3B . If larger

time series data were available, one could have used the usual trend analysis or multipleregression techniques. Here, very simple but logical techniques have been used for forecasting an item for financial planning. The results are indicated in Tables-4A, 4B, 5Aand 5B .

Table-3A: Methodology for Financial Planning for the Period 2009-2011

ITEMS Methodology Value1. TOTAL REVENUE AND GRANTS 2+3+42. CURRENT REVENUE 2.1+2.2

2.1 Tax revenue 2.1.1 to 2.1.82.1.1 Income Tax PIT+CIT+WT2.1.1.1 PIT Elasticity with respect to GDP 0.42



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2.1.1.2 CIT Elasticity with respect to GDP 1.152.1.1.3 wind fall tax GR in 2008 0.16

2.1.2 Social security contributions Average GR during 2006-2008 22.152.1.3 Tax on immovable properties Average GR during 2006-2008 19.532.1.4 Sales Tax ( VAT ) Elasticity with respect to GDP 1.10

2.1.5 Excise Tax Elasticity with respect to GDP 0.772.1.6 Special purpose revenue Average GR during 2006-2008 17.122.1.7 Taxes on foreign trade Elasticity with respect to GDP 1.152.1.8 Other Taxes and fees Average GR during 2006-2008 37.83

2.2 Nontax revenue GR in 2008 7.483. CAPITAL REVENUE Average GR during 2006-2008 13.914. FOREIGN GRANTS Stable at 2008 level5. TOTAL EXP & NET LENDING 6+7+86. CURRENT EXPENDITURE 6.1+6.2+6.3

6.1 Goods and Services 6.1.1+6.1.26.1.1 Wages and Salaries Inflation rate 0.10

6.1.2 Purchase of goods/services Inflation rate 0.10

6.2 Interest payment Average GR during 2006-2008 1.716.3 Subsidies and transfers 6.3.1+6.3.26.3.1 Subsidies GR in 2008 15.126.3.2 Transfers GR in 2008 37.78

7. CAPITAL EXPENDITURE 7.1 to 7.47.1 Domestic Investment Investment/ GDP ratio in 2008 0.077.2 Capital Repairs Average ratio of (7.1) 0.087.3 Other capital expenditures Average GR during 2006-2008 40.387.4 Road fund by project loan GR of GDP 0.10

8. NET LENDING 8.1+8.28.1 Domestic (net) Stable at 2008 level8.2 Foreign (net) Stable at 2008 level

9. Overall Balance (1)-(5)10 Current Balance (2)-(6)11. Mineral balance ----



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Table-3B: Methodology for Financial Planning for the Period 2009-2011

ITEMS Methodology Value12. FINANCING: 12.1+12.212.1 Foreign (net) 12.1.1 to 12.1.3

12.1.1 Project loans Residual after domestic12.1.2 Cash loans Stable at 2008 level12.1.3 Amortization As per debt profile

12.2 Domestic (net) 12.2.1 to 12.2.612.2.1 Privatization receipts Stabilize at 2008 level

12.2.2 Repayment of Govt bonds As per debt profile12.2.3 Long term bond New Amortization

12.2.3.1 New GR in 2008 18.4412.2.3.2 Amortization As per debt profile

12.2.4 IMF ( Net ) As per IMF loan profile12.2.4.1 Disbursement As per IMF loan profile12.2.4.2 Amortization As per IMF loan profile

12.2.5 Banking system net credit 12.2.5.1 to 12.2.5.312. 2.5.1 Increase in the DF bal Estimated by Bank of Mongolia12.2.5.2 Net changes in C/A Estimated by Bank of Mongolia

12.2.5.3 Opening Balance No balance12.2.6 Non-banking system Preferably nil



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Table-4-A: Financial Planning for the Govt of Mongolia for 2009-2011 (Billion MNT)ITEMS 2005 2006 2007 2008 2009 2010 2011

Outturn Outturn Outturn MOFFinal

Forecast Forecast Forecast

.1. . 2. . 3. . 4. . 5. .6. .7. .8.

1. TOTAL REVENUE AND GRANTS 838 1360 1786 2404 2865 3431 41292. CURRENT REVENUE 833 1354 1781 2387 2848 3414 4112

2.1 Tax revenue 692 1128 1417 1996 2428 2962 36262.1.1 Income Tax 179 477 626 800 945 1118 13252.1.1.1 PIT 58 77 70 85 92 99 1082.1.1.2 CIT 121 222 242 352 433 532 6552.1.1.3 wind fall tax 0 178 314 363 421 487 563

2.1.2 Social security contributions 96 112 135 174 212 259 3172.1.3 Tax on immovable properties 6 7 8 11 13 15 182.1.4 Sales Tax ( VAT ) 181 241 237 451 550 672 8192.1.5 Excise Tax 79 100 119 163 188 217 2512.1.6 Special purpose revenue 11 11 13 17 20 24 28

2.1.7 Taxes on foreign trade 57 72 98 169 208 255 3142.1.8 Other Taxes and fees 84 108 181 211 291 402 553

2.2 Nontax revenue 140 226 364 391 421 452 4863. CAPITAL REVENUE 1 2 1 1 1 2 24. FOREIGN GRANTS 4 5 4 16 16 16 16

5. TOTAL EXP & NET LENDING 765 1237 1832 2569 3037 3622 43636. CURRENT EXPENDITURE 600 982 1414 1968 2335 2798 3391

6.1 Goods and Services 387 692 667 1020 1122 1234 13576.1.1 Wages and Salaries 143 197 307 566 623 685 754

6.1.2 Purchase of goods/services 244 496 360 454 499 549 6046.2 Interest payment 21 18 20 21 22 22 236.3 Subsidies and transfers 193 272 727 927

1191 1542 20116.3.1 Subsidies 8 12 330 380 437 503 5796.3.2 Transfers 185 259 397 548 754 1039 1432

7. CAPITAL EXPENDITURE 90 176 312 482 584 706 8547.1 Domestic Investment 67 146 250 375 450 540 6497.2 Capital Repairs 5 12 19 27 34 41 497.3 Other capital expenditures 7 9 18 17 24 34 487.4 Road fund by project loan 10 9 26 63 76 91 109

8. NET LENDING 74 79 106 118 118 118 1188.1 Domestic (net) -14 -10 19 -44 -44 -44 -448.2 Foreign (net) 89 89 87 162 162 162 162

9. Overall Balance 73 123 -46 -165 -172 -191 -23410 Current Balance 232 372 367 419 513 616 72111. Mineral balance -49 -190 0 0 0 0 0



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Table-4-B: Financial Planning for the Govt of Mongolia for 2009-2011 (Billion MNT)ITEMS 2005 2006 2007 2008 2009 2010 2011


Forecast Forecast Forecast

.1. . 2. . 3. . 4. . 5. .6. .7. .8.

