Public-Private Infrastructure Investment and Deposit Insurance in Mongolia
Public-Private Infrastructure
www. Investment and Deposit Insurance in Mongolia ksp .go.kr
2011
Ministry of Strategy and Finance, Republic of Korea Government Complex 2, Gwacheon, 427-725, Korea Tel. 82-2-2150-7732www.mosf.go.kr
Korea Development Institute 130-740, P.O.Box 113 Hoegiro 49 Dongdaemun-gu Seoul Tel. 82-2-958-4114www.kdi.re.kr
Knowledge Sharing Program Center for International Development, KDI 2011 ● P.O. Box 113 Hoegiro 49 Dongdaemun-gu Seoul, 130-740 MINISTRY OF STRATEGY ● Tel. 02-958-4224 AND FINANCE Korea Development Institute ● www.ksp.go.kr Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Public-Private Infrastructure Investment and Deposit Insurance in Mongolia
Project Title Public-Private Infrastructure Investment and Deposit Insurance in Mongolia
Prepared by Korea Development Institute (KDI)
Supported by Ministry of Strategy and Finance (MOSF), Republic of Korea
Prepared for The Government of Mongolia
In cooperation with Ministry of Finance of the Government of Mongolia
Program Directors MoonJoong Tcha, Managing Director, Center for International Development (CID), KDI Kwang-Eon Sul, Former Managing Director, CID, KDI Taihee Lee, Director, Policy Consultation Division, CID, KDI
Project Manager Kang-Soo Kim, Research Fellow, KDI
Authors Chapter 1: Hyungtai Kim, Research Fellow, KDI Tsend-Ayush Sosor, Senior Specialist, Ministry of Finance, Mongolia Baljinnyam Davaadorj, Officer, National Development and Innovation Committee, Mongolia Chapter 2: Kang-Soo Kim, Research Fellow, KDI Zayabal Batjargal, Head, State Property Committee, Mongolia Chapter 3: Jae-Youn Lee, Research Fellow, Korea Institute of Finance Seungkon Oh, Research Fellow, Korea Deposit Insurance Corporation Bayarkhuu Tsookhuu, Officer, Ministry of Finance, Mongolia Battulga Ulziibat, Senior Supervisor, Bank of Mongolia
English Editor Minah Kang, Freelance Editor
Government Publications Registration Number 11-1051000-000124-01 ISBN 978-89-8063-538-2 93320 Copyright ⓒ 2008 by Ministry of Strategy and Finance, the Republic of Korea Knowledge Sharing Program
Public-Private Infrastructure Investment and Deposit Insurance in Mongolia
2011
MINISTRY OF Korea Development STRATEGY AND FINANCE Institute Preface
In the 21st century, knowledge is one of the key determinants of a country’s level of socio-economic development. Based on this recognition, Korea’s Knowledge Sharing Program (KSP) was launched in 2004 by the Ministry of Strategy and Finance (MOSF) and the Korea Development Institute (KDI). KSP aims to share Korea’s development experience and knowledge accumulated over the past decades to assist socio-economic development of the partner countries. Former high-ranking government officials are directly involved in policy consultations to share their intimate knowledge of development challenges, and they complement the analytical work of policy experts and specialists who have extensive experience in their fields. The government officials and practitioners effectively pair up with their counterparts in development partner countries to work jointly on pressing policy challenges and share development knowledge in the process. The Program includes policy research, consultation and capacity building activities, all in all to provide comprehensive, tailor made assistance to the partner country in building a stable foundation and fostering capabilities to pursue self sustainable growth.
Year 2010 is the first to conduct Knowledge Sharing Program with Mongolia. Written demand survey forms were submitted by the Ministry of Finance of the Government of Mongolia via official channels in December 2009 and April 2010. Upon the request, 2010-2011 KSP with Mongolia, entitled ‘Public Private Infrastructure Investment and Deposit Insurance in Mongolia,’ was launched in June 2010 to focus on the following three areas: Improvement on the Preliminary Feasibility Study (PFS) System of Mongolia; Improvement in Legal and Procedural Public Private Partnership (PPP) System in Mongolia; and A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia.
I would like to take this opportunity to express my sincere gratitude to Senior Advisor Dr. Jung-Taik Hyun and Project Manager Dr. Kang-Soo Kim, as well as all the project consultants including Dr. Hyungtai Kim, Jae-Youn Lee and Seungkon Oh for their immense efforts in successfully completing the 2010 2011 KSP with Mongolia. I am also grateful to Managing Director Dr. Kwang- Eon Sul, Program Directors Mr. Taihee Lee, Dr. Wonhyuk Lim and Program Officer Ms. Sae Byul Chun, all of whom are the members of the Center for International Development, KDI, for their hard work and dedication to this Program. Lastly, I extend my warmest thanks to the Ministry of Finance of Mongolia, related Mongolian government agencies, local project consultants, program coordinators and participants for showing active cooperation and great support.
In your hands is the publication of the results of the 2010-2011 KSP with Mongolia. I sincerely hope the final research results including policy recommendations on the selected areas could be fully utilized to help Mongolia in practicing PFS and PPP and implementing limited deposit insurance system in the near future.
Oh-Seok Hyun President Korea Development Institute 2010 KSP with Mongolia
2010 KSP with Mongolia was initiated in December 2009 when the Ministry of Finance (MOF) and the National Development and Innovation Committee (NDIC) of the Government of Mongolia submitted a written Demand Survey Form. The form was officially channeled through the KOICA Mongolia office, the Embassy of Korea in Mongolia and the Ministry of Strategy and Finance (MOSF). The Government of Mongolia sent an additional written Demand Survey Form with priority listing in April 2010. There were 8 topics requested in total: Developing Public-Private Partnership in Mongolia; Developing a Deposit Insurance Scheme in Mongolia; Sovereign Bond Issuance; Introducing Livestock backed Loans in Rural Area; Preliminary Feasibility Study; Improving Fiscal Policy and Public Financial Management; Development of Accepted Standards and Procedure for Long, Medium Term National Development Strategic Planning and Macroeconomics Policies; Strategies for Developing Knowledge based Enterprises through Enhancement of University and Industry Collaboration.
Based on the priority listing of the topics submitted by the partner country, the Korea Development Institute (KDI) tried to select and provide consultation in the areas where Korea has the necessary know-how and is ready to share its experience. Under such consideration, the following three topics were reviewed with great interest: Preliminary Feasibility Study (PFS); Public Private Partnership (PPP) and Deposit Insurance (DI).
With the above three topics in mind, a Korean delegation composed of 8 members headed by Dr. Jung Taik Hyun, Chairman of Korea Trade Commission, visited Ulaanbaatar to conduct High-Level Demand Survey and a Pilot Study from June 30 to July 7, 2010. During the visit, the Korean delegation met with Mr. T. Ochirkhuu, then-Vice Minister of the Ministry of Finance of Mongolia, to finalize the topics for 2010 KSP with Mongolia. Participants from both countries engaged in an active discussion about the current economic state of Mongolia. The discussion covered a wide range of issues - from dealing with the great shortage of public infrastructure in Mongolia, to formulating an exit strategy from the current blanket deposit guarantee system. Mr. Ochirkhuu showed great enthusiasm for the aforementioned three topics, and requested Korean experts to share their knowledge in the given areas. The Korean experts subsequently held meetings with Mongolian government officials and specialists from the Bank of Mongolia, Financial Regulatory Commission (FRC), MOF, NDIC and State Property Committee (SPC) to decide on the specific research topics. The delegation also met with local consultant candidates to discuss the scope of research and to request relevant information and data updates from Mongolia. In addition, the Korean delegation visited the World Bank, International Monetary Fund (IMF) and Asian Development Bank (ADB) regional offices to collect necessary information and data. KDI and the MOF of Mongolia then signed an MOU to ensure continued cooperation throughout 2010 KSP.
After the first visit to Mongolia, MOSF, KDI and Dr. Kang-Soo Kim, the Project Manager for 2010 KSP with Mongolia, settled on the grand theme of Public Private Infrastructure Investment and Deposit Insurance in Mongolia covering the three areas with the following research titles: “Improvement on the PFS System in Mongolia”; “Improvement in Legal and Procedural PPP System in Mongolia”; and “A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia.”
From August 29 to September 3, 2010, a Mongolian delegation composed of 7 members from the Bank of Mongolia, FRC, MOF, NDIC and SPC visited Consultation Topics Korean Researcher Mongolian Researcher Improvement on the PFS System in Ms. Sosor Tsend-Ayush & Dr. Hyungtai Kim Mongolia Dr. Davaadorj Baljinnyam
Improvement in Legal and Procedural Dr. Kang-Soo Kim Mr. Batjargal Zayabal PPP System in Mongolia A Study on the Foundation for Dr. Jae-Youn Lee & Mr. Bayarkhuu Tsookhuu & Introducing Limited Deposit Protection Dr. Seungkon Oh Mr. Battulga Ulziibat Scheme in Mongolia Role Name Senior Advisor Dr. Jung-Taik Hyun Project Manager for 2010 KSP with Dr. Kang-Soo Kim Mongolia Program Director Mr. Taihee Lee Program Officer Ms. Sae-Byul Chun
Seoul to participate in Policy Seminar and Policy Practitioners’ Workshop I. Policy Seminar included presentations on the research topics as well as Korea’s broad development experience. The seminar fully served its purpose by facilitating active exchange of information and research progress as well as discussion on the research plan for the final consultation report. Furthermore, the Mongolian delegation was welcomed by relevant Korean institutions and organizations including the Ministry of Strategy and Finance, Financial Services Commission and Korea Deposit Insurance Corporation (KDIC), Public and Private Infrastructure Investment Management Center (PIMAC) and Incheon Bridge Corporation. The delegation traveled via Korea’s high-speed train (KTX) to visit POSCO, Hyundai Motors, Hyundai Heavy Industries and Gori Nuclear Complex based on their great interest in the field of industrial development and energy. All in all, the visit enhanced the understanding of the Mongolian participants in their respective sectors and Korea’s development experience. Starting from September 27 to October 3, 2010, 6 delegates from Korea visited Mongolia to conduct Pilot Study II. The Korean experts met local consultants to finalize and sign Terms of Reference (TOR). Both sides actively engaged in in-depth discussions for each topic to get feedback on the outline and content of the final report. During the visit, Korean experts Dr. Jae-Youn Lee and Dr. Seungkon Oh participated in a seminar on deposit insurance hosted by the ADB. Dr. Kang Soo Kim visited Energy Resources LLC and Erdenes MGL LLC located in Dalanzadgad to assess the status of infrastructure development and gather information for research.
Interim Reporting and Policy Practitioners’ Workshop II took place in Korea from November 28 to December 7 for the purpose of sharing research findings and policy recommendations with Mongolian government officials and the local consultants, as well as providing training programs for capacity-building. The delegation consisted of 34 members: 8 PFS, 12 PPP, 10 DI members from the Bank of Mongolia, FRC, MOF, NDIC, SPC, Ministry of Road, Transportation, Construction, and Urban Development, Ministry of Mineral Resources and Energy, Ministry of Education, Culture and Science, Ministry of Justice and Home Affairs, Cabinet Office and Office of the President, plus 4 members from the World Bank. During the Interim Reporting Workshop held at KDI, experts from both Korea and Mongolia presented their findings to exchange research results for discussion. Training sessions were 3-day long and were part of Policy Practitioners’ Workshop II. The sessions for PFS and PPP members were held at PIMAC, KDI, while DI training sessions were organized by KDIC. The delegation traveled via KTX to visit POSCO, SK Energy, Doosan Heavy Industries and Busan Port, all of which were related to Mongolia’s interest in industrial development, energy and PPP. As the final stage of 2010 KSP with Mongolia, Senior Policy Dialogue and Final Reporting Workshop was held in Ulaanbaatar from February 14 to 19, 2011. For Senior Policy Dialogue on February 16, the Korean delegation headed by Dr. Jung Taik Hyun held meetings with high-ranking officials including Mr. Bayartsogt, Minister of Finance, and Mr. Ganhuyag, Vice Minister of Finance. The Final Reporting Workshop took place at Kempinski Hotel. Thematic sessions on PFS, PPP, and DIwere chaired by Mr. Hyoung-Kwon Ko from the World Bank, Dr. Kwang Eon Sul from KDI and Mr. Byung Rae Lee from the World Bank, respectively. The Korean experts presented the final report and policy recommendations, and the local consultants participated as discussants for their corresponding topics.