12. FINANCING: -73 -123 46 165 172 191 23412.1 Foreign (net) 90 74 65 170 201 237 298

12.1.1 Project loans 99 98 112 225 280 336 41712.1.2 Cash loans 11 6 1 6 6 6 612.1.3 Amortization -20 -29 -48 -62 -85 -105 -125

12.2 Domestic (net) -163 -198 -19 -5 -30 -46 -6412.2.1 Privatization receipts 5 30 32 16 16 15 10

12.2.2 Repayment of Govt bonds -14 0 0 0 0 0 012.2.3 Long term bond -12 -94 24 -15 -41 -56 -69

12.2.3.1 New 0 0 56 67 79 94 11112.2.3.2 Amortization -12 -94 -33 -82 -120 -150 -180

12.2.4 IMF ( Net ) -7 -7 -8 -6 -5 -5 -512.2.4.1 Disbursement 0 0 0 0

0 0 012.2.4.2 Amortization -7 -7 -8 -6 -5 -5 -512.2.5 Banking system net credit -135 -126 -67 0 0 0 0

12. 2.5.1 Increase in the DF bal 0 0 317 463 600 600 60012.2.5.2 Net changes in C/A -135 -126 -384 -463 -600 -600 -600

12.2.5.3 Opening Balance 0 0 0 0 0 0 012.2.6 Non-banking system 0 0 0 0 0 0 0

Memo Items GDP at current market prices 2267 3715 4526 5464 6557 7869 9442GR of GDP at market prices (%) 19 64 22 21 20 20 20Real GDP GR (%) 7.0 8.7 10.1 10.1 9.9 9.8 9.8Overall inflation by GDP deflator (%) 10.9 50.8 8.2 12.1 10.0 10.0 10.0CPI inflation rate (%)

9.5 7.0 8.65.5

5.5 5.5 5.5



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Table-5-A: Financial Planning for the Govt of Mongolia for 2009-2011Share of GDP (in percentage)2005 2006 2007 2008 As % As % As %


Of GDP of GDP of GDP

.1. . 2. . 3. . 4. . 5. .6. .7. .8.1. TOTAL REVENUE AND GRANTS 37.0 36.6 39.5 44.0 43.7 43.6 43.72. CURRENT REVENUE 36.7 36.4 39.3 43.7 43.4 43.4 43.5

2.1 Tax revenue 30.5 30.4 31.3 36.5 37.0 37.6 38.42.1.1 Income Tax 7.9 12.8 13.8 14.6 14.4 14.2 14.02.1.1.1 PIT 2.6 2.1 1.5 1.5 1.4 1.3 1.12.1.1.2 CIT 5.3 6.0 5.3 6.4 6.6 6.8 6.92.1.1.3 wind fall tax 0.0 4.8 6.9 6.6 6.4 6.2 6.0

2.1.2 Social security contributions 4.2 3.0 3.0 3.2 3.2 3.3 3.42.1.3 Tax on immovable properties 0.3 0.2 0.2 0.2 0.2 0.2 0.22.1.4 Sales Tax ( VAT ) 8.0 6.5 5.2 8.3 8.4 8.5 8.72.1.5 Excise Tax 3.5 2.7 2.6 3.0 2.9 2.8 2.72.1.6 Special purpose revenue 0.5 0.3 0.3 0.3

0.3 0.3 0.32.1.7 Taxes on foreign trade 2.5 1.9 2.2 3.1 3.2 3.2 3.32.1.8 Other Taxes and fees 3.7 2.9 4.0 3.9 4.4 5.1 5.9

2.2 Nontax revenue 6.2 6.1 8.0 7.2 6.4 5.7 5.13. CAPITAL REVENUE 0.0 0.0 0.0 0.0 0.0 0.0 0.04. FOREIGN GRANTS 0.2 0.1 0.1 0.3 0.2 0.2 0.2

5. TOTAL EXP & NET LENDING 33.7 33.3 40.5 47.0 46.3 46.0 46.26. CURRENT EXPENDITURE 26.5 26.4 31.2 36.0 35.6 35.6 35.9

6.1 Goods and Services 17.1 18.6 14.7 18.7 17.1 15.7 14.46.1.1 Wages and Salaries 6.3 5.3 6.8 10.4 9.5 8.7 8.0

6.1.2 Purchase of goods/services 10.8 13.3 7.9 8.3 7.6 7.0 6.46.2 Interest payment 0.9 0.5 0.4 0.4 0.3 0.3 0.26.3 Subsidies and transfers 8.5 7.3 16.1 17.0 18.2 19.6 21.3

6.3.1 Subsidies 0.4 0.3 7.3 6.9 6.7 6.4 6.16.3.2 Transfers 8.2 7.0 8.8 10.0 11.5 13.2 15.2

7. CAPITAL EXPENDITURE 4.0 4.7 6.9 8.8 8.9 9.0 9.07.1 Domestic Investment 3.0 3.9 5.5 6.9 6.9 6.9 6.97.2 Capital Repairs 0.2 0.3 0.4 0.5 0.5 0.5 0.57.3 Other capital expenditures 0.3 0.2 0.4 0.3 0.4 0.4 0.57.4 Road fund by project loan 0.5 0.2 0.6 1.2 1.2 1.2 1.2

8. NET LENDING 3.3 2.1 2.3 2.2 1.8 1.5 1.38.1 Domestic (net) -0.6 -0.3 0.4 -0.8 -0.7 -0.6 -0.58.2 Foreign (net) 3.9 2.4 1.9 3.0 2.5 2.1 1.7

9. Overall Balance 3.2 3.3 -1.0 -3.0 -2.6 -2.4 -2.510 Current Balance 10.2 10.0 8.1 7.7 7.8 7.8 7.611. Mineral balance -2.2 -5.1 0.0 0.0 - - -



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Table-5-B: Financial Planning for the Govt of Mongolia for 2009-2011Share of GDP (in percentage)2005 2006 2007 2008 As % As % As %


Of GDP of GDP of GDP

12. FINANCING: -3.2 -3.3 1.0 3.0 2.6 2.4 2.512.1 Foreign (net) 4.0 2.0 1.4 3.1 3.1 3.0 3.2

12.1.1 Project loans 4.4 2.6 2.5 4.1 4.3 4.3 4.412.1.2 Cash loans 0.5 0.2 0.0 0.1 0.1 0.1 0.112.1.3 Amortization -0.9 -0.8 -1.1 -1.1 -1.3 -1.3 -1.3

12.2 Domestic (net) -7.2 -5.3 -0.4 -0.1 -0.5 -0.6 -0.712.2.1 Privatization receipts 0.2 0.8 0.7 0.3 0.2 0.2 0.1

12.2.2 Repayment of Govt bonds -0.6 0.0 0.0 0.0 0.0 0.0 0.012.2.3 Long term bond -0.5 -2.5 0.5 -0.3 -0.6 -0.7 -0.7

12.2.3.1 New 0.0 0.0 1.2 1.2 1.2 1.2 1.212.2.3.2 Amortization -0.5 -2.5 -0.7 -1.5 -1.8 -1.9 -1.9

12.2.4 IMF ( Net ) -0.3 -0.2 -0.2 -0.1 -0.1 -0.1 -0.112.2.4.1 Disbursement 0.0 0.0 0.0 0.0

0.0 0.0 0.012.2.4.2 Amortization -0.3 -0.2 -0.2 -0.1 -0.1 -0.1 -0.112.2.5 Banking system net credit -6.0 -3.4 -1.5 0.0 0.0 0.0 0.0

12. 2.5.1 Increase in the DF bal 0.0 0.0 7.0 8.5 9.2 7.6 6.412.2.5.2 Net changes in C/A 0.0 -3.4 -8.5 -8.5 -9.2 -7.6 -6.4

12.2.5.3 Opening Balance 0.0 0.0 0.0 0.0 0.0 0.0 0.012.2.6 Non-banking system 0.0 0.0 0.0 0.0 0.0 0.0 0.0

4.3 Financial Planning for 2009-2011

It may be observed from the above tables that the overall fiscal balance as per the fiscal planning is projected to decline to 2.5 percent of GDP during 2009-2011 compared with

MTBF ceiling on fiscal deficit at 3 percent of GDP. This implies that the financial planning for the period is consistent with fiscal sustainability over time. Resourcemobilizations from individual taxes and duties and expenditures by economicclassifications appear to be reasonable and realistic. Governments financing planningalso appears to be feasible. Needs for foreign project loans will continue and thegovernment will be able to repay domestic and foreign loans and make associated interest

payments in time without undue pressure on budgets. Underlying parameters for the realGDP growth rates and the inflation rates for consumer prices are realistic as judged by

past trends. Overall, the fiscal planning as indicated in the Tables 4-A, 4-B, 5-A and 5-Bappears to be realistic and feasible.



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5. Policies for Financial Planning and Risk Management5.1 Management for Natural Disaster

One of the major objectives of the ex-ante Financial Planning is to deal with contingentliabilities of the government and risk management for unforeseen events such as

droughts, floods, earthquakes, land slides and other natural disaster. Risk managementand emergency response need to be clearly distinguished. Risk management calls for ex-ante planning and investments to reduce vulnerability. Emergency response involves ex-

post expenditures for reconstruction, rehabilitation and restoration of public infrastructureaffected by natural disaster, which can be greatly reduced through ex-ante planning andinvestments in prevention and mitigation.

While the occurrence of natural events can not be predicted precisely and prevented fully,there is a possibility to reduce the degree of vulnerability of populations through risk management. This can be achieved in two ways: (i) planning with the purpose of theidentification and reduction of risk by integrating prevention and mitigation measures

into national development and financial plans and programs and (ii) financial protection provided by transferring risk partly to the private sector or spreading it over time. Thelatter can be achieved by strengthening both life and non-life insurance institutions.

5.1.1 The Credit System

The development of commercial banks, co-operative banks, savings banks, informal andformal non-banking financial institutions, and micro-credit institutions can contribute tothe mobilization of the resources needed to finance investments in prevention, mitigation,rehabilitation and reconstruction. The system of contingent credit mechanism makes iteasier to obtain financing in the event of a disaster. In the case of a contingent credit, in

exchange for an annual fee to a general insurance company, the right is obtained to takeout a specific loan amount post-event that has to be repaid at contractually fixedconditions. In order to tackle the adverse impact of dzuds in Mongolia, if any in future, asystem of contingent credits or crop insurance or herds insurance can be very useful.

5.1.2 Risk Transfer Instruments

Risks can be transferred by creating suitable risk transfer instruments and mechanismscurrently in use in developed countries, especially insurance. Financing through ex antecredits offers even more incentives to mitigate risk because risk transfer instruments offer opportunities to contain moral hazards or adverse selection problems.

Ex-ante measures to tackle unforeseen events include prevention and mitigation,insurance, contingent credit and reserve funds. Mitigation reduces the damages, whereasrisk financing measures reduce losses by transferring risk or sharing risk with others.Mitigation is directed towards decreasing engineering or physical vulnerability, whereasrisk financing reduces financial vulnerability (Fig. 1).



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naturalhazard

exposure

engineeringvulnerability

engineeringvulnerability damage financialvulnerability

financialvulnerability

economiloss

mitigation ex-ante instruments

Fig. 1: Mitigation and Risk Financing

+

-

Capital Accumulation

Fund Paymenta) Reserve Fund

+

-

Credit Payment

Debt RepaymentAdministrative Costs

b) Contingent Credit

+

-

Insurance Payment

Premium

c) Insurance

Flow of Funds from ThreeInstruments

Fig.2- Flow of funds from three ex-ante financing instruments -Reserve Fund, Contingent Credit and Insurance

Risk transfer provides indemnification against losses in exchange for a premium payment. Risk is transferred from an individual to a (large) pool of risks throughinsurance/ reinsurance, reserve funds and contingent credit systems (Fig.2) . Insuranceand reinsurance funds bear part of the risk. In a reserve fund arrangement, liquid funds



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are laid aside so that the fund accumulates over the years without unviable impact on the present budget. In case an unforeseen disaster takes place, the accumulated funds can beused to finance the losses.Contingent credit arrangements do not transfer risk, but rather spread it intertemporally.As explained earlier, in exchange for an annual fee, the right is obtained to take out a

specific loan amount post-event that has to be repaid at contractually fixed conditions.

5.1.3 Insurance and development bonds

Development of insurance markets requires updating legislation and institutional set up.This requires development of appropriate rules and regulations, strengthening theindependent regulatory authorities to improve monitoring of the solvency of insurancecompanies and eliminate conditions that favor anticompetitive practices.

The possibility of introducing innovative capital market mechanisms such as catastropheor natural calamity bonds, commodity futures and weather-related derivatives may be

examined . These instruments, which may be of interest to international financial entities,avoid the major difficulties related to asset valuation and loss settlement procedures, buthave to be implemented at pool or governmental levels.

The same arguments hold good for life and non-life insurance. But, catastrophe or naturalcalamity bonds are difficult to be developed by developing countries like Mongoliawhich lack efficient money and capital markets. It may be easier for Mongolia to developother kinds of bonds such as development funds (viz. municipal, social, urban, rural,roads, infrastructure development bonds etc.) to meet critical needs for infrastructuredevelopment. This can be helped by international development agencies.

Another instrument that could be highly useful is to establish a contingent liability fundand to make budgetary contributions. Government of Mongolia has already establishedsuch a contingent fund, road development fund and a general Development Fund.

The private sector and the community-wide formal and informal financing instruments perform a very important role at the local level by supplying resources, particularly in poorer areas. Regardless of the source of financing, the implementation of thesemechanisms requires close cooperation between the public and private sectors, especiallyin reference to the establishment of the appropriate legal and regulatory framework.

Table-6 summarizes various sources of ex ante and ex post disaster financing. The ex

ante non-reimbursable and reimbursable financing mechanisms without risk transfer include grants and credits. The corresponding risk transfer instruments encompassinsurance and natural calamity bonds, which can cover the damage based on real losses(indemnification) or the parametric payments.

Ex post financing instruments include grants, taxes, emergency and reconstruction loans,and refinancing of existing loans. In the event of a disaster, immediately available andlowest-cost financing options, such as an existing calamity fund or catastrophe bonds,



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insurance and reinsurance, are generally used first. Similarly, part of budgeted resourcesfrom the existing programs can be transferred to meet immediate emergency needs.

In some cases, existing development funds (municipal, social, urban, rural) may also beused. Government can impose an emergency cess or tax on the existing tax payers. At the

same time, the government could seek as much international aid and donations as possible and resort to contingency credits.

Table-6 Provisional Classification of Disaster Financing Mechanisms

5.2 Management of Contingent Liabilities

5.2.1 Contingent liabilities- definitions and measurementContingent liabilities are defined by the System of National Accounts 1993 as contractualfinancial arrangements that give rise to conditional requirements to make payments or to

provide objects of value. A key characteristic of such financial arrangements, asdistinguished from the current financial liabilities, is that one or more conditions must befulfilled before a contingent liability takes place. A key characteristic that makes suchliabilities different from normal financial transactions is that they are uncertain.

Fiscal Risk Matrix for Mongolia

Following Polackova (1998), contingent liabilities can be best described in terms of aFiscal Risk Matrix classifying sources of potential risks on government finance into four types: direct or contingent, each of which may be explicit or implicit. Table-9 presents atypical fiscal risk matrix for Mongolia.



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Table-7: Fiscal Risk Matrix for Mongolia

L IABILITIES Direct Contingent

Explicit Sovereign debt (domestic and

external) Committed Expenditures-legal and non-discretionary inthe long term (civil servicesalaries and wages, socialsecurity and insurancecontributions, employment of specialized staff in rural areas,

pension other compensation tocivil servants, Social WelfareFund)

Benefits to children and poor families

Benefits to SMEs and ruralareas, jobs creation andnational development

Direct guarantees for external loans by

Aimags, local bodies, budgetary entities and public sector enterprises Guarantees on currency risks of foreign loans

by commercial and development banks, if any Guarantees on various types of risks

(including market, currency, regulatory, political) in Built on Transfer (BOT) contractsor other Public-Private Partnership, for thedevelopment of infrastructure and socialsectors

Umbrella guarantees for various types of loans(agriculture, agro-business, micro-enterprises,housing etc.)