The Final Reporting Workshop was a great success with nearly 120 people participating from the related ministries and organizations. Furthermore, the policy recommendations for each topic have been well-received by participating Mongolian government ministries and agencies. As evidence, some recommendations have already been reflected or are in the process of being implemented in Mongolia’s measures to practice PFS and PPP, and to introduce a limited deposit insurance scheme. Examples include preparation of regulations and guidelines for PPP project initiation, division of role between the line ministries in conducting feasibility studies, and formulation of a draft Law on Deposit Insurance. KDI plans to issue updates on the implementation of the policy recommendations in this report and further enhance its close ties with the Government of Mongolia.
Sae-Byul Chun Program Officer for 2010 KSP with Mongolia
Contents
Executive Summary∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙20
Chapter 01 Improvement on the PFS System of Mongolia
Summary ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙28 1. Introduction ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙30 2. Infrastructure in Mongolia ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙32 2.1. Mongolian Economy ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙32 2.2. Infrastructure in Mongolia: Now and Issues ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙34 2.2.1. Current Status of Infrastructure ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙34 2.2.2. Investment in Infrastructure ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙35 2.2.3. Road and Transportation∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙38 2.2.4. Energy ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙39 2.2.5. Water Supply ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙40 3. Mongolian PFS ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙40 3.1. Legal Framework of Mongolia ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙42 3.2. Institutional Arrangements of Mongolia ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙45 3.3. Analytical Guidelines and Data Requirements ∙∙∙∙∙∙∙∙∙∙∙∙∙∙48 4. Assessment of Mongolian PFS in Comparison to the Korean Case ∙∙∙∙∙∙∙50 4.1. Legal Framework and Legislation of Korea ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙50 4.2. Institutional Arrangements of Korea ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙55 4.3. Analytical Guidelines and Data Requirements ∙∙∙∙∙∙∙∙∙∙∙∙∙∙57 4.4. Performance ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙63 5. Conclusion and Policy Recommendations ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙64
Chapter 02 Improvement in Legal and Procedural PPP System in Mongolia
Summary ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙78 1. Introduction ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙79 2. Infrastructure in Mongolia: Issues and Challenges ∙∙∙∙∙∙∙∙∙∙∙∙∙∙81 2.1 Overview Focusing on Transport Infrastructure ∙∙∙∙∙∙∙∙∙∙∙∙∙∙81 2.1.1. Road Transport ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙82 2.1.2. Rail Transport ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙83 2.1.3. Air Transport ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙85 2.2. Investment Gap ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙85 3. Public Private Partnerships ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙88 3.1. The Need for Private Participation in Infrastructure Development in Mongolia 88 3.2. Mongolian Concession ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙90 3.2.1. Legal Framework ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙90 3.2.2. Institutional Arrangements Defining Roles and Responsibilities of Key Players ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙90 3.2.3. Procurement Process ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙91 3.2.4. Financial Support and Risk Sharing ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙93 4. Assessment of Mongolian Concession in Comparison to Korean PPP ∙∙∙∙∙∙94 4.1. Legal Framework and Legislation ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙94 4.2. Institutional Arrangements ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙96 4.3. Procurement Procedure ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙97 4.4. Facility and Objects Eligible for Concession ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙100 4.5. Tendering and Direct Agreement ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙101 4.6. Government Financial Support for Risk Sharing ∙∙∙∙∙∙∙∙∙∙∙∙∙101 4.7. Fiscal Risk Management ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙103 Contents
5. Policy Recommendations ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙104 5.1. Complement and Strengthen Legal and Institutional Framework ∙∙∙∙∙∙104 5.2. Build a Transparent and Competitive Procurement Process ∙∙∙∙∙∙∙∙105 5.3. Attract Private Participants through Incentives and Risk Sharing Mechanisms with Appropriate Fiscal Management ∙∙∙∙∙∙∙∙∙∙∙∙106 5.4. Build Capacity of SPC and Provide Training for Public Sector Officials ∙∙∙∙108 6. Summary and Conclusion ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙110
Chapter 03 A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia
Summary ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙126 1. Introduction ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙128 2. Financial System in Mongolia ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙129 2.1. Overview of Financial Industry ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙129 2.1.1. Banking Sector ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙130 2.1.2. Non Bank Financial Institutions ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙131 2.1.3. Savings and Credit Unions ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙131 2.1.4. Insurance and Reinsurance ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙132 2.1.5. Securities Companies ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙132 2.2. Banking Industry∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙133 2.2.1. Transfer to Two-tier System ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙133 2.2.2. Structure of the Banking Industry ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙134 3. Financial Crisis and Depositor Protection ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙136 3.1. Banking Crisis and Blanket Guarantee Protection ∙∙∙∙∙∙∙∙∙∙∙∙136 3.1.1. 1st Banking Crisis∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙136 3.1.2. 2nd Banking Crisis ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙139 3.1.3. Blanket Guarantee Protection ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙142 3.2. Crisis of SCUs and Depositor Protection∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙145 3.2.1 Background ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙145 3.2.2 Origin of Crisis ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙146 3.2.3 Depositor Protection ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙148 4. The Transfer to Limited Protection ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙148 4.1 Conditions for the Transition to a Limited Coverage ∙∙∙∙∙∙∙∙∙∙∙∙148 4.1.1 Reasons for the Transition to a Limited Coverage ∙∙∙∙∙∙∙∙∙∙148 4.1.2 Preconditions for the Transition and Related Issues ∙∙∙∙∙∙∙∙∙149 4.2 Cases of Transition to a Limited Coverage and Implications for Mongolia ∙∙∙152 4.2.1 Cases of Transition to a Limited Coverage ∙∙∙∙∙∙∙∙∙∙∙∙∙152 4.2.2. Implications for Mongolia ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙161 4.3. Review of Fulfillment of the Preconditions ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙163 4.3.1. Macroeconomic Environment∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙163 4.3.2. Conditions of Banking Industry ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙165 4.3.3. Infrastructure ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙169 4.3.4. Policy Proposals ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙171 5. Deposit Guarantee Scheme in SCU Industry ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙171 5.1. Role of Deposit Guarantee Scheme ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙171 5.1.1. Protecting Small Depositors ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙171 5.1.2. Stabilizing the Financial System∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙172 5.1.3. Facilitate Resolving the Insolvent Deposit Taking Institutions ∙∙∙∙∙172 5.1.4. Stimulate Development of SCU ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙173 5.2. Deposit Guarantee Scheme ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙173 5.2.1. Government Guarantee ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙173 5.2.2. Consolidated Protection Scheme ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙176
REFERENCES ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙179 Contents | LIST OF Tables
Infrastructure Investment Plan by 2015 ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙37
Insured Financial Institutions in Countries ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙177 Contents | LIST OF FIGURES
Economic Growth and GDP per Capita ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙33 Financing Source for Infrastructure Projects ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙35 Public Investment Plan ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙36 2011 Budget Investment in Infrastructure Sector ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙36 Budget Investment of Electric Sector ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙39 Process of Existing Budget Investment Planning ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙42 Procedures and Roles in PIP ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙46 New Initiatives of Public Investment Management ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙54 PFS Procedure ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙56 Structure of AHP in PFS ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙61 International Comparative Road Network Indicators ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙83 International Comparative Railway Density Indicators ∙∙∙∙∙∙∙∙∙∙∙∙∙∙84 Investment in Infrastructure as % of GDP ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙86 Investment in Road and Transport Sector ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙86 Estimated Annual Investment Gap ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙88 Procurement Steps of Solicited Projects (One Stage)∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙92 Procurement Steps of Solicited Projects (Two Stage) ∙∙∙∙∙∙∙∙∙∙∙∙∙∙92 Procurement Steps of Unsolicited Projects ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙93 History of PPP Act∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙95 Procurement Procedure for BTO Project ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙99 Procurement Procedure for BTL Project ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙100 Financial and Tax Incentives for Korean Public Private Partnership Projects ∙∙∙∙102 Management Performance of the 1st Banking Crisis∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙137 Soundness of Bank Loans (1996) ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙138 Monthly Deposit Growth Rate∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙141 Demand and Savings Deposit∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙143 Changes in Real GDP Growth of Korea∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙153 Changes of Deposit Insurance Coverage in Japan ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙158 Contents | LIST OF FIGURES
Changes in Real GDP Growth of Japan ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙159 Corporate Bankruptcies in Japan ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙160 Nikkei Stock Index ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙161 Economic Growth Rate of Mongolia ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙163 Inflation Rate of Mongolia∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙164 Total Asset of Banks to GDP ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙165 Bank’s Deposit ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙166 Loans and NPL ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙167 Capital Adequacy ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙168 Bank’s Net Interest Margin ∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙∙169
Executive Summary
The mining sector is the main driver for the Mongolian economy. Expansion of mining is expected to bring important benefits such as new investments, jobs, export earnings, and a surge in government revenues. The solid progress of the one of the world’s largest untapped copper deposits, Oyu Tolgoi Project, the economy of Mongolia has entered the recovery phase since the recent global recession. The real GDP growth in 2011 is anticipated to reach 8.2 percent, mainly due to the swift growth in mining of coal, oil and iron ore and in 2013, the GDP per capita is projected to reach 4772.8 MNT, 1.9 times higher than in 2009.
However, development in mining industry also has caused a significant pressure on the supply of infrastructure. Current status of infrastructure is unable to meet increasing demand, and the lack of basic infrastructure has been being clearly a major factor constraining economic growth. Mongolian government has identified that the persistent underinvestment in infrastructure is having a negative impact on economic growth and transaction costs of businesses. However, as other developing countries are facing with the same constraints, the fiscal resources have not been sufficient to provide the requisite investment to supply adequate infrastructure for economic and social developments. Clearly, a new model and a new investment management system to modernize and supply Mongolia’s infrastructure is required.
Mongolian government identified that properly structured public investment management system, and Public-Private Partnership (PPP) are key instruments to increase the efficiency of fiscal infrastructure expenditure management, and attract necessary private investment for the development of the infrastructure.
Meanwhile, as Mongolia switched from socialist planned economy to the market economy in 1990, it has experienced many changes in the financial sector. The State Banking Committee was split up into a central bank and commercial banks following the transition to the market economy. In particular, during the financial crisis in 2008, the government temporarily introduced a blanket guarantee system to stabilize the banking industry.
The Mongolian government plans to terminate the blanket guarantee system in 2012 though the inflation rate remains high and government deposits and borrowing from the central bank still account for a large share of banks’ funding. There are some preconditions to introducing the new deposit protection scheme instead of the blanket guarantee system. Firstly bank’s financial health needs to be improved and winning the public’s confidence needs to be considered. Furthermore, for asset allocation, Mongolian banks need to expand their loan portfolios and lower the ratio of non performing loans (NPLs).
In consideration of such development challenges facing the country on management of the fiscal expenditure and increased alternatives of the investment for infrastructure as well as the establishment of the measures for new deposit protection scheme, the 2010 Knowledge Sharing Program for Mongolia, sponsored by the Korean Ministry of Strategy and Finance, analyzes and gives policy recommendations to the Mongolian government for the following topics by mutual agreement between the governments of Korea and Mongolia.
1) Improving the PFS system to increase the allocative efficiency of fiscal investment in the infrastructure sector; 2) Improving the legal framework and procedural guidelines of PPP in infrastructure development; and 3) Providing foundation and guidance for introducing limited deposit protection scheme.
(1) Improvement on the PFS System of Mongolia
This chapter compares the PFS system between Korea and Mongolia in order to draw policy implications that the Mongolian government may need to consider when implementing the PFS.
First, the government of Mongolia should not only attempt to introduce the ex ante evaluation system such as PFS, but also needs to prepare for the intermediate evaluation systems and a different form of ex ante evaluation system such as Simplified PFS, which have worked as effective measures to improve the Public Investment Management (PIM) system in Korea. This is important because line ministries tend to overestimate benefits and underestimate costs. Furthermore, this is also important given that the authority that the Mongolian parliament has exercised regarding budgeting is too strong compared to international standards.
Second, the operational guideline prepared by NDIC is not detailed enough to provide a clear course of action regarding PFS. For example, the guideline does not elaborate the unit of projects subject to PFS and the requirements for and procedures of exemption from PFS as well as Ex Officio Selection, which has functioned well in Korea as effective measures to keep line ministries from breaking down large projects into smaller projects and to keep line ministries from deliberately underestimating costs to avoid PFS. In this respect, the Mongolian government and NDIC would need to make an additional effort to refine the operational guidelines in a more detailed and elaborate manner while considering the establishment of intermediate evaluation frameworks.
Third, the rights and duties of line ministries, NDIC, and MOF are still not clear or appropriate and the government of Mongolia needs to consider rearranging the division of duties of related institutions. For example, line ministries are supposed to take charge of the preparation of project proposals and PFS for small scale projects in the current arrangement. But line ministries may not be able to conduct rigorous PFS given the limited capability, and the project proposals may not be consistent across ministries and across sectors. The government of Mongolia is recommended to clearly and appropriately specify the rights and responsibilities among line ministries, NDIC, and MOF.
Forth, the analytical guidelines prepared by NDIC is stated in too generic terms to provide clear methodologies for line ministries or local governments. Thus analytical guidelines need to be refined in a more elaborate and detailed manner in order to ensure transparency, consistency, and accuracy of the PFS results. In addition, the evaluation methods are totally based on qualitative methods, which may harm the objectivity of the evaluation. The evaluation procedures are not clearly specified, which may increase the risks of being swung by political pressures. In a longer term, the government of Mongolia needs to consider the adoption of a coherent and standardized evaluation method in order to increase the objectivity of the comprehensive evaluation by preventing arbitrary decision making while, in a shorter term, clearly specifying the evaluation procedures such as the criteria to form the evaluation committee.
Finally, the government of Mongolia faces a great shortage of appropriate databases while adequate data such as transportation O/D data are essential preconditions for conducting PFS. In this respect, NDIC and the government of Mongolia should make a great deal of effort to build an adequate national database system, which is essential for successful PFS.
(2) Improvement on Legal and Procedural PPP System in Mongolia
Mongolia succeeded in enacting the Law on Concessions in January 2010, opening up state and local properties for better investment opportunities. The burden on the government to develop infrastructure is to be reduced and social services provided to the citizens are to be improved. In order for the expansion of infrastructure investments to yield desired outcome, four policy recommendations were made in light of Korean PPP experience.
First, complement and strengthen the current legal framework to be workable and implementable. The newly ratified Law on Concessions will no doubt be facing challenges of legal loopholes that allow circumvention or avoidance of some of the most critical regulatory stages, which must be addressed through detailed guidelines according to specific sector and different procurement procedures. Specific guidance for tendering, contracting, risk sharing and conflict resolution must be adopted.
Second, build transparent and competitive procurement process. Procurement of concession projects, bid, and evaluation methods suggest ways for optimal procurement for transparent selection process, which contributes to fostering a competitive PPP market. Standard documents for bidding that clearly and comprehensively address content of proposals, financing and reimbursement issue would act as guidance to the possible concessionaires. Third, educate public sector officials through training and capacity building. As advisory and project facilitating entity, staffs of State Property Committee require knowledge and expertise in the relevant field. Through active cooperation with foreign advanced PPP units, it may build inward capacity to be, in the future, disseminated to other ministries and local government officials in charge of concession projects through training and education services.
Fourth, adopt measures to attract private partner investment through incentives and risk sharing. Government support could be considered to induce private sector’s active participation. Korea’s case of government incentives, in forms such as construction subsidy, infrastructure credit guarantee via infrastructure credit guarantee fund, tax incentives, and early termination payment are introduced as well as ways of fiscal risk management.
(3) A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia
As response to series of financial crises, the Mongolian government provided protection for some depositors of banks and SCUs. During the 2006 SCU crisis, the government paid compensation for half of depositor claims to reduce losses to individual depositors. During the recent financial crisis, the government adopted a temporary blanket guarantee in late 2008 that would be in place for four years in order to prevent bank runs and maintain the stability of the financial system. The blanket guarantee system helped stabilize the financial system by protecting all deposits, but also increased moral hazard of banks and depositors.
However, the Mongolian government planned to terminate the blanket guarantee system by November 2012. To ensure a successful transition to a limited coverage, some preconditions should be met in order to enhance public confidence in the banking industry. In particular, since depositors in Mongolia once lost their money due to bank failures, they may withdraw all their deposits for fear of loss if the blanket guarantee is removed. A deposit protection scheme for SCU requires government guarantees, which would strengthen protection for small depositors of SCUs and put SCUs on an equal footing with banks as bank deposits are already protected by the government. However, should a large number of SCUs go bankrupt at once and the deposit insurance fund proves not to be sufficient enough to cover all claims, the government will have to use taxpayers’ money to protect depositors of SCUs. Thus, the SCU industry should be restructured first before the government provides guarantees for SCU deposits.
Mongolia also needs to consider creating a single deposit insurance scheme for banks and SCUs. This will help reduce operating costs through economies of scale. At the moment, however, regulation and supervision of SCUs are not rigorous enough to enable an efficient operation of a single scheme for both banks and SCUs. And if separate protection schemes are adopted, it will be very difficult to combine them later. Thus, it is urgent to strengthen regulation and supervision of SCUs with the aim of building a single protection scheme.
Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Chapter 01
Improvement on the PFS System of Mongolia
Summary 1_ Introduction 2_ Infrastructure in Mongolia 3_ Mongolian PFS 4_ Assessment of Mongolian PFS in Comparison to the Korean Case 5_ Conclusion and Policy Recommendations Chapter 01
Improvement on the PFS System of Mongolia
Hyungtai Kim (Korea Development Institute) Tsend-Ayush Sosor (Ministry of Finance) Davaadorj Baljinnyam (National Development and Innovation Committee)
Summary
Infrastructure plays a decisive role in the improvement of national competitiveness and economic development. Especially, as investment in infrastructure provides long term economic benefits through increases in overall productivity, most countries have made consistent investment in the provision of public infrastructure. Like most developing countries, however, Mongolia could not afford to provide an adequate level of infrastructure to boost economic growth due to limited budget resources. As a result, the level and quality of infrastructure in Mongolia are relatively poor. Nonetheless, Mongolia, with abundant natural resources and excellent human capital, has experienced rapid economic growth and it is expected to grow more rapidly when the production of Oyu Tolgoi is planned to start in 2013.
However, further economic development hinges on whether an adequate level of public infrastructure is provided. Having identified the necessity of public infrastructure to sustain further economic growth and the problems embedded in the current PIP (Public Investment Planning), the Mongolian government has endeavored to develop a couple of legal frameworks such as the PPP (Public-Private Partnership) system, and the PFS (Pre-feasibility Study) system for fiscal investment. The PPP framework is an efficient device to promote the implementation of privately financed infrastructure projects and thereby decreasing the fiscal burden. However, because infrastructure provision is not always profitable enough to attract private investment, the provision of public infrastructure cannot depend only on PPP. In this respect, the government of Mongolia has attempted to introduce the PFS system to increase the allocative efficiency of fiscal investment.
028 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia In this regard, this chapter first analyzes the current status and outlook of the economy and infrastructure development in Mongolia, focusing on the challenges and needs for PFS. Then, it introduces the current public investment evaluation system of Mongolia and the PFS system of Korea, which is considered as one of the best practices in the world, focusing on the legal and operational framework, institutional arrangements, and issues associated with analytical guidelines and data. Finally, it compares the PFS system between the two countries in order to draw some policy implications that the Mongolian government may need to consider when implementing the PFS system in Mongolia.
The policy implications of this chapter are as follows. First, the government of Mongolia should not only attempt to introduce the ex ante evaluation system such as PFS, but also needs to prepare for the intermediate evaluation systems such as TPCM, RDF, RSF, and an ex ante evaluation system such as Simplified PFS, which have been implemented in Korea and worked as effective measures to improve the PIM system. This is important because line ministries tend to overestimate benefits and underestimate costs. Furthermore, this is also important given that the authority that the Mongolian parliament has exercised regarding budgeting is too strong compared to international standards. It would be ideal if all the large-scale investment projects subject to PFS presented by the parliament also go through a rigorous PFS. Given the political structure of Mongolia, however, it may be very difficult to keep such powerful political groups only with an ex ante evaluation system as specified in the IBL, as the parliament may try to avoid the PFS or hide the projects in the budget. Second, the operational guideline prepared by NDIC is not detailed or elaborate enough to provide a clear course of action regarding PFS. For example, the guideline does not elaborate the unit of projects subject to PFS and the requirements for and procedures of exemption from PFS as well as Ex Officio Selection, which has worked pretty well in Korea as effective measures to keep line ministries from breaking down large projects into smaller projects and to keep line ministries from deliberately underestimating costs to avoid PFS. In this respect, the Mongolian government and NDIC would need to make an additional effort to refine the operational guidelines in a more detailed and elaborate manner while considering the establishment of intermediate evaluation frameworks.
Third, the rights and duties of line ministries, NDIC, and MOF are still not clear or appropriate and the government of Mongolia needs to consider rearrangements in the division of duties of related institutions. For example, line ministries are supposed to take charge of the preparation of project proposals and PFS for small-scale projects in the current arrangement. But, line ministries may not be able to conduct rigorous PFS given the limited capability and the project proposals may not be consistent across ministries and across sectors. In addition, line ministries are inclined to underestimate costs and overestimate demands in order to launch the project. To make things worse, line ministries or local governments are generally direct beneficiaries, which may harm the objectivity of PFS. More importantly, the rights and roles between NDIC and MOF are not clearly defined. Considering that one of the key reasons for
029 Chapter 1 _ Improvement on the PFS System of Mongolia Korea’s success is that the division of roles among KDI, MOSF, and line ministries has been clearly and appropriately set up, the government of Mongolia should clearly and appropriately specify the rights and responsibilities among line ministries, NDIC, and MOF.
Forth, the analytical guidelines prepared by NDIC is stated in too generic terms to provide clear methodologies for line ministries or local governments and thus analytical guidelines need to be refined in a more elaborate and detailed manner in order to ensure transparency, consistency, and accuracy of the PFS results. In addition, the evaluation methods are totally based on qualitative methods, which may harm the objectivity of the evaluation and the evaluation procedures are not clearly specified, which may increase the risks of being swung by political pressures. So, in a longer term, the government of Mongolian needs to consider the adoption of a coherent and standardized evaluation method such as the AHP method implemented in Korea in order to increase the objectivity of the comprehensive evaluation by preventing arbitrary decision-making while, in a shorter term, clearly specifying the evaluation procedures such as the criteria to form the evaluation committee. Fifth, the government of Mongolia faces a desperate shortage of appropriate databases while adequate data such as transportation O/D data are essential preconditions for conducting PFS. In this respect, NDIC and the government of Mongolia should make a great deal of effort to build an adequate national database system, which is essential for successful PFS.
1. Introduction
Infrastructure plays a very important role in the improvement of national industrial competitiveness and economic development. Since investment in infrastructure provides long term economic benefits through increases in output, income, employment, and productivity, or reductions in costs of production, many countries around the world have consistently made a huge amount of investment to improve the level of public infrastructure. Like most developing countries, however, Mongolia could not afford to provide an adequate level of infrastructure to support economic growth due to limited budget resources. As a result, the level of infrastructure is generally poor in Mongolia although the investment-to-GDP ratio is quite high in comparison to other developing countries. Moreover, Mongolia, heavily dependent on the international economic cycle, was severely hit by the worldwide economic recession and was not able to provide infrastructure essential to support economic growth. As a result, public infrastructure such as roads, railways, energy facilities, and so on is still insufficient and outdated, which has been impeding Mongolia’s further economic growth. Nevertheless, Mongolia is abundant in natural resources and excellent human capital and thus has been growing somewhat rapidly compared to other developing countries. Throughout 2010, the Mongolian economy has almost recovered from the recession and the recovery is expected to sustain in 2011. It is also hoped that economic growth will hover around 7.0~8.0 percent between 2010~2012 and will continue through the year of 2013 when the production of Oyu Tolgoi is projected to start, which will
030 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia then provide even more rapid growth for the Mongolian economy. But, this economic growth hinges on whether the government of Mongolia can provide a sufficient level of public infrastructure, which will be enough to sustain further economic development.
The government of Mongolia identified that the current level of infrastructure cannot meet the increasing demand for further economic development and has made a great deal of effort to develop a few legal frameworks to improve the level of public infrastructure, one of which is the PPP (Public-Private Partnerships) framework, a system intended to attract private investment for the development of public infrastructure. In order to support the PPP framework legally, the government of Mongolia enacted the Law on Concessions in 2010 with the aim to promote and facilitate the implementation of privately financed infrastructure projects and thereby, to reduce the investment gap. However, the improvement of public infrastructure cannot depend only on the PPP framework because the private sector would not make investment on public infrastructure if profitability is not expected, and infrastructure provision necessary for economic development would not always be profitable enough to attract private investment. In this respect, the government of Mongolia also identified the need to make fiscal investment on infrastructure provisions. But, the problem is that the fiscal resources are limited, which is why the government of Mongolia has been recently attempting to introduce an efficient public investment evaluation system, which is PFS (Pre-Feasibility Study).