Deposit insurance of savings and commercial banks Guarantees on benefits (unfunded liabilities)

of the social security system Future health care financing

Implicit Future recurrent costs of public investment projects

Support to insurance and pension companiesin case of financial crisis;

Support to Bank failures (beyond stateinsurance or guarantees)

Support to Bank of Mongolia (the central bank) in case possible default

Possible need to further recapitalize week commercial and development banks

Cleanup of the past liabilities of privatizedentities

Support to institutions of national interest (incase of financial crisis and for non-guaranteedobligations)



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5.2.3 Lessons from International Best Practices

The issue of managing contingent liabilities in an emerging economy like Mongolia is to be seen in the broader context of economic development. Provision of governmentguarantees per see is not bad. But, problems of contingent liabilities arise when the risksinherent in such liabilities are not properly assessed and quantified, and adequate

provision is not made for the possible impact of such risks.

An emerging country like Mongolia can adopt several public policy measures to containthe risk of contingent liabilities. These include the following:

1. As an initial step towards risk management, it is necessary to promote disclosure andaccountability with regard to explicit contingent liabilities. A centralised unit may beset up in the Department of Fiscal Policy and Coordination in the MOF to identify

and measure the magnitude and associated risk of all contingent liabilities.

2. In its Code of Good Practices on Fiscal Transparency , the IMF has recommendedthat countries should disclose the central government contingent liabilities in their Budget documents, provide a brief indication of their nature and extent, and indicatethe potential beneficiaries.

3. Best management practice for contingent liabilities is to make adequate provision for expected losses and to hold additional assets against the risk of unexpected losses.

4. It is useful that the said centralised unit designs and issues contingent liability

instruments and monitors the associated risk exposures, and ensures that thegovernment is well informed of these risks.

5. Once the concepts, definitions, methodology and data problems have been resolvedand key organisational challenges addressed, a computerized recording system for management of debt and contingent liability could be introduced. Ministry of Finance, Mongolia is using the UNCTAD Debt Management and Financial AnalysisSystem (DMFAS) for recording and monitoring external debt. The same system can

be easily extended for management of internal debt and contingent liabilities.

6. A guarantee fee must be charged for all guarantees. The fee needs to be determined

on the basis of the cost of borrowing plus the cost of provisioning. Guarantee feescollected should not be taken as general revenues; rather be kept in a separatecontingency fund or contingent liability redemption fund. The Government of Mongolia has already established such a Contingency Fund.

7. Sound risk sharing arrangements would include providing termination dates or sunsetclause for the contingent claims, pricing the contingent liability on a risk adjusted

basis and charging the beneficiaries accordingly.



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8. Risks associated with contingent liabilities can be reduced by promoting soundgovernance rules for managing sub-national entities and state-owned enterprises, andmaking them accountable for managing their own risks.

9. It is equally important to improve the supervision and regulation of the banking andinsurance system and capital markets, including the use of such instruments asmandatory risk limits and minimum capital adequacy norms.

10. The odds for the occurrence of a financial crisis and so the risk of implicit contingentliabilities can be reduced by sound macro-economic policies, complemented byappropriate legal, regulatory and institutional set-up for effective prudentialregulation, monitoring, surveillance and supervision of the financial system andimproved corporate governance. However, these entail structural reforms with anunavoidably long-time scale.

5.3 Management of Public Debt

5.3.1 Public Debt of Mongolia

Mongolias public debt at around 55 percent of GDP is not high as judged byinternational standards, and it does not pose any problem for financing debt services asthe Government of Mongolia has maintained a surplus on current fiscal account for thelast few years. However, government revenues are highly dependent on mineral taxes andare subject to risk in volatility of international prices of minerals, particularly copper andgold. Although there is surplus on minerals account, there is a significant deficit on non-minerals balance.

One of the major challenges for the government to maintain fiscal sustainability is toreduce non-minerals deficit over time. This can be done by taking a number of measuressuch as the following:

(a) To widen tax base to include services which now account for about 55 percentof Mongolian GDP but remains relatively under-taxed.

(b) It is also necessary to strengthen tax administration for personal and corporateincome taxes and value added tax.

(c) At present the personal income tax is ten percent at all levels of income whichdoes not satisfy the basic principle of equity for a tax system. It may benecessary to make it progressive while strengthening the tax administration todeal with tax evasion.

(d) On the expenditure side, there may be a need to set limits on rise of salaries,subsidies and social securities as have been explained earlier in financial

planning.



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5.3.2 Debt Sustainability and Fiscal Deficit

Debt sustainability is closely related to the fiscal deficit, particularly to the primarydeficit (i.e. fiscal deficit less interest payments). Sustainability requires that there should

be a surplus on primary account. It also requires that the real economic growth should behigher than the real interest rate. Countries with high primary deficit, low growth andhigh real interest rates are likely to fall into debt trap. Economic theory states that highfiscal deficit spills over current account deficit of the balance of payments. Persistent andhigh levels of current account deficit is an indication of the balance of payments crisisand needs to be tackled by encouraging exports and non-debt creating financial inflows.

At present, Mongolia does not face these problems. For the past few years, Mongolia hashigh economic growth, surplus on both domestic and external current account and verylow (in fact negative) real interest rate on external debt. These positive developmentsshould not lead to complacency on the part of the government. The main challenge will

be to ensure fiscal sustainability, low inflation rates and stability in real exchange rates byadopting strict fiscal and monetary discipline and sound management of mineralresources. Medium term output is vulnerable to unfavourable weather shocks in thedomestic sector and risk of sharp fall of global prices of minerals, which may lead to fallin government revenues and put constraints on social welfare and investment programsfinanced by the windfall profits tax on minerals.

Among other challenges, public investment plan needs to address the environmentaldegradation due to overuse and illegal trade in forest products and wild life.Overexploitation of natural resources, lax control on smaller mines and faster urbanization may lead to loss of agricultural production, shortage of water supply,

sanitation problems, traffic hazards and pollution. These issues also put constraints for achievement of primary education and the achievement of environmental targets in theMillennium Development Goals.

5.3.3 Risk Management Systems for Public Debt

Public debt needs to be managed in such a way that the required amount of financialresources is raised at the lowest possible medium and long-term cost and with a prudentdegree of risk. Risks include foreign exchange and financial crisis; change increditworthiness and insolvency (debt distress); leading to economic crisis and socialinstability (as in the case of East Asian crisis in 1997-1999). Ministry of Finance shouldhave a risk management framework that identifies and assesses the financial andoperational risks for the management of public debt including external debt.

(a) Independent and Integrated Public Debt Office

International best practices indicate that there is generally an independent and integrated public debt office dealing with both internal and external debt, and in most of thecountries such an office is situated in the Ministry of Finance. Although the MOF inMongolia deals with management of domestic and external debt, there is no such well



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structured and integrated office. It may be useful to examine the feasibility of setting upan independent and integrated Public Debt Office under the Ministry of Finance with thefollowing functions:

(i) To deal with both domestic and external debt(ii) To set bench marks on interest rate, maturity mix, currency mix, composition of

debt in terms of domestic debt and external debt.(iii) Identification and measurement of contingent liabilities(iv) Policy formulation for debt management(v) Monitoring risk exposures(vi) Building Models in Assets Liability Management (ALM) framework

(b) Composition and Function of the Public Debt Office:

An integrated Public Debt Office consists of the following independent debt offices withassociated functions:(i) Independent Front Offices , which are responsible for negotiating new loans with

multilateral and bilateral funding organisations and other sources of internal andexternal finance.