PFS is a short and provisional evaluation of a project to produce information for effective budgetary decisions and to enhance allocative efficiency and has been effectively applied in several countries including Korea, Great Britain, and Japan, among which Korea is said to be one of the best cases in the world. PFS was introduced in Korea because, like other countries, demands on public expenditure increased from various budget areas such as welfare while needs for large-scale infrastructure investment also increased considerably. Therefore, prioritizing among large-scale infrastructure projects became important and this is why the Korean government officially introduced the PFS system with the enactment of the NFA (National Finance Act), Enforcement Decrees, along with related operating and analytical guidelines. The government of Mongolia has also identified the necessity of an effective public investment evaluation system and established NDIC (National Development and Innovation Committee) as an institution in charge of the PIP (Public Investment Planning) including strategic planning and project evaluation and has been attempting to enact the IBL (Integrated Budget Law or New Budget Law) and related operational and analytical guidelines necessary for the effective operation of the public investment evaluation system. Still, the IBL does not seem to be extensive or comprehensive enough to ensure an efficient and sustainable public investment management and moreover, the IBL is still under discussion. Furthermore, the current operational and analytical guidelines regarding PFS, prepared by NDIC, are not elaborate or detailed enough to provide a clear course of action regarding PFS. To make matters worse, the authority and duties of NDIC are not clear. That is, the institutional arrangements among NDIC, MOF (Ministry of Finance), and line ministries are not yet clearly set up.
031 Chapter 1 _ Improvement on the PFS System of Mongolia In this regard, this paper attempts to contribute to the establishment of the PFS system in Mongolia by introducing the Korean PFS system, which has been referred to as one of the best practices in the world. Furthermore the paper will try and achieve this by comparing the public investment evaluation systems between the two countries. To meet this goal, the second section briefly looks at the Mongolian economy and the current situation and challenges of infrastructure provision of Mongolia. The third section focuses on the legal frameworks, institutional arrangements of Mongolia, and analytical issues and data concerns in Mongolia. The fourth section introduces the legal frameworks, institutional arrangements, and analytical issues and data quality in Korea and then makes a brief assessment on the PFS system of Mongolia compared to that of Korea. Finally, the fifth section summarizes the discussion and draws several policy implications considered to be significant for the successful implementation of the Mongolian PFS.
2. Infrastructure in Mongolia: 2.1. Mongolian Economy1)
The economy of Mongolia entered the recovery phase since the recent global recession. The recovery in Mongolia, first started in the transport, communications and mining sectors and it is now becoming broad based. The increase in GDP for 2010 was mainly due to the 23.4 percent increase in wholesale and retail trade; repair of motor vehicles and motorcycles, 11.3 percent increase in manufacturing and 6.3 percent increase in the mining and quarrying sector, respectively. The industrial manufacturing sector has been revitalized since the end of 2009, reflecting the recovery in commodity prices as well as demand. As the result of gradual increase in industrial production, its share of GDP is expected to reach 7.1 percent in 2015.
In 2010, the GDP per capita is predicted at 2987.1 MNT, which is a 555.2 MNT increase compared to the previous year. Throughout 2010, the Mongolian and global economies are recovering from the recession, and by 2011 the recovery should reach the closing stages. Economic growth is expected to be steady around 7.0-8.0 percent during the period 2010-2012, however in 2013, after the launch of Oyu Tolgoi mining project, the economy is projected to grow more rapidly. The real GDP growth in 2011 is anticipated to reach 8.2 percent, mainly due to the swift growth in the manufacturing industry along with the further increase in mining of coal, oil and iron ore. In 2013, the GDP per capita is projected to reach 4772.8 MNT, 1.9 times higher than in 2009.
The national consumer price index in December 2010 increased by 2.4 percent compared to
1) Section 2.1 is based on the “Mongolia Quarterly Economic Update (October 2010)” published by the World Bank.
032 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Figure 1-1 | Economic Growth and GDP per Capita
GDP per capita, 1000MNT Economic growth in real terms, %
Source: NDIC, World Bank the previous month, and 13.0 percent compared to the same period of the previous year. Annual average inflation rate was 10.1 percent. The increase in national index compared to the previous month was mainly due to the 5.2 percent increase in food and non alcoholic beverages. The mining sector is the main driver for the Mongolian economy and the production of gold, copper and coal is expected to increase in the coming years. A full scale mine construction is underway at the Oyu Tolgoi Project, considered to be one of the world’s largest untapped copper deposits. Various estimates suggest that Mongolia’s economic growth will be accelerated after 2013 as the Oyu Tolgoi mine comes online. Over the longer term, coal output has the potential to grow further with the development of Tavan Tolgoi mine. Hard coking coal of Tavan Tolgoi is in strong demand in China. China imports coking coal from Australia, however Mongolian imports are fast displacing Australian coal because of its strategic location near Chinese boarders and the massive amount of coal reserve in Mongolia. Also, increases in infrastructure construction works such as the Sainshand industrial complex, railway connecting from Tavantolgoi to Choibalsan, millennium road project, and energy networks, all have influenced the economic recovery of Mongolia. Expansion of mining will bring important benefits such as new investments, jobs, export earnings, and a surge in government revenues. However, infrastructure challenges remain for the development of the mining sector, rail transport, efficient border crossings, electricity and water supply. To support the development of natural resource production, Mongolia will need more infrastructure provision.
033 Chapter 1 _ Improvement on the PFS System of Mongolia 2.2. Infrastructure in Mongolia: Now and Issues
2.2.1. Current Status of Infrastructure
Considering the current status of investment policy for ensuring proper structure of economic growth in Mongolia and promoting intensiveness of development, the issue to improve its planning is gaining greater significance. Mongolia pursues an objective to increase the extent of investment in the sectors of transportation, social education, health, culture and science and at the same time, to boost economic growth and to reduce poverty in the near future through developing the mining sector and maintaining economic growth. Mongolia successfully overcame the recent economic crisis and its GDP grew to 6.1 percent in 2010. In this scope, large-scale projects having certain phases of exploiting new mineral deposits, which are essential in producing products in much demand from both foreign and domestic markets, were highlighted. As such, the mining sector is considered as the priority area that will boost the overall economic growth of Mongolia.
In order to implement this objective, the Mongolian government is highly concerned about establishing applicable infrastructure, subject to the development of the mining sector. The current infrastructure status in Mongolia is unable to meet the increasing demand. Ongoing research clearly demonstrates that it is impossible to successfully implement industrialization policies without developing the infrastructure sector. At present, the Mongolian government is planning to implement 24 large-scale projects which are to help in maintaining industrialization as well as developing agriculture and the national infrastructure. Among these projects are the Oyu Tolgoi project, having the prosperity to process ore and produce 35 million tons of copper concentrate per year, and the Tavan Tolgoi project, having the prosperity to mine 20 million tons of coal and 15 million tons of concentrated coal, which will be implemented in the southern part of Mongolia.
Mongolia worked out a plan to establish a huge industrial complex for copper smelting as well as coke chemical ventures. Projects on mining ventures for mineral mining as well as ventures for processing and producing of end products will be implemented in the southern region where infrastructure is weakly developed. In this concern, there is a large amount of investment in establishing the required infrastructures. Mining ventures are expected to produce products starting from the year 2012. According to the projects to be implemented in Mongolia, the work to establish ventures for production of end products has been arranged for implementation. Accordingly, the work to maintain infrastructures for the energy, road, transport and construction sectors is planned to be implemented starting from the year 2011. Investment will be made in the infrastructure sector from the state budget along with the involvement of both foreign and domestic investors pursuant to the law on foreign loan, grant and concession.
034 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia 2.2.2. Investment in Infrastructure
The Law of Mongolia on Concessions was adopted in 2010 and it was legalized that the list of concession items belonging to the state shall be passed by the government. The list of 121 concession items was passed according to Decree No. 198 dated 2010 by the government. It includes 4 projects on building 8,031 km roads (Build-Transfer-Operate, Build-Transfer-Lease), 16 projects on energy resources (Build-Transfer-Operate, Build-Transfer-Lease), 3 projects on transportation (Build-Transfer-Operate), 2 projects on construction (Build-Transfer-Operate, Build-Transfer-Lease), and other 56 projects (Build-Transfer-Operate, Build-Transfer-Lease). The Mongolian government targets to implement the objectives, which are proposed to establish infrastructural facilities such as auto roads, construction, urban development, electricity and heating in the medium term. This depends mainly upon foreign and domestic investments as well as financing by the development bank pursuant to the law of Mongolia on concessions, due to the lack of budgetary financial sources in implementing those objectives.
Figure 1-2 | Financing Source for Infrastructure Projects
FINANCING SOURCE OF INFRASTRUCTURE SECTOR
FOREIGN AND CENTRAL DEVELOPMENT FOREGN LOAN DOMESTIC BUDGET BANK AND GRANT INVESTOR
Source: NDIC
With the advantage of fast growing budgetary revenues of the Mongolian government since 2011, the amount of investment made to the infrastructure sector is on the rise. The Parliament approved the 2011 budget law and the budget law approved an investment of 627.7 billion MNT from the state budget. About 81 percent of the central budget investment is assigned for construction facilities as well as extension and renovation work, while 7.4 percent is for capital repair and 11.6 percent is for equipment purchase. 44.1 percent of the central budget investment is assigned for infrastructure.
An investment of over 277.0 billion MNT is to be made from the state budget in the road, transport, construction and energy sectors in 2011. Extremely important measures are used to provide consumers with reliable electrical and thermal energy and to extensively develop auto
035 Chapter 1 _ Improvement on the PFS System of Mongolia Figure 1-3 | Public Investment Plan (Billion MNT)
Source: NDIC road, transport, production and service as well as to maintain a proper environment for engagement in business and conditions for comfortable and peaceful living. The Mongolia Development Bank, to be newly established is expected to play a leading role for the infrastructure sector.
Total budget investment From which: in infrastructure sector
Source: NDIC
036 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Table 1-1 | Infrastructure Investment Plan by 2015
Infrastucture Million MNT Electrocity 796,800 Electric station 650,800 Electric airway and sub station 146,000 Road and transportation 2,533,920 Rail road 2,232,950 Road 300,970 Water supply 494,200 Exploration research 4,200 Water tunnel 490,000 Urban development and public infrastucture 525,800 City and village development plan 10,000 City and village engineering infrastructure and design 170,000 Apartment 120,000 Public construction 80,000 Engineering infrastucture of construction materials industry 20,000 Engineering infrastucture of border point 95,800 Engineering infrastucture of universities and collages 30,000 TOTAL 4,350,720
Source: NDIC
It is vital to ensure the aptness and efficiency of investment policies, limit useless distribution of investment to various small projects in little amounts, and enhance investment yield upon spending such capital in the priority sectors. It is also vital to follow the principle based on priority in correlation with the development policy and strategy pursuance in the near and midterm future. Considering the structure of investment made in infrastructure, the projects establish new energy sources, which lean on coal-mines and electrical conduction lines. They deliver the products of mining ventures to processing ventures as well as maintain transportation networks for product exports. According to the preliminary research in Mongolia, the infrastructure of South Gobi required 4.4 trillion MNT and was implemented based on the Public Private Partnership.
Currently, large manufacturing-cities are provided with energy resources, water supply, auto roads and railroads and improved infrastructure of newly developing mining sectors in the south regions have become the main goals of the Mongolian government. Considering that the state budgetary capital does not provide the full investment amount required for Mongolia’s infrastructure, licensed foreign investors who are to exploit mineral deposits and companies to operate business in Mongolia are expected to work jointly in order to provide infrastructures through their investments. Moreover, national companies that are engaged in the mining
037 Chapter 1 _ Improvement on the PFS System of Mongolia industry initialized the work to pave roads, construct energy source facilities and improve water supply and communication.
2.2.3. Road and Transportation
The length of the state network of highway in Mongolia is 11,218 km, out of which 2,162. 2 km is paved roads. In recent years, the number of roads and bridges has been rapidly increasing, which has been built with the state budget, investment of "Fund to Develop Mongolia" and foreign loans and assistance.
In 2011, 166.1 billion MNT of the state budget will be invested in the highway and transportation sector. Paved highway construction will be implemented by its own capital under the condition to be paid later. They include a 107 km highway between Arvaikheer and Bayankhongor, 128 km highway between Altai and Bayankhongor, 100 km highway between Ulaanbaatar and Mandalgobi, 163 km highway between Mandalgobi and Dalanzadgad, 251 km highway from Dalanzadgad to Oyuntolgoi bypassing Tavantolgoi, 143 km highway between Undurkhaan and Choibalsan, 80 km highway between Khatgal and Khankh, and 100 km highway from Mankhan to Darvi.