(ii) Back office , which is responsible for auditing, accounting, data consolidation andthe dealing office functions for debt servicing.

(iii)(iv) Middle office , which is responsible for identification, assessment, measurement and

monitoring of debt and risk, dissemination of data and policy formulation for bothshort and medium term, and setting benchmarks for debt composition and currency-interest rate- maturity mix, and

(v) Head Office, which accords final approval for both internal and external debt.

Some may feel that having a comprehensive debt management system as described herewill be expensive, but not having one may be more expensive.

(c)Transparency in Risk Management: Debt management objectives should be clearlydefined, documented and disclosed at all levels dealing with debt management. Themeasures of cost and risk that are adopted should be explained. Objectives of debtmanagement and preferred policies and measures should be clearly indicated by themiddle office. Equally important are the rules, regulations, institutional and legalframework for debt management.

(d) Limits on Public Debt: As regards legal framework, m any countries have enactedFiscal Responsibility and Budget Management Acts and have set limits on annual

borrowing and total outstanding public debt as a percentage of GDP. Parliament is theappropriate authority to set new limits of public debt . It will be beneficial for Mongolia tolegislate similar acts with limits on fiscal deficit, annual borrowing, total outstanding

public debt and also separate limits on non-mineral balance.



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(e) Assessment of Risk :

Another task of the Public Debt Office is to define, identify, measure and monitor risk.There are various models for risk assessment:

(i) To conduct stress tests of the debt portfolio based on economic and financialshocks.

(ii) Simple scenario models used by the World Bank and IMF.(iii) To project future debt services over medium and long term.(iv) To list key risk indicators over time.(v) To summarize costs and risks for alternative strategies and debt portfolio.

5.4 Management of External Debt

5.4.1 Various Risks of External Debt

External debt of Mongolia constitutes about 95 percent of public debt and is subject tovarious risks such as liquidity risk, exchange rate risk, market risk, convertibility risk,interest rate risk and yield risk ( see Box-1) . At present, external debt service ratio at 2

percent of exports does not pose any problem for the Mongolian economy, but in futuredebt sustainability may be at risk if there is sudden fall of international prices of Mongolias major exports or unexpected rise of prices of major imports. Significant fallsin the global prices of copper, coal, gold and cashmere and substantial rise of prices of

petroleum products may affect adversely the current account of the balance of paymentsand may lead to the problem of external debt servicing for Mongolia.

5.4.2 External Debt Sustainability Measurements

Debt sustainability basically implies the ability of a country to service all debts internaland external on both public and private accounts- on a continuous basis without affectingadversely its prospects for growth and overall economic development. It is linked to the

credit rating and the creditworthiness of a country. Various debt sustainability measuresare indicated in Table-8.

5.4.3 Risk Management Policies for External Debt

Although there is no unique solution to tackle various types of risk, general risk management practices of the government aim at minimizing risk for government bodiesand public enterprises. These include development of ideal benchmarks for public debt



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and monitor and manage credit risk exposures. Typical risk management policies aresummarized in Table-9.



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Box 1. Risks for External DebtA. External Market-Based Risks

(A1) Liquidity risk. Shortage of revenues, cash and foreign exchange to repay debt and make

interest payments. East Asian financial and foreign exchange crisis during 1997-1999 is the bestexample of liquidity crisis.(A2) Interest rate risks. While fixed interest rate has the advantage of having fixed interest

payments over time, there may be a substantial loss in a regime of falling interest rates. Solutionlies to have a proper mix of variable and fixed interest rates.(A3) Rollover risk. The risk that debt will have to be rolled over at a high cost or in extremecases that it cannot be rolled over at all. To the extent that rollover risk is limited to the risk thatdebt has to be rolled over at higher interest rates, it may be considered a type of market risk.(A4) Credit risk. Central government on-lends external debt to Aimags, local governments and

public sector enterprises. Losses may arise if these investments donot have sufficient yields torepay debt and pay associated interests. (A5) Currency risk. Currency risk arises when there is substantial depreciation of the domestic

currency in terms of the currencies in which external dent is denominated.(A6) Settlement risk: Refers to the potential loss that the government could suffer as a result of failure to settle, for whatever reason other than default, by the counterparty. (A7) Convertibility risk: Easy convertibility of the domestic currency may lead to capitalflight at the slight anticipation of crisis.(A8) Budget/ Fiscal Risk: Fiscal risk may arise from unanticipated shortfalls in revenue or expenditure overruns. Government should consider both budget and off-budget liabilities andtry to minimize contingent liabilities.

B. Operational and Management Risks

(B1) Operational Risk is the risk that arises from improper management systems resulting in

financial loss. It is due to improper back office functions including inadequate book keeping andmaintenance of records, lack of basic internal controls, inexperienced personnel, and computer failures. Probability of default is high with inadequate operational and management systems.(B2) Control system failure risks arise due to outright fraud and money laundering because of weak control procedures, inadequate skills, and poor separation of duties.(B3) Financial error risk. Incorrect measurement and accounting may lead to large andunintended risks and losses.

C. Country specific and political risks influence foreign investment by the multinationalcompanies. Political and economic stability, scale economies, lower wages, fiscal incentives,high yields, trade openness and open door policy for foreign investment stimulate non-debtcreating financial flows. Foreign capital is attracted by countries which allow free repatriation of capital and profits, and donot insist on appropriation of private capital in public interest.

Source: Tarun Das (2006a)



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Table-8: Debt Sustainability Indicators

Purpose Indicators

1. Solvency ratios (a) Ratio of interest payments to exports of goods and services

(XGS)(b) Ratio of interest payments to foreign exchange reserves(c) Ratio of interest payments to revenue(d) Ratio of external debt to GDP(e) Ratio of external debt to XGS(f) Ratio of external debt to revenue(g) Ratio of present value of external debt to GDP(h) Ratio of present value of external debt to XGS(i) Ratio of present value of external debt to revenue

2. Liquidity monitoringratios

(j) Debt service ratio: Ratio of total debt services (interest payments plus repayments of principal) to XGS

(k) Ratio of interest payments to reserves(l) Ratio of short-term debt to XGS(m) Ratio of total imports to foreign exchange reserves.(n) Ratio of reserves to short-term debt(o) Ratio of short-term debt to total debt

3. Debt burden ratio (p) Ratio of external debt outstanding to GDP(q) Ratio of external debt outstanding to XGS(r) Ratio of debt services to GDP(s) Ratio of public debt to budget revenue(t) Ratio of concessional debt to total debt

4. Debt structureindicators (u) Rollover ratio- ratio of amortization (i.e. repayments of principal) to total disbursements(v) Ratio of interest payments to total debt services(w) Ratio of short-term debt to total debt(x) Average maturity of external debt(y) Currency mix of external debt(z) Ratio of government external debt to total public debt

5. Public sector indicators

(aa) Ratio of public sector debt to total external debt(bb) Ratio of public sector debt to GDP(cc) Ratio of public sector debt to XGS(dd) Ratio of public sector debt to revenue

(ee) Ratio of concessional debt to total external debt(ff) Ratio of concessional debt to total public debt



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(gg) Average maturity of public debt(hh) Average maturity of non-concessional debt(ii) Ratio of foreign currency debt to total public debt

Source: IMF (2003) and Tarun Das (2006a)

Table-9 Policies for Risk Management

Type of Risk Risk Management Policies

1. Liquidity risk (a) Monitor debt by residual maturity(b) Maintain certain minimum level of cash balance(c) Fix limits for short-term debt(d) Do not negotiate for huge bullet loans(e) Develop liquidity benchmarks

2. Interest rate risk (f) Fix benchmark for ratio of fixed versus floating rate debt(g) Use interest rate swaps

3. Credit risk (h) Have credit rating by major credit rating organizations(i) Have proper project appraisal before lending;

4. Currency risk (j) Fix benchmark for the ratio of domestic and external debt(k) Fix ratios of short-term and long-term debt(l) Fix composition of currencies for external debt(m) Use currency swaps and have policies for use of market derivatives(n) Try to have natural hedge by linking dominant currency of exports

and remittances to the currency of external debt5. Convertibility risk (o) Gradual approach towards capital account convertibility.