Through the projects for developing regional highways, a 432 km highway will be built on the route from Choir to Ude passing through Sainshand and Zamyn using the loan capital from the Asian Development Bank, PRC and the Republic of Korea. Through the project "ErdenetBulgan Unit", a 60 km highway will be built financed by Kuwait and a bridge will be built in Ulaanbaatar city with the assistance of the Japanese Government. These large highway projects, which will increase Mongolia’s exports, will start this year.
Furthermore, a 997 km highway from Altanbulag to Ude connecting Ulaanbaatar and Zamyn will be built using 2,583.9 billion MNT. Also, a 250 km highway will be built by 2012 using investment worth of 647.9 billion MNT and a 747 km highway will be built using 1,936 billion MNT from 2012 until 2016. By doing this, Mongolia will join the auto transportation network, which connects the markets in North East Asia with the markets in the Russian Federation, the People’s Republic of China and also with the markets in Eastern Europe and Siberia. The Ulaanbaatar Railway Association, which Mongolia and Russia jointly incorporated, was founded in 1949. The highway from Sukhbaatar to Ude and from Ereentsav to Choibalsan is considered as the international highway, and from Salkhit to Erdenet, from Darkhan to Sarhyn gol, from Ulaanbaatar to Baganuur, and from Khar airag to Undur is considered as the local highway. The total length of Mongolian railway including Dornod railway is 1815 km. The new line of railway to be built will be the cross axis of railway network, including the Gobi Eastern and Western regions.
038 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia 2.2.4. Energy
An investment of 65.6 billion MNT will be made by the state budget in 2011 to implement significant projects improving power supply and operations with reliability, increasing power and heating capacity, and supplying citizens with hot water and heating with the renewal of thermal station in provinces and technology of thermal power stations. There are, in total 331 soums and sedentary areas, the prefecture of Mongolia. 98 percent of them are supplied with power source. As of today, electricity distribution lines were built and put into operation in over 20 soums of Gobi Altai and Zavkhan provinces. When the construction of Taishir hydro electric station is completed, it will provide citizens with better power and electricity.
Figure 1-5 | Budget Investment of Electric Sector (Billion MNT)
The lists of highways and power stations to be built by own capital with the condition to be paid later was approved by the decree of Parliament. 47 projects in 2008 were considered “impossible to implement” and they are as follows: construction of highways, supply of electric power related to initial exploitation of larger mining deposits, development of infrastructure including highways, construction, electricity, and urban development including strategies and plans for sustainable regional development, programs on government activities and sectors promoted by the state using only the state capital budget.
The contract to build a electricity transmission line of 220 kW with 2 circuits in Mandalgobi, Tavantolgoi, and Oyutolgoi and substations were concluded by choosing an Execution Company. The line work will begin in 2011. The contract was concluded with an aim to build a new source for electricity by using private or foreign capital loan to supply electricity to the industrial complex in Sainshand city and larger mining deposits that will be put into operation in the southern area of the county. Also, there is a plan to construct an electric power station for Tavantolgoi coal mine and the 5th electric power station will be built in order to improve power
039 Chapter 1 _ Improvement on the PFS System of Mongolia and heating consumption of Ulaanbaatar. Other cities are also working to renew and expand thermal and electric stations in Dornod, Erdenet and the 3rd electric station is planned.
2.2.5. Water Supply
Between the periods of 2004-2008, network, construction and facilities had been built. This includes over 410 pure water, sewage and heating line networks, 10 reservoirs, 2 treatment facilities, 12 Abyssinian wells, flood protection dam of 200 m, 5 pump stations and about 10 baths.
Within the “2nd stage project for public utilities development of local cities,” which is implemented by the soft loan of the Asian Development Bank, projects such as water, sewage, heating line and networks, hot water, Abyssinian wells, water distribution point with hydrant, reservoir, and treatment facilities have been installed. As a result of the above work, the employment and living conditions for 180 thousand people in 8 provinces where projects have been implemented were improved. Through the “2nd stage project for public utilities' development of Ulaanbaatar city,” the line and network of pure water have been installed in the southern and northern part of Bayankhoshuu and Chingeltei yurt district. The water distribution point was connected to the centralized line and network. Reservoirs and water distribution points were newly built and put into operation in Dambadarjaa, Dari Ekh, Naran and Uliastai. The line and network of pure and impure water, wells and water distribution points were completed and started operation in the yurt district of Dari-Ekh of Ulaanbaatar city, Baganuur district, the 2nd micro district of Darkhan city, Nomt bag of Zuunmod city and Altai city within the “Project for accommodation financing” of the Asian Development Bank. Having improved drinking water in 102 soums, which was stated in the Action plan of the Government of Mongolia, the goals were successfully implemented to provide population with drinking water that meets the standard.
Since larger mining deposits that will be exploited starting from 2011 are located in the sandy Gobi areas, the research on water reserves is being conducted in the region. The research on water reserves of Oyu-Tolgoi deposit, where copper ore will be mined, is being conducted by a private company and the possibility of using deep water not far from the mine was determined. It was then planned to use the water required to exploit coal deposits of Tavan Tolgoi from Ulaan nuur, which is located 65 km from the mine. However, since deposits are located in the desert region, it has been surveyed that reserves of deep water is sufficient.
3. Mongolian PFS
As discussed earlier, Mongolia has witnessed an impressive recovery from the economic recession since late 2008. Throughout 2010, the Mongolian economy has almost recovered from
040 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia the recession and the Mongolian economy is anticipated to grow more rapidly from 2011. But, further sustainable growth is dependent on whether adequate infrastructure is provided or not. In this way, a huge amount of investment is needed for large-scale infrastructure development to strategically exploit important mineral resource deposits and to implement the industrialization policy. Given that budget resources are limited, the government of Mongolia has enacted the Law on Concessions to promote private investment on infrastructure in 2010, but the PPP framework may not be a panacea because all public infrastructure provisions cannot be profitable. In this respect, the government of Mongolia needs to make a fiscal investment for some infrastructure development projects. But, the existing legal framework for public investment evaluation has not always been able to distribute limited budget resources in a way to achieve allocative efficiency.
There seems to be a few reasons why allocative efficiency was not achieved. One is that there was no appropriate legal system that provided the public investment evaluation system with a firm legal basis. Only a regulation or a decree issued by MOF existed, but it could not provide any firm legal basis nor provided any concrete methodologies regarding the PFS. It specified that new projects should comply with national priorities and should be accompanied by technical and economic appraisals. With no robust methodologies on the socio economic analysis being provided, including the cost-benefit analysis, no robust economic feasibility analysis has been conducted so far in Mongolia, often causing prioritizing among projects to be very difficult, thus making limited budget resources to be distributed to less feasible projects. In addition, often, spending ministries that submitted project proposals over-estimated the benefit and under-estimated the cost in order to launch their projects without appropriate PFS because they are the direct beneficiaries of the project implementation. In addition, the Investment Division of the MOF that reviewed project proposals could not manage the task effectively given both the limited number of staff in the Division and the absence of appropriate proposals submitted by spending ministries. To make matters worse, the degree of authority that the Mongolian parliament exercises has been very high. With no firm legal basis and methodologies for evaluation, the parliament has often amended the budget considerably to increase the budget for the local projects of their own interests, often causing allocative inefficiency. As a result, a need for improving public investment evaluation system became urgent.
Faced with these challenges and needs, the government of Mongolia has been attempting to establish a robust public investment evaluation system and also attempting to refer to the Korean PFS system as a way to reinforce the public investment evaluation system. With this goal, the government of Mongolia has been attempting to enact the IBL, which is supposed to provide the PFS with a firm legal basis. Based on this background, this chapter attempts to look at the current efforts made by the government of Mongolia.
041 Chapter 1 _ Improvement on the PFS System of Mongolia 3.1. Legal Framework of Mongolia
The legal framework of budgeting in Mongolia is specified in the Constitution of Mongolia (1992), the General Budget Law (1992), and the Public Sector Management and Finance Law (2002), and the Construction Law (2008), etc. According to the Public Sector Management and Finance Law, the annual budget process for public investment projects begins with the submission of a draft of strategic business plan to the line minister no later than within the 1st of July, the line minister to the state central administrative body responsible for finance and budget within the 15th of August, respectively. The state central administrative body responsible for finance and budget should compile appropriate estimates of line ministries and submit them to the government no later than the 15th of September. The government should submit the following state budget documents to the Parliament within the 1st of October preceding the fiscal year. The parliament is required to approve the state budget by the 1st of December.
Figure 1-6 | Process of Existing Budget Investment Planning
Agency
Long Term Draft Plan
Budget Limits for Budget Investment Governors Limit GDP Minister in Charge
Investment Draft Plan Outlining Investment Type and Amount within Framework
Budget Governor Draft Budget Law of Finance and Budget /Draft Plan for Investment Projects Government Parliament Undertaken by Budget/
Source: MOF
According to the provision 15.2 of the Construction Law, technical and feasibility analysis should be conducted for new construction projects and cost calculations should be made under approved norms before being reflected into the state budget asset plans. But the existing budget legal framework specified in the General Budget Law, the Public Sector Management and Finance Law, and the Construction Law fails to secure allocative efficiency, which is one of the key priorities in Mongolian public investment planning system given the limited fiscal resources. Although engineering design and feasibility study should be conducted before being budgeted, an excessive number of construction projects without engineering design, feasibility
042 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia study are submitted to the list of budget investment and disqualified projects are on the list of starting construction. In this way, the existing budget legal framework has not worked properly and the key problem is the inadequate legal support for the public investment planning system. To make things worse, in the existing legal framework, the Mongolian parliament has used its discretion to amend the budget considerably to increase the budget for the local projects of their own interests without being bound by the fiscal disciplines, as stated by the World Bank (2010), often causing distributive inefficiency. Furthermore, no specific guidance or decree regarding the methodologies on socio-economic analysis including cost-benefit analysis makes the current situation worse. These are the reasons why the improvement of PIP was urgently required.
Having identified the issues and problems embedded in the existing legal framework, the government of Mongolia has made a great deal of effort to reform the public investment planning system. In 2008, for example, MOF issued Decree 58 to impose certain criteria for the planning, financing, and monitoring of projects, specifying that projects need to be aligned with government priorities, and have to be accompanied with technical and economic appraisals. MOF also issued Order 135 in 2010 to impose more specific criteria for more efficient public investment planning, specifying that new construction projects should be accompanied by technical and feasibility studies approved engineering designs, and profit forecasts and that construction projects without feasibility study and engineering designs cannot be submitted to investment planning. These were steps in the right direction, but still had some problems. That is, it was stated in generic terms. In other words, there was no rigorous investment evaluation methodology in place. Also, a critical point was that parliament is not bound to the Decree or Order which only has the status of an administrative order. For example, the parliament continued to add projects that did not go through rigorous PFS and those that did not meet the fiscal requirements, or decrease the budget for the projects in progress that needed more budget for completion and reallocate it in order to increase the budget for smaller local projects of their own interests, which often led to allocative inefficiency.
Having identified the serious drawbacks in the existing legal framework on the public investment planning system, the government of Mongolia has prepared for the Integrated Budget Law (IBL or the New Budget Law) attempting to address issues in the regulatory framework of the PIP (Public Investment Planning), including the introduction of PFS and has presented it to the parliament for approval. Article 27 (Budgetary Investment) of the IBL includes some important issues. That is, investment projects or activities with socio-economic priorities, which have been reflected in the relevant sector's development strategic planning documents should be proposed (Article 27.1.1) and the investment projects should be proved to be economically and socially beneficial through feasibility studies and other relevant calculations and studies (Article 27.1.2), and for investment projects or measures which are estimated over 30 billion MNT, a state administrative body in charge of economic planning should review their feasibility studies and determine their benefits (Article 27.1.3). In addition, respective cost estimations related to operational costs of a capital asset to be established
043 Chapter 1 _ Improvement on the PFS System of Mongolia through investment projects such as recurrent expenditures, staffing and financing resources should be made and assessment of its impact on the budget should be carried out (Article 27.1.7). All requests on projects and activities in terms of their benefits and implementation sequences should be prioritized and those parts that are within the medium-term fiscal framework statement and expenditure ceiling for the concerned fiscal year should be included (Article 27.1.8). Furthermore, investment projects or activities related to national security and defense and those related to recovery from natural disaster are exempt from the feasibility analysis (Article 27.2).