(p) Eencourage initially non-debt creating financial flows followed bylong term capital flows.

(q) Short term or volatile capital flows may be liberalised only at theend of capital account convertibility.

6. Budget Risk (r) Enact a Fiscal Responsibility Act.(s) Put limits on debt outstanding, annual borrowing, fiscal deficit(t) Use government guarantees and other contingent liabilities (such

as insurance and pensions etc.) judiciously and sparingly7. Operational risks (u) Allow independence and transparency of different offices (such as

front, back, middle and head offices) dealing with public debt(v) Strengthen capability of different offices

8. Country specificand political risk

(w) Have stable and sound macro-economic policies(x) Have co-ordination among monetary and fiscal authorities

Source: Tarun Das (2006a).

5.4.4 Stress Tests

Stress tests are closely related to the debt sustainability indicators and are useful inidentifying major liquidity risks, as well as strategies to mitigate them. Stress tests can beused to test a variety of scenarios such as the following:(a) Types of capital inflows (FDI, trade credit, other credits)(b) Periods of access to capital markets



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(c) Exchange rate changes/ derivative positions(d) Risks due to price and interest rate changes(e) Macroeconomic uncertainties (such as outlook for exports and imports)(f) Policy uncertainties (fiscal and monetary policies)

(a) Standard Stress Tests

(b) Revenue growth = Baseline GR 1 SD(c) Export value growth = Baseline GR 1 SD(d) Assets value growth = Baseline GR 1 SD(e) Inflation rate = Baseline Rate + 1 SD(f) Net non-debt creating flows = Baseline Inflows 1 SD(g) One-time major nominal or real exchange rate depreciation = Baseline + SD

where GR stands for growth rate and SD for Standard Deviation 3 of a variable.

(b) Indications of debt distress episodes

Debt distress indicated by recourse to any of the following forms of exceptional finance:(a) Arrears: Number of years in which principal and interest arrears to all creditors

is in excess of 5% of total debt outstanding(b) Debt rescheduling: Year of initial debt restructuring plus two subsequent years(c) Bailout by financial institutes(d) Normal times are non-overlapping periods of five years in which no signs of

above mentioned debt distress are observed .

(c) Determinants of debt distress

(1) Traditional Debt Indicators(i) Present value of debt/exports ratio(ii) Present value of debt/revenues ratio(iii) Present value of debt/assets ratio(iv) Debt service/exports ratio(v) Debt service/revenues ratio(vi) Debt service/assets ratio

(2) Measures of Shocks

(i) Real revenue growth

3 If X1, X2 ..Xn be n observations of any variable Xi (i=1, 2 .. n)then = Xi is the arithmetic mean of X;VAR = (Xi - ) /n is the Variance of X;SD = VAR is the Standard Deviation of X, andCV = 100 SD/ is the coefficient of variation of X.



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(ii) Real depreciations(iii) Assets value growth

(d) Quality of institutions and policies

1. Substantial value-added can be achieved by reviewing the role of organizationalquality, good governance, policies and shocks in addition to traditional debt

burden indicators when assessing probability of debt distress2. There is a strong tradeoffs between quality of institutions, policies, systems of

auditing and sustainable level of debt

(e) Indicative Debt and Debt-Service Thresholds (%)

On the basis of experiences of several countries, World Bank has determined thresholdsfor various debt indicators for a country depending on the quality of its debt management policies and systems. These indicators are presented in Table-10. For example, if acountrys debt management policies and systems are considered to be poor, then the ratioof net present value of debt to total assets for the country should not exceed 30 percent.The NPV debt/ assets ratio can go up to 45 percent for a country having medium qualityfor debt management system, while the ratio can go up further to 45 percent for a countryhaving a strong and very efficient system for debt management policies and systems.Other thresholds have similar interpretations.

Table-10 Thresholds for Debt Indicators (in percentage)

Indicators Quality of Debt Management Policies and SystemsPoor Medium Strong

NPV of debt/Assets 30 45 60 NPV of debt/XGS 100 200 300 NPV of debt/Revenue 200 275 350Debt Service/XGS 15 25 35Debt Service/Revenue 20 30 40

(f) Debt Distress Classifications

(i) Low risk all indicators well below thresholds(ii) Moderate risk baseline OK, but scenarios/shocks exceed thresholds(iii) High risk baseline in breach of thresholds(iv) In debt distress current breach, that is sustained over projection period



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5.4.5 International best practices for external debt management(a) Legal and Institutional Set Up

As regards legal and institutional set up, International experience suggests thatcentralized debt offices in most of the countries are located under the Ministry of Finance(MOF). The main argument for entrusting the public debt management responsibilitywith the Ministry of Finance or Treasury is the proximity of location, which enables thesenior management within the Ministry of Finance to review, assess and monitor publicdebt more easily. Another factor, which prompted many governments to locate the debtoffice within the Ministry of Finance, is that the public debt has budgetary implications in

terms of payments of debt services, and co-ordination between the budget office and thedebt office facilitates effective management of debt and fiscal deficit.

As regards governance of external debt, most of the countries donot allow Sub national or provincial governments to borrow directly from the external sources . Only the Centralgovernment borrows from multilateral and bilateral sources and then on-lends money tothe states and local governments.

Government of Mongolia has the system of locating the debt management offices withinthe MOF. It is necessary to continue with the system but to strengthen its structure, debtmanagement policies and to adopt modern techniques for risk management.

(b) Policy Framework

As regards policy framework, international best practices for the management of externaldebt leads to the following broad conclusions:

(1) Management of external debt is closely related to the management of domestic debt,which in turn depends on the management of overall fiscal deficit.

(2) Debt management strategy is an integral part of the wider macro economic policiesthat act as the first line of defense against any external financial shocks.

(3) Nearly all of the autonomous debt management offices have adopted anorganizational structure similar to that in leading corporate treasury and investment

banks. They divide functional responsibilities for managing transactions into differentoffices within the debt management organization and established procedures to ensureinternal control, accountability, checks and balances. Usual practice is to establish

separate front offices, middle office, back office and head office, as explained earlier.



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(4) For an emerging economy like Mongolia, it is better to adopt a policy of cautious andgradual movement towards capital account convertibility.At the initial stage, it is beneficia

l to encourage non-debt creating financial flows (such as foreign investment and equity)followed by liberalization of long-term and medium-term commercial debt.

(5)

There is need to have a cautious approach on external short-term credit. In manydeveloping countries, like India, government does not resort to any short term

borrowing from external sources, although the private sector is allowed to borrow short-term credit externally subject to certain conditions.

(6) Big bullet loans are bad for small economies like Mongolia, as these can createrefinancing risk in future.

(7) It is not enough to manage the government balance sheet well, it is also necessary tomonitor and make an integrated assessment of national balance sheet and to put moreattention on surveillance of overall debt- internal and external, private and public. In eachof the major Asian crisis economies- Indonesia, Korea and Thailand- weakness in thegovernment balance sheet was not the source of vulnerability, rather vulnerabilitystemmed from the un-hedged sort-term foreign currency debt of commercial banks,finance companies and corporate sector.

(8) It is not sufficient to manage the balance sheet exposures, it is equally importantmanage off balance sheet and contingent liabilities.

(9)

It is necessary to adopt suitable policies for enhancing exports and other current accountreceipts that provide natural hedge and the means for financing imports and debtservices.