The IBL is the first firm legal framework that concretely defines the coverage of PFS including important requirements that public investment planning should meet in the process of public investment planning. It is hoped that the enactment of IBL would contribute to the establishment of a PFS system in Mongolia and to the improvement in the public investment planning system as a whole. However, the IBL, the top legal basis for the PFS system, needs support from other legal frameworks. In order to support the IBL by addressing the operational and analytical issues related to PFS, NDIC recently prepared the “Regulation of Public Investment Program,” which was approved by the Government Resolution 123, and the “Methodology for Formulation of Investment Projects Proposed Inclusion of the Public Investment Program” (hereinafter referred to as Methodology for Formulation of Investment Projects), the “Methodology for Evaluation of Investment Projects Proposed for Inclusion of Public Investment Program” (hereinafter referred to as Methodology for Evaluation of Investment Projects), and the “Methodology for Prioritizing Investment Projects Proposed for Inclusion of Public Investment Program” (hereinafter referred to as Methodology for Prioritizing Investment Projects) pursuant to Article 2.7 of MOF Resolution 123, which were approved by the Chairman of NDIC (Decree 137) in December 30, 2010.2) Such regulations and methodologies deal with the operational and analytical issues which are absent in the IBL. For example, the Regulation of Public Investment Program prepared by NDIC and approved by the government introduces the following; the definition and coverage of PIP, the key steps for formulating PIP, the rights and responsibilities among governmental bodies related to the PIP. It specifies that the PIP should be in line with the following; the objectives of the Millennium Development Goals based Comprehensive National Development Strategy of Mongolia, the top priorities of the government, the Action Plan of the Government, the Annual socio-economic Guideline, the development policies of sectors, the annual budget limit, the medium term fiscal framework, the acceptable amount of government debt, the public debt management, and the country’s economic absorption, that NDIC in cooperation with line ministries. Moreover it states that agencies should formulate the project management guidelines for project evaluation and should enforce the compliances, and that NDIC should formulate project evaluation methodologies and project preparation guidelines and enforce the methodology and guidelines. Additionally, the three methodologies specify some key operational and analytical issues for
2) These guidelines did not receive approval from MOF as of February 2011.
044 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia preparation, evaluation, and prioritization of investment projects proposed for inclusion of the public investment program.
Again, while these were a step in the right direction, such regulations and methodologies (as of the end of 2010) are stated still in generic terms, especially in terms of analytical methodologies3). In other words, there is no rigorous investment evaluation methodology in detail. Under such circumstances, powerful political groups may easily be able to evade an approval process or hide the project in the budget. As a way to holding it back, the IBL specifies several key principles regarding the budget and investment planning, specifying that investment projects and activities should be included in the budget considering such significant principles as national long , medium and short term development policies, government action programs, priority areas and general standards for public services delivered by the government, general guidelines for socio-economic development, sector development policies, regional development policies, and local development index. However, these principles are just principles that the government should follow in the process of prioritization and a powerful political interest group or a member of the parliament may not be bound to them while, ideally, they should also abide by the principles, and investment projects proposed by the parliament should also go through a rigorous PFS specified in the IBL. In a democratic society in which the Parliament has the final deciding power regarding budgeting, it would be hard to specify in the law that all investment projects proposed by the parliament should also go through rigorous PFS. In this respect, the government of Mongolia may not just need to reinforce the ex ante evaluation system but also may need to introduce several intermediate project evaluation systems that may indirectly help keep powerful political interest groups including the Mongolian parliament from using their discretion too much. Such intermediate project evaluation systems have been successfully implemented in Korea, which will be discussed later in Section 4.
3.2. Institutional Arrangements of Mongolia
Until recently, the rights and responsibilities of MOF, NDIC, and other line ministries and agencies were inappropriately distributed and created risks for the PIP and budgeting. For example, under the existing institutional arrangements, line ministries were responsible for preparing the project proposal with project evaluation, but they were not able to conduct a rigorous PFS; one, because they lacked capable staffs and the other, because they are themselves the interest group, directly in charge of project implementation. In addition, Mongolia had no specialized institution for the PIP and the absence of an independent institution to effectively evaluate and prioritize project proposals submitted from line ministries reduced the ability to ensure allocative efficiency. Until recently, the task of reviewing project proposals and preparing the PIP was given to the investment division of the MOF. However, it
3) NDIC has been endeavoring to develop detailed general guidelines specifying analytical methodologies regarding PFS, which is expected to be published in the near future. NDIC is also developing standard guidelines by sector. The judgment is based on the current situation as of the end of 2010.
045 Chapter 1 _ Improvement on the PFS System of Mongolia was not easy for the division alone to manage the task effectively given both the limited number of staff in the division and lack of appropriate PFS conducted by line ministries as discussed by the World Bank (2010).
Figure 1-7 | Procedures and Roles in PIP
Project definition, analysis, Project appraist. efaboration of the proposals integraled planning Project financing, monitoring
Project Annual projects proposal in PIP -Agencies National Development and Ministry of Mongolian -Local Line Ministries Innovation Finance Government of Parliament Government and Agencies Committee Mongolia
Project Selected Approved Pubilc Proposal Projects Projects Investment Program
Otakhb Hmudrsldms Oqnfq`l
Approved Projectsj
OER
Dmfhmddqhmf Fq`oghbr
Source: NDIC
Faced with the problems related to institutional arrangements, the Mongolian government created NDIC under the Prime Minister's Office in 2009, as the central agency responsible for the PIP including strategic planning and independent appraisal of the public investment projects. In addition, the IBL indirectly entrusts the role of reviewing PFS to NDIC by specifying that a state administrative body in charge of economic planning reviews the feasibility studies for investment projects or activities estimated over 30 billion MNT. Following the IBL, NDIC and the government of Mongolia have made a great deal of effort to clearly define the rights and roles of MOF, NDIC, line ministries and local governments by developing the Regulation of Public Investment Program (2010). Under the new Regulation of Public Investment Program, line ministries or local governments should choose from a social and economic priority project, which is reflected in the sector development strategy plan and conduct policy, financial, or economic analysis on the investment projects as specified in the guidelines formulated by NDIC and submit the draft investment proposals along with the
046 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia protocol of the discussion of the Minister's committee to NDIC; NDIC receives, reviews, consolidates, and evaluates the draft project proposals, and formulates, selects and ranks the investment project proposals submitted by line ministries, and formulates project evaluation methodology and project preparation guidelines and conducts training for the officials of line ministries and local governments for improving their PIP formulation capacity. The MOF is responsible for ensuring that only those projects that are certified to meet the national priority and have the appropriate financial or economic analysis are included in the capital budget and is also responsible for executing and monitoring investment projects.
In addition to the Regulation of Public Investment Program, the Methodology for Formulation of Investment Projects specifies that in the formulation process of the project proposals, line ministries or local governments are responsible for defining demands for the project, the goal and objectives of the project, policy compliance with the documents, and formulating the project's financial and economic calculation and defining the outcomes, while NDIC is responsible for the project evaluation.
In this way, the Regulation of Public Investment Program and related guidelines have clearly defined the rights and roles of government entities. But, there still seems to be a few problems in the new institutional arrangements. First, line ministries or local governments are still responsible for preparing for the investment proposals along with conducting PFS for small- scale investment projects,4) following the guidelines formulated by NDIC, which may lead to some problems in the PIP. First, it may decrease the quality of evaluation and thereby, allocative efficiency may not be achieved since line ministries and local governments are not capable of conducting a rigorous PFS, which would be aggravated unless the analytical guidelines are developed in detail. Second, it may harm the transparency and objectivity of PFS and thereby allocative efficiency because line ministries or local governments directly in charge of the project implementation are a direct beneficiary, are inclined to underestimate costs and overestimate benefits because once a project starts it is hard to stop it due to the sunk cost.
Second, NDIC is expected to be given the centralized role in the process of PIP under the new institutional framework, which would enhance the efficiency of fiscal management if NDIC plays an objective gate keeper role independently from political pressures or away from its own political interests. However, the precise role of NDIC is still being defined, and its coordination with MOF is still a key pending issue. For example, the main body in charge of evaluation and its reviews of large-scale investment projects is yet to be clearly defined. Uncertain role of NDIC and unclear division of roles with MOF may lead to serious concerns, which should be resolved in the near future. This is because, unless the ownership of the project appraisal is clearly defined, the PIP system would be polluted by powerful political groups. Another concern is the limited number of staffs in NDIC to review investment proposals, which
4) Financial analysis, but no economic analysis, is made for small-scale investment projects.
047 Chapter 1 _ Improvement on the PFS System of Mongolia may harm the accuracy of the project evaluation. Hence, NDIC should make a great deal of effort to build capacity as soon as possible.
3.3. Analytical Guidelines and Data Requirements
Until now, we have dealt with the importance of securing a firm legal framework and defining the rights and responsibilities of institutions related to PFS. However, it is also important to secure well developed and detailed guidelines regarding the analytical methodologies and good quality databases in the process of PFS implementation. Having identified the necessity of well specified documents regarding analytical methods, NDIC has endeavored to develop the Methodology for Preparing Investment Projects and the Methodology for Evaluating Investment Projects.
The Methodology for Preparing Investment Projects, pursuant to the Resolution 123 of the Government of Mongolia, was developed to help line ministries prepare for the draft project proposals and specifies that the formulation of the project proposals should be completed in the following 4 phases: 1) identify project needs and demand; 2) identify project goals and objectives; 3) check if the projects identified are in compliance with policies and documents and 4) complete financial and economic estimation of the projects and identify the expected outcome. In the first phase, real demand for the proposed investment, goods and services is defined. After defining the demand for the project, project goals and objectives need to be identified. In the third phase, policy analysis is carried out. The compliance with policies should be identified. For example, how the project is connected to short, mid, and long term development policies of Mongolia, government’s action programs, and national and sectoral top priorities should be identified in detail. In the fourth phase, financial and economic estimation of the projects should be performed and the guideline should introduce how to make financial and economic estimation of the projects along with the definitions of the lifespan of the project by sector, residual values, and social discount rate (5% or the Government Bond rate). The guideline also introduces the definition of NPV (net present value), IRR (internal rate of return), and BCR (benefit cost ratio) and provides the project information sheet, which consists of Part A (basic and detailed information including; 1) basic information of the project, 2) goals and objectives of the project, 3) compliance with policy goals and objectives, 4) financial or economic analysis results, 5) impact on society and environment, etc.) and Part B (project cost and financial sources) with the provision of the instruction to fill out the sheet.
For a comprehensive evaluation of the project feasibility, the government of Mongolia prepared for the evaluation guideline, the Methodology for Evaluation of Investment Projects, which was recently approved jointly by both MOF and NDIC. The evaluation guideline specifies six basic criteria for evaluation, including; 1) needs and demands of the project, 2) whether the project meets the goals and objectives of the development policy, 3) if the project has its defined goals, objectives, and expected outcome, 4) if the project defined the activities to
048 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia be taken under the project, 5) the result of financial analysis, and 6) the result of economic analysis. According to the amount of investment of the projects in the PIP, analysis methods are varied and divided into two categories; project costs less than 10 billion MNT and project costs more than 10 billion MNT. Subject to its category, the projects should be evaluated using the qualitative score system. Aforementioned analysis must be done for every investment project. If project costs amount to 10 billion or more, additional economic analysis should be conducted on the basis of pre technical and economic feasibility. The project evaluation is to be completed based on the project document that has been formulated in accordance with the Methodology for Formulation of Investment Projects.
The projects are to be evaluated through a 100 points system based on the conclusion drawn on whether the project meets the qualitative criteria. Next, the final evaluation is completed by adding up the scores of each category weighted by their significance. The weight ratio of importance in evaluating measures is different for each project evaluation categories. Project evaluations are made through the evaluation matrix illustrated in Appendix 2. Specifically speaking, the evaluation matrix for investment projects of less than 10 billion MNT consists of; 1) project needs and demand (20 points), 2) compliance with goals and objectives of the development policy (40 points), and 3) opportunity for implementing the project (40 points) while the evaluation matrix for investment projects of more than 10 billion MNT consists of; 1) project needs and demand (20 points), 2) compliance with goals and objectives of the development policy (30 points), 3) opportunity for implementing the project (20 points), and 4) result of economic analysis (30 points). Project evaluation must be made after reviewing the project documents formulated by the Methodology for Formulating Investment Projects and it is evaluated by a proficient evaluation group, which has the capacity of faithfully rating projects. Every single member of the group evaluates the projects by the rating matrix, and the final rating point is defined by the average of total points given by all members. The projects that receive more than 60 points are prioritized by their rating and evaluating points.
Likewise, NDIC has made a great deal of effort to develop relevant guidelines specifying analytical and evaluation methodologies. However, it has two key problems as of the end of 2010. First, the analytical guideline is stated in too generic terms. In other words, it just introduces simple definitions particularly regarding the financial or economic analysis, considered as the most important component of PFS, and there is no specific methodology for rigorous evaluation of the project in place. For example, no specific benefit items, including methodologies regarding cost-benefit analysis, are provided. Second, the evaluation system appears to cause some problems. For example, the evaluation is to be completed based on the qualitative score system, which may harm the transparency of PFS. In addition, the criteria to form an evaluation committee are not clearly defined, which would increase the risks of being bound to political pressures.
While it is important to secure well specified and detailed guidelines regarding analytical
049 Chapter 1 _ Improvement on the PFS System of Mongolia and evaluation methodologies aforementioned, it is equally important to secure good quality databases for a sound establishment of the evaluation system because the accuracy of the analysis hinges on the quality of data. For example, the travel demand forecast and its validity would not be secured without suitable databases such as travel demand data at the national and local levels. It seems that the government of Mongolia identifies the importance of accurate and extensive databases considering Resolution 123, which states that all ministers and agency chairmen should use all necessary data for successful formation and execution of the PIP and that one of the requirements for drafting project proposals is that project proposal should be based on accurate and correct data and information. However, the reality is that the Mongolian government faces a desperate shortage of accurate and extensive databases essential for producing accurate outcomes. Faced with the data problem, the Mongolian government should make a great deal of effort to build adequate national database systems as soon as possible.
4. Assessment of Mongolian PFS in Comparison to the Korean Case 4.1. Legal Framework and Legislation of Korea
The PFS is an ex ante public investment evaluation system, which evaluates the overall feasibility of large-scale public investment projects and helps to establish public fund management plan before budgetary decision-making and concrete project design. It aims to assist the government in accomplishing the purpose of upholding transparency and fairness of the public investment decision according to its priority, and further enhance the efficiency of fiscal management. PFS, through economic feasibility analysis as well as policy analysis, focuses on comprehensively reviewing the efficiency of fiscal management on large-scale public investment projects by investigating proper investment priority and timing from a nation wide perspective.
The PFS system was implemented in Korea as demands on large SOC projects and demands from various budget areas such as social welfare increased considerably as the economy grew, whereas the fiscal resources were limited. Hence, prioritizing among SOC projects became more important. Before 1999, the PFS had been conducted by the line ministries. However as Korea witnessed a severe failure in the evaluation of large-scale fiscal projects (i.e. high speed railways), criticism on the feasibility analysis by line ministries became large and objective, and fair feasibility studies were required for efficient budget allocation. This is because line ministries, directly in charge of the implementation of the projects, are generally inclined to underestimate costs and overestimate benefits to launch the project and the feasibility studies conducted by line ministries are often polluted by interests groups. In this respect, the Korean government officially introduced the PFS system in 1999 and since then, KDI (Korea Development Institute) has been in charge of conducting PFS on large fiscal projects on the
050 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia basis of Article 38 of the NFA (National Finance Act) enacted in 2006 and Article 13 of the Enforcement Decree of NFA, which provides the Korean PFS with a firm legal basis.
Article 38 of the NFA and Article 13 of the Enforcement Decree of NFA define the projects subject to or exempt from PFS. For example, the project subject to PFS is a new project that costs 50 billion KRW (Korean Won) or more in total, out of which the financial aid by the State amounts to 30 billion KRW or more, and which falls under; 1) a project in which construction works are included, 2) an informatization project, 3) a national research and development project, or 4) other projects in the field of social welfare, health, education, labor, culture and tourism, environmental protection, agriculture, forestry, ocean, fishery, industry, and small and medium enterprises. The project exempt from PFS is a project that falls under; 1) a project for construction or extension of public office buildings, correctional facilities, and facilities for elementary and secondary education, 2) a project for restoration of cultural heritage, 3) a project relating to national security or national defense that requires security, 4) a project pertaining to inter Korean exchanges and cooperation or a project promoted in accordance with conventions and treaties with other countries, 5) a project for simple improvement, management and repairing of existing facilities to enhance their effects, such as managing and repairing roads, improving old water supply facilities, etc., 6) a project urgently required to be promoted, such as prevention from a disaster, aid for restoration, securing of facility safety, safety of health and food, etc., 7) a project to be established or promoted in accordance with Acts and subordinate statutes, 8) a project conducted for the purpose of simple transfer of income, such as direct payment in cash or in kind to beneficiaries like persons eligible for basic stability support, persons with disabilities, etc., 9) a project having no practical use of the preliminary feasibility survey, such as support for personnel expenses and ordinary expenditures of government invested institutes and subsidiary organs, and lending business, etc., or 10) a project prescribed by MOSF as necessary to promote as a policy for balanced regional development, response to urgent economic or social conditions, etc. The reason why the projects subject to or exempt from PFS are clearly defined in this way is to keep line ministries from avoiding PFS, which contributed to the successful settlement of the system.
In addition to the NFA and the Enforcement Decree, MOSF has also developed the operational guideline, pursuant to Article 38.4 of the NFA, with the aim to provide clearer and more detailed course of action concerning the standards related to selecting projects subject to PFS, including the definition of new projects and unit of projects subject to PFS, entities performing such evaluation, methods and procedures of such evaluation and so forth and kept updating it. Especially, it is important to clearly define the total project cost and the unit of projects subject to PFS in order to keep the line ministries from breaking down the projects into smaller projects. Furthermore, the operational guideline clearly specifies Ex Officio Selection as well as requirements for and procedures of exemption for projects undertaken under the National Policies in addition to types of projects exempt from PFS. For example, Provision 22.1 specifies Ex Officio Selection by stating that if deemed necessary, in his or her reasonable
051 Chapter 1 _ Improvement on the PFS System of Mongolia discretion, in connection with budget compilation and fund management planning and so on, the Minister of Strategy and Finance may implement PFS even without a request from the head of the central government agency concerned, with an example that when it is obviously expected from an objective point of view that total project costs will increase to 50 billion KRW or more considering the unit cost of a similar project, volume, etc. although total project costs presented by the head of a central government agency amounts to less than 50 billion KRW. In addition, Provision 22.2 vests the National Assembly with the authority to request for PFS, which in turn may work as an effective device to keep the National Assembly from budgeting projects subject to PFS without going through PFS. However, such specifications were not clearly addressed in any of the current legal frameworks or guidelines in Mongolia although it is very important to clearly set requirements for and procedures of exemption including the definition of the unit of projects subject to PFS as well as Ex Officio Selection because line ministries are generally inclined to avoid the cumbersome PFS. In addition to the operational guideline, KDI, pursuant to Provision 31 of the operational guideline, also developed the general guideline and standard guidelines by sector and has updated them if deemed necessary in order to ensure the accuracy and the consistency of PFS, which will be discussed later in this section in detail.
In this way, the Korean PFS system has been supported by the legal framework and related guidelines such the NFA, the Enforcement Decree, the operational guidelines, and the analytical guidelines, which contributed to enhancing the objectivity, efficiency and consistency of the public investment planning. However, the ex ante evaluation system would not have performed successfully without further support from such intermediate evaluation systems as TPCM (Total Project Cost Management System), RDF (Re assessment of Demand Forecast), and RSF (Reassessment Study of Feasibility) as well as other ex ante evaluation systems such as Simplified PFS, those of which do not exist in the current PIP in Mongolia. The TPCM, which was introduced in 1994 in order to prevent cost escalation and time overruns, is a device by which the Budget Ministry monitors expenditure on public investment and checks increase in project costs throughout the project cycle from planning to the construction completion stage. Projects subject to the TPCM include; 1) projects whose construction period exceeds two years; and 2) civil engineering works whose TPC exceeds 30 billion KRW, or architectural projects whose TPC exceeds 10 billion KRW; and 3) projects implemented by the central government or its agents, or by local governments or private institutions that include central government funding. Under the TPCM, 1) increase in construction size through design modification is not allowed except for inevitable events, 2) the construction costs are not arbitrarily inter changeable between project phases or between construction units, 3) the minister in charge of the project is to consult with MOSF about adjusting TPC, if TPC change is inevitable, and 4) the line ministry is allowed to set construction contingencies for up to 8% of the contract price of a project to cope with inevitable design modification and amendment of the law and so on. The TPCM is important because it has two important devices by which to more effectively implement PFS. Those are RDF and RSF.
052 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia The RDF was introduced in 2006 in order to prevent overestimation of demand. Under the TPCM, RDF is to verify the adequacy of demand forecast with the latest information available, reflecting the changes in the project environment. At the request of MOSF, KDI conducts RDF if TPC is over 50 billion KRW while the line ministry conducts RDF if TPC is less than 50 billion KRW. Among the projects under the TPCM, SOC projects including roads, railroads, airports, ports, or dams are covered by RDF. The RDF can be conducted at any phase throughout the project cycle from planning to construction completed when 1) a substantial decrease of demand is anticipated due to material changes in the premises on which demand forecast has been made or errors have been found in demand forecast; or 2) more than five years have passed since the latest demand forecast had been conducted. When the demand forecast for a project is decreased by 30% or more, MOSF (thereby KDI) conducts RSF and decides whether to continue or to stop the project. The RDF has helped in establishing the PFS system, in that it has prevented line ministries from overestimating demand, and encouraged line ministries to submit the latest trustable data, which enhanced the accuracy of PFS.
The RSF, which is a key device to support ex ante PFS, was introduced in 1999 in order to help keep projects subject to PFS from being budgeted without a rigorous PFS, for example, by parliament as well as to prevent inaccurate demand forecast & cost estimation and significant cost escalation. The RSF guidelines were developed in 2003 and RSF was strengthened in 2006 as the NFA was legislated. Under the TPCM, RSF is conducted if; 1) TPC has increased by more than 20 percent (excluding price escalation and increase in land acquisition cost) of the cost endorsed by MOSF at the previous phase of the project; 2) PFS has not been conducted although it falls under the PFS coverage; 3) the demand forecast for a project is decreased by 30% or more; or 4) the Board of Audit and Inspection requests the RSF. Compared with PFS, it is emphasized to find alternatives to cut down size and cost of a project and the RSF team of KDI makes suggestions on whether to continue or to stop the project. This has worked quite well to prevent deliberate overestimations of demand and underestimations of costs. Having been conducted on 113 projects between 2003 and 2009, the RSF has not just kept line ministries from deliberately underestimating project costs in the planning stage and escalating project costs once the project is commenced, but it has also prevented the National Assembly from budgeting projects subject to PFS without going through PFS, which is now considered as a key device to support the Korean PFS system. Figure 1-8 briefly depicts an introduction to the history of new initiatives of public investment management in Korea.
Simplified PFS specified in Provision 13 of the operational guideline was introduced in 2008 and concentrates mainly on the cost estimation of the projects exempted from PFS, the total project cost of which is over 30 billion KRW, but under 50 billion KRW. Simplified PFS was introduced in order to keep line ministries from deliberately underestimating project costs in order to avoid PFS since it is hard to stop the project once it is commenced. Simplified PFS checks mainly the adequacy of the size of the projects and contributed to the establishment of the PFS system. The Ex Officio Selection specified in Provision 22.1 has contributed to the
053 Chapter 1 _ Improvement on the PFS System of Mongolia Figure 1-8 | New Initiatives of Public Investment Management
1994 1999 2003 2006
TPCM introduced PFS introduced
RSF introduced RSF guidelines RSF strengthened developed
RDF introduced
TPCM (Total Project Cost Management) PFS (Preliminary Feasibility Study) The National Finance RSF (Re-assessment Study of Feasibility) Act legislated RDF (Re-assessment of Demand Forecast)
Source: KDI successful operation of the PFS system in Korea.
Operational Guidelines also specifies that the results of the PFS should not just be notified to the ministries concerned, including MOSF, in order to ensure that the results of PFS are effectively used for budget decision-making, but also to the public immediately upon the completion of the analysis in order to ensure the transparency of PFS. In addition, the results of PFS should be presented by comprehensively considering the evaluation results concerning economic analysis, policy analysis and balanced regional development analysis. In this way, this contributed to enhancing the transparency of PFS and to the establishment of the Korean PFS system.