(10) Detailed data recording and dissemination are pre-requisites for an effectivemanagement and monitoring of external debt and formulation of appropriate debtmanagement policies.



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(11) It is vital that external contingent liabilities and short-term debt are kept within prudential limits.

(12) It is important to strengthen public and corporate governance and enhancetransparency and accountability.

(13) It is also necessary to strengthen the legal, regulatory and institutional set up for management of both internal and external debt.

(14) A sound financial system with well developed debt, money and capital markets is anintegral part of a countrys debt management strategy.



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Selected References

Das, Tarun (1999a) East Asian Economic Crisis and Lessons for External Debt Management, pp.77-95, in External Debt Management, ed. by A. Vasudevan, April 1999, Reserve Bank of India (RBI), Mumbai , India.

_______ (1999b) Fiscal Policies for Management of External Capital Flows , pp. 194-207, inCorporate External Debt Management, edited by Jawahar Mulraj, December 1999, CreditRating and Investment Services of India Ltd. (CRISIL), Mumbai , India.

_______ (2000) Sovereign Debt Management in India, pp.561-579, in Sovereign DebtManagement Forum: Compilation of Presentations , November 2000, World Bank, WashingtonD.C .

_______ (2002) Management of Contingent Liabilities in Philippines- Policies, Processes, Legal Framework and Institutions, pp.1-60 , March 2002, World Bank , Washington D.C .

______ (2003a) Off budget risks and their management, Chapter-3, Philippines ImprovingGovernment Performance: Discipline, Efficiency and Equity in Managing Public Resources- APublic Expenditure, Procurement and Financial Management Review (PEPFMR), Report No.24256-PH, A Joint Document of The Government of the Philippines, the World Bank andthe Asian Development Bank, Poverty Reduction and Economic Management Unit, WorldBank Philippines Country Office, April 30, 2003.

______ With Raj Kumar, Anil Bisen and M.R. Nair (2003b) Contingent LiabilityManagement- A Study on India, pp.1-84 , Commonwealth Secretariat, London.

_______ (2003c) Management of Public Debt in India , pp.85-110, in Guidelines for Public DebtManagement: Accompanying Document and Selected Case Studies, 2003, IMF and the WorldBank, Washington D.C .

_______ (2005) International Cooperation Behind National Borders- A Case Study for India, pp.1-50, Office of Development Studies, UNDP, UN Plaza, New York , 2005.

_______ (2006a) Management of External Debt: International Experiences and Best Practices, pp.1-46, Best Practices series No.9, United Nations Institute for Training and Research(UNITAR), Geneva, January 2006 .

_______ (2006b) Governance of Public Debt- International Experiences and Best Practices, pp.1-23, Best Practices series No.10, United Nations Institute for Training and Research(UNITAR), Geneva, January 2006 .

_______ (2008) Accrual Accounting Rules for Government Finance Statistics, pp.1-36, ADBCapacity Building Project on Governance Reforms, Ministry of Finance, Govt of Mongolia , Ulaanbaatar, January 2008.

Das, Tarun and E. Sandagdorj (2007a) Strategic Business Planning- objectives and suggested structure for Mongolia, pp.1-95, ADB Capacity Building Project on Governance Reforms,Min of Finance, Govt of Mongolia , Ulaanbaatar, August 2007.



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_______ (2007b) Output costing and output budgeting , pp.1-50, ADB Capacity BuildingProject on Governance Reforms, Ministry of Finance, Govt of Mongolia , Ulaanbaatar,October 2007.

_______ (2007c) Transition from Cash Accounting to Accrual Accounting, pp.1-35, ADBCapacity Building Project on Governance Reforms, Ministry of Finance, Govt of Mongolia , Ulaanbaatar, October 2007.

________ (2008) Seven-Year (2008-2014) Action Plan for the Complete Implementation of the Provisions of Public Sector Management and Finance Act (27 June 2002) , ADB CapacityBuilding Project on Governance Reforms, Ministry of Finance, Govt of Mongolia , January2008.

International Monetary Fund (2002) Government Finance Statistics Manual 2001, StatisticsDepartment, IMF, Washington D.C., August 2002.

_______ (2003a) The Implications of the Government Finance Statistics Manual 2001 for Country Work in the Fund , GFS Policy Development Taskforce, IMF, Washington D.C., August2003.

_______ (2003b) External Debt Statistics- Guide for Compilers and Users , 2003, IMF,Washington D.C .

International Monetary Fund and the World Bank (2003) Guidelines for Public Debt Management: Accompanying Document and Selected Case Studies, 2003, Washington D.C .

Ministry of Finance, Government of Mongolia (2007) Government Budget 2008, Ulaanbaatar,December 2007.

Keipi, Kari Juhani and Justin Tyson (2002) Planning and financial protection to survivedisasters, Sustainable Development Department Tech. Studies series: ENV-139, Inter-AmericanDevelopment Bank, Washington D.C., Oct. 2002.

Reserve Bank of India (RBI) (1999) External Debt Management- Issues, Lessons and Preventive Measures, pp.1-372, edited by A. Vasudevan, RBI, Mumbai , April 1999.

World Bank (2000) Sovereign Debt Management Forum: Compilation of Presentations , November 2000, World Bank, Washington D.C .



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Chapter-7Core and Non Core Functions of the Govt of Mongolia

1. Basic Functions of a Government1.1 To Repair Market Failures

One of the basic functions of the government is to repair market failures. Market failure occurswhen the free market fails to allocate resources in an optimal and efficient manner. There are four main sources of market failures viz. (a) existence of externalities, (b) no provision of publicgoods, (c) existence of imperfect competition and (d) existence of inequity. According to theoriesin welfare economics, allocative efficiency in these situations can happen when marginal social

benefit (MSB) equals marginal social cost (MSC), which cannot be achieved without appropriategovernment interventions.

(a) Externalities

Externalities occur when some of the costs or benefits associated with production or consumptionof goods and services spill over onto third parties. There could be positive or negativeexternalities depending on the nature of the impact on the society. Positive externalities occur when society benefits from the consumption or production of a commodity or service such as

basic education, basic health care, sanitation, vaccination, public parks, public libraries etc.Negative externalities occur when costs are imposed on society from the consumption or

production of a commodity or service such as air and water pollution, road congestion, accidents,smoking, spreading of communicable diseases, smuggling, terrorism, illegal trade, and immoraltraffic, over-exploitation of natural resources and degradation of environment in general. Positive externalities are highly correlated with the so-called merit goods, which the societyvalues most, and judges that everyone should have, for example, basic healthcare, basiceducation, public libraries, sanitation, national defense, internal security, individual safety and

protection of environment.

On the other hand, negative externalities are highly associated with the so-called demerit goods,which the society values least, and judges to be bad for individuals. For example, consumption of alcohol, cigarettes, prohibited drugs, addiction to gambling, money laundering, terrorism,smuggling, illegal trade, immoral trafficking. Government needs to develop and strengthenappropriate legal and institutional set up to prohibit these activities.

(b) No provision of public goods



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A public good is a good or service which is non-rivalrous 4, non-excludable 5 and non-contestable 6. Examples of public goods include national defense, street lights, internal securityand policing, basic health and basic education, national highways, rural roads, ruralelectrification, public transport infrastructure, public parks and public libraries etc. A privategood is one that is both rivalrous, excludable and contestable such as private transport andautomobiles, clothing, food etc.

(c) Existence of imperfect competition

Real markets are neither competitive nor perfect due to existence of various market barriers suchas lack of free entry, existence of licenses, and heterogeneity in the quality of goods and services.In most of the cases, free market forces do not exist, and we need government interventions for fair play by the market. (d) Existence of inequity

The existence of inequity also calls for government intervention.