As discussed in Section 3, the government of Mongolia has made a great deal of effort to reform the PIP including the public investment evaluation system after having identified the problems embedded in the system. As a first step to achieve allocative efficiency, the Mongolian government has endeavored to establish firm legal frameworks and relative operational guidelines such as the Regulation of Public Investment Program. Although the IBL itself appears to be a step in the right direction, there seem to be a few problems. First, the operational guidelines are not detailed or elaborate enough to provide a clear course of action concerning the standards related to selecting projects subject to PFS, entities performing such evaluation, methods and procedures of such evaluation and so forth. Particularly, it is very important to clearly define the unit of projects subject to PFS in order to keep line ministries from breaking down the projects into smaller projects to avoid PFS. Furthermore, it is important to clearly
054 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia specify the requirements for and procedures of exemption for large-scale investment projects and Ex Officio Selection in order to prevent the attempts of line ministries to avoid PFS. But, the operational guideline is quiet regarding those issues and the government of Mongolia may need to consider the adoption of such specifications.
Compared to the legal frameworks of the Korean PIM (Public Investment Management), the Mongolian legal framework lacks some important components to keep line ministries from deliberately underestimating project costs or overestimating demand forecasts, and more importantly to keep the powerful political groups such as the Mongolian parliament from avoiding an appraisal process or hiding the project in the budget. For example, the Korean ex ante evaluation system has been supported by the intermediate evaluation system such as TPCM, RDF, and RSF as well as another ex ante evaluation system such as Simplified PFS, which contributed to the firm establishment of the Korean PFS system. Until recently, the Mongolian parliament has continued to add projects that did not go through rigorous PFS and those that did not meet the fiscal requirements or decrease the budget for projects in progress that needed more budget for completion. That is, the Mongolian parliament has used its discretion to amend the budget too much, often causing allocative inefficiency. In order to establish the PIP system in a more efficient and sustainable manner, the Mongolian government may need to consider the introduction of the intermediate evaluation system in addition to the ex ante evaluation system such as PFS.
4.2. Institutional Arrangements of Korea
The Korean PFS was introduced in 1999 after the Korean government witnessed a severe failure in planning of large-scale fiscal projects, the feasibility of which was then evaluated by the line ministries. The Korean government strongly felt the necessity of a 3rd party agency between line and budget ministries, which evaluates the feasibility of large-scale fiscal projects objectively and transparently. KDI, a state funded research institute was chosen as an objective evaluator and since then KDI has been in charge of conducting PFS.
According to the operational guideline of MOSF, the roles and functions of PFS related entities are clearly defined as follows. MOSF selects projects subject to PFS with comments and aids from the 'Fiscal Project Evaluation Advisory Council'; requests PFS to KDI; and allocates and releases fiscal budget to line ministries, based on the final allocative decision. The Public and Private Infrastructure Investment Management Center (PIMAC) of KDI takes charge of conducting PFS at the request of MOSF and; develops guidelines stipulating the basic principles and analysis methods for efficient and consistent implementation of PFS projects. The role of line ministries is to submit a written request for PFS that clearly states the project plan, need for project implementation, adequacy of the central government subsidy, amount and financing method of necessary resources, and risks associated with project implementation, etc. after identifying, designing, prioritizing, and forecasting the effects of the project. Figure 1-9
055 Chapter 1 _ Improvement on the PFS System of Mongolia describes the procedures and roles of organizations regarding PFS.
In this way, the division of responsibilities among MOSF, KDI, and line ministries is clearly specified. PFS is owned by MOSF, however, PIMAC of KDI takes charge of independent PFS, and the National Assembly votes on the final budget, during which large-scale projects that did not go through PFS are not budgeted. This is one of the reasons for the successful operation of the Korean PFS system. Another reason for the successful operation of the Korean PFS is that a competent and independent research institution such as KDI has taken charge of the evaluation. That is, KDI, which has served as a leading think tank of the Korean government on socio- economic policies since 1971, has had enough capacity to conduct a rigorous PFS. Furthermore, the institutional arrangements along with the efforts of KDI supported to keep independence and transparency of the evaluation, providing some buffer from the political pressures and other influences over the project. That is, a clearly defined institutional arrangement, along with support from the competent staffs of KDI, the Korean PFS has witnessed a successful operation and PFS is now regarded as a necessary step in the process of budgeting and most of the PFS results are directly reflected in budget formulation.
Figure 1-9| PFS Procedure
Ministry of Line Ministry Strategy & Finance KDI (PIMAC)
The government of Mongolia established NDIC under the Minister's Office in 2009 as a central agency in charge of strategic planning as well as investment evaluation. In addition, NDIC recently prepared for the Regulation of Public Investment Program. Compared to the
056 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia clearly specified institutional arrangements in Korea, however, those in Mongolia are still not yet clearly specified in the Regulation of Public Investment Program yet. For example, according to the operational guideline, it seems that line ministries or local governments are supposed to prepare for project proposals along with the PFS documents (no economic analysis), and NDIC is supposed to receive and evaluate investment project proposals, conduct a rigorous PFS for large-scale investment projects, and then prioritize the investment projects while MOF is responsible for budgeting.
However there seems to be a few problems in this institutional arrangement. That is, line ministries may not be capable of preparing for project proposals or conducting PFS due to the lack of capacity. Furthermore the PFS results may not be consistent across ministries or by sector although consistency is the top priority in PFS. To make matters worse, line ministries can be considered as interest groups because they are directly in charge of the project implementation and thus often tend to underestimate costs and overestimate benefits, combined results of which are escalated BCR. Such concerns could be alleviated if NDIC makes a consistent and complete review over the investment proposals submitted by line ministries. Although the future institutional settings are not yet clear, it is hoped that the government of Mongolia bears in mind that one of the important reasons for the Korean success is the clear and appropriate division of rights and responsibilities among the concerned organizations.
4.3. Analytical Guidelines and Data Requirements
It is important to establish firm legal framework including detailed operational guidelines and specific institutional arrangements for successful PFS. But, it is also important to secure well developed, detailed analytical guidelines as well as extensive databases of good quality in order to ensure the objectivity, consistency, and accuracy of PFS. PFS starts from securing clearly specified project proposals from line ministries and Provisions 17 and 18 of the operational guidelines for PFS in Korea have specified the format and the contents to be included in the project proposal. For example, Provision 17 (Review of Project Prioritization and Concreteness of Project Plan) states that the head of ministries concerned should determine the priority of the projects subject to PFS in consideration of a medium and long term fiscal management plan direction of national policies, equality among different areas and so forth, and reflect such prioritization in a written request for preliminary feasibility study and prior to making a request for PFS, the minister should specify, through utilization of advance services, etc., the goal, scale, implementation system, budget and so forth of the pertinent project.
In addition, Provision 18 (Written Request for Preliminary Feasibility Study) states that a written request for PFS submitted by the minister should clearly state 1) the project plan (draft), 2) need for project implementation, 3) adequacy of the central government subsidy, 4) amount and financing method of necessary resources, 5) factors of balanced regional development (‘need for technological development’ in the case of an R&D project), and 6) risks associated
057 Chapter 1 _ Improvement on the PFS System of Mongolia with project implementation and countermeasures, etc. In addition, the project plan should contain the purpose, related developments and scale of the project, total project costs, implementation system, financing method, performance of advance services, anticipated benefits thereof, etc. The guidelines enumerate matters which must be clearly stated in a written request for PFS by project type and, for example, construction projects must clearly include planned project site, major routes, whether the project is reflected in applicable laws or other higher plans including a national land utilization plan or urban plan, future facility utilization plan, etc. In addition, KDI can ask for more information to the line ministries at any stage of the PFS. Since the Operational Guidelines clearly lists what must be included in a written request for PFS and the degree of preparation is very important, many line ministries have developed their own guidelines and conducted ex ante evaluation similar to PFS as they prepare for a written request. Hence, the line ministries must provide accurate information, not selective information, through prior studies, the prior information became more reliable.
Once the project proposals are submitted by the line ministries, the official PFS process starts. In order to secure the consistency, transparency and accuracy of the PFS results, it is important to secure well developed, detailed analytical guidelines as well as good quality extensive databases. In this respect, Provision 31 of the operational guidelines of MOSF specifies that the entities in charge of PFS should formulate; 1) the general guidelines, which stipulate the standards commonly applied to the process of PFS including the economic feasibility analysis and discount rates, and 2) the standard guidelines by sector, which stipulate detailed matters concerning the methods and standards to perform PFS by project area including roads, railways, airports, harbors, water resources, informatization, R&D, etc. In this respect, KDI, which has been in charge of PFS, has continuously developed the general and standard guidelines by sector (i.e. road & railway, water resources, R&D, cultural facilities, etc.) in a very detailed and elaborate manner and updated the methods when needed. For example, in the year of 1999 when PFS was introduced in Korea, economic and policy analysis including the definitions of appraisal period, social discount rate, etc. were introduced. In 2000, the AHP method for Multi Criteria analysis was introduced and different discount rates were applied by sector (general sector: 7.5%, water resources sector: 6.0%). In 2001, a new benefit item, environmental benefits was added. In 2004, the social discount rate was changed from 7.5% to 6.5% after reconsidering changes in financial conditions, the appraisal period for road sector changed from 20 to 30 years, and the AHP techniques were improved. In 2007, the social discount rate was adjusted again from 6.5% to 5.5% and as of 2009, KDI published the 5th edition of the general guidelines and standard guidelines for the road sector. In the next part, important analytical components in economic analysis, policy analysis, balanced regional development analysis, and comprehensive evaluation that should be thoroughly analyzed in the process of PFS are introduced.
First, an economic feasibility analysis constitutes a core study process, where the effects of a project subject to PFS on the national economy and the adequacy of investment are analyzed.
058 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia For such analysis, a cost-benefit analysis should be adopted as a basic method. For the purpose of a cost-benefit analysis, benefits should be calculated by estimating the needs for implementation of a project, and costs should be computed by aggregating TPC and all other expenses incurred for the operation of the project. That is, the economic feasibility analysis evaluates the attractiveness of projects and measures the benefits and costs for the whole society from the national economic point of view. The reference year is the last year prior to the beginning of the study and the time span of the analysis is 30 years after the completion of the projects for roads, rails, etc. and 50 years for water resources projects. The spatial scope of the analysis includes all the areas necessary for measuring economic feasibility and the areas are to be divided into directly and indirectly influenced areas. Basically, B/C analysis is a comparison of ‘do something’ with ‘do nothing’ alternatives and scenarios may be added according to the uncertainty that can influence the economic feasibility of the project. Currently, 5.5% of the social discount rate is applied to estimate future costs and benefits in terms of the reference time point. Cost is estimated by aggregating TPC, including construction, incidental, compensation and contingency costs, and all other expenses incurred for the operation of the project, including maintenance, management, and reinvestment costs, in order to support rational decision- making. Benefits should be estimated in monetary terms for appropriate categories using appropriate benefit criteria according to the type of the project. For example, the basic benefit items for transportation projects include savings in vehicle operating costs, travel time costs, accident costs, and environmental costs. Also, the standard 4 stage travel demand forecast model, which consists of trip generation, trip distribution, model split, and traffic assignment, is used.
Second, in a policy analysis, evaluation items including, but not limited to, 1) policy consistency including consistency of the project with higher level plans and policies, the degree of willingness of the project participants and the degree of preparation, 2) risks associated with implementation of the project including financing risks and environmental risks, and 3) project specific evaluation items should be analyzed quantitatively or qualitatively. If it is deemed necessary to consider the environmental value of a project including cultural and ecological values in performing a policy analysis, such items should be reflected in the project specific evaluation items. For example, projects to preserve cultural and historic sites where a number of cultural properties designated by the central, municipal or provincial governments exist or areas with a strong ecological importance such as mud flats and wetlands or to promote environment friendly use or tourism thereof should be reflected in the project specific evaluation items. Moreover, if it is deemed necessary to consider the technical adequacy, such items should be analyzed. In a technical analysis, the adequacy of a technological development plan, possibility of the success of technological development, overlaps with existing technologies and projects and so on should be analyzed.
Third, in a balanced regional development analysis, factors affecting local and regional development, including the labor inducing effects, the effects on the local economy and
059 Chapter 1 _ Improvement on the PFS System of Mongolia improvement of the degree of regional underdevelopment are analyzed in order to prevent the deepening of regional imbalances and enhance equality among different regions. In order to compute the degree of regional underdevelopment, KDI has developed a composite index and ranking for 168 regions in Korea, which accounts for various statistics such as population, economic indicators, infrastructure, etc. In addition, KDI developed its own MRIO (Multi regional Input Output) model to measure the increase in production, value added and employment within the region of project implementation.
After conducting economic, policy, and balanced regional