1.2 Government Interventions

Government needs to intervene in these situations to ensure social justice and social equity.Table-1 below describes various kinds of governments interventions and their relative meritsand demerits to tackle these situations. These interventions basically include the following:

(a) Direct provision of public goods/ merit goods at low prices or free of charge;(b) Enacting laws and regulations, imposing environment tax, and organizing

education campaigns/ advertisements in the case of negative externalities;(c) Providing subsidies to producers or consumers for positive externalities;(d) To tackle imperfect market conditions, government interventions include

iimposition of tax or price controls on a monopolist, enacting antitrust laws, and4 Non-rivalrous its benefits are not depleted by an additional user. The supply of public goods has nomarginal cost. Thus, for allocative efficiency, price equals zero marginal cost (i.e. P = MC = 0), and publicgoods have to be provided at no charge.

5 Non-excludable impossible (or difficult) to exclude people from its consumption or benefits. Publicgood is a free rider. There is a problem for collecting user charges as no one will pay for what he can getfree. The private firms will not provide public goods as they are unable to charge the consumers. So the

public goods have to be exclusively provided by the government.

6 Non-contestable- A market may be described as perfectly contestable if no barriers to entry or exit exist.Consequently, contestability can act as a surrogate for competition in markets dominated by a monopoly,

duopoly or an oligopoly firms. However, there could be circumstances when contestability cannot exist.For example, the private sector may not be willing to develop basic infrastructure such as rail, roads, sea-

ports and air-ports in the initial stage of development of an emerging economy like Mongolia because of low or negative financial return, high risk, long gestation period, high incremental capital/output ratio(ICOR) and lumpiness of huge capital etc. Another case of non-contestability arises when there is nogeneral trust that the organization producing the good will not engage in ' opportunism' or illegibleactivities (Vining and Weimer 1991, p. 6/7) . Best examples of public goods where "trust" is veryessential and justices continued public production are production of critical defense products and cadres of armed forces.



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ensuring competition through deregulation, delicensing and decontrol of investment, production and trade;

(e) To reduce inequalities, government interventions include imposition of wealthtax and inheritance tax; to make the tax system progressive; to provide cash or in-kind benefits to the poor; unemployment benefits, State pensions, child benefits,

and universal basic healthcare and basic education.(f) Nationalization of private enterprises engaged in unfair production and trade

practices (for example natural monopolies supplying public utilities).



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Table-1A : Government Interventions

Problem Intervention Evaluation

Zero provisionof public goods

(a) Direct provision of publicgoods

(b) Provision of merit goods atlow prices or free of charge

Advantages(a) Increases social welfare at lower

public expenditure, for example, the provision of free health serviceshelps to contain and combat thespread of disease and so lessexpenditure on curative andhospitalization expenditure;

(b) Social justice : Merit goods should be provided according to needs andnot ability to pay

(c) Protection of Dependants:Dependants are subject to their guardians decision which are not

necessarily the best, so provision of services like free education and freedental treatment is needed to protectdependants from bad decisions

Disadvantages(a) Puts constraints on public resources.(b) Non-targeted provision may lead to

misuse and over consumption.

Negativeexternalities

(a) Financial intervention: taxes(equal to the monetary value of the Marginal Externality Cost)

are imposed on individuals or afirm, internalizing externalitycosts.

(b) Legislation: laws andadministrative rules are

passed to prohibit or regulateBehaviour that imposes anExternality Cost, e.g. pollution

permits(c) Education, campaigns and

advertisements solve the problem of imperfectinformation by allowing the

external costs to be madeknown to the consumer,discouraging demand.

Advantages(a) Leaves space for market forces to

interact(b) Generates revenue for the govt

Disadvantages(a) Difficulty in valuating externality

cost.(b) Overvaluation means output is

below social optimum, andundervaluation means that negativeimpact is not sufficiently controlled.

(c) Tax effectiveness depends onexternality costs.

(d) Enforcement is difficult andexpensive in many situations.

(e) Benefits must outweigh the costs of implementation.

(f) A lot of time may be needed for effects to be felt.



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Table-1B : Government Interventions


Positiveexternalities

(a) Financial intervention:subsidies paid to the producer or consumer

(b) Legislation include regulationsuch as seatbelt usage,compulsory education etc.

Advantages(a) Considered the most effective way

of solving under-consumption andit can be easily implementation.

Disadvantages(a) Like taxes, the valuation of external

benefit is difficult(b) High government expenditure is

required and it may put pressureson government resources.

(c) Okuns leaky bucket: each dollar transferred from a richer to a poorer individual, results in less than adollar increase in income for therecipient. Leaks arise due to highadministrative costs, changes inwork efforts, attitudes etc. as aresult of redistribution

(d) Enforcement requires constantchecking which may translate tohigh costs.

Imperfectmarkets

(a) Imposition of a lump-sum taxon a monopolist (shifts ACupwards), and supernormal

profits are taken as tax.

(b) Governments may also regulateMC/AC pricing for monopoliesthrough price controls.

(c) Government may imposeregulations to control monopoly

power, unfair production. tradeand business practices:

(i) Forbidding the formation of monopolies (e.g., antitrust laws)

(ii) Forbidding monopolistic Behaviour (like predatory pricing)

(iii) Ensuring standards of provision.(iv) Ensuring competition exists (e.g.,deregulation, delicensing,decontrol)

Advantages(a) Ensures fair price for consumers.

Disadvantages(a) Determination of fair price and

monopoly profits is difficult.(b) Monopolies will transfer taxes to

the consumers who might actually pay higher prices.

(c) Price controls need to be avoided ina free market economy. It may be

better to remove barriers to entry of new firms in investment,

production and trade.



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Table-1C : Government Interventions


Inequity andinequality

(a) The tax system can be usedto reduce inequalities in incomeand wealth.

(i) Progressive taxes : people earning higher incomes are taxed a higher

percentage of their income(ii) Direct taximposition on wealth(inheritance taxes)

(b) Monetary provision :money raised through the taxsystem is paid to low-incomegroups to increase their disposableincome

(i) Means-tested benefitsare paid to those that fitcertain criteria, such asunemployment benefits(ii) Universalbenefits are paid out toeveryone for certaincategories of peopleregardless of their income/wealth, such as State

pensions, child benefits

(c) Direct provision of goods/ servicesfinanced through the tax system.Free provision means that if services are used equally by all,lower income groups gain more

benefits leading to reduction of income inequality.

(i) Universal basichealthcare and basiceducation.

Advantages(a) Ensures social justice by reducing

income differentials.

Disadvantages

(a) Progressive tax may createdisincentives to work efforts withexcessive progressivity.

(b) Unemployment benefits are notalways claimed by those for whomthey are designed.

(c) Expensive to administer.(d) Low take-up of unemployment

benefits due to bureaucracy andsocial stigma.

(e) Universal benefits may be veryexpensive for the govt due to

political reasons, and may imply paying out money to those who donot need it.

(f) Okuns leaky bucket discussedunder positive externalities mayalso arise.

Unfair trade andproductionpractices

NationalizationNationalization refers to the public(government) ownership of certain firmsto provide goods and services sold in themarket i.e. corporations engaged incommercial activities. Government oftentakes over natural monopolies engaged in

production and distribution of publicutilities (power, water, gas and sanitation)to prevent monopoly power.

Advantages(a) Consumers are protected from high

prices.(b) Social costs and benefits are taken

into account when productiondecisions are made.

Disadvantages(a) Cross inefficiency may arise.(b) No profit motive may lead to

nationalized enterprises beingallocatively inefficient.


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ADB Project on Governance Reforms in Mongolia-Terminal Report Part-3 by Tarun Das

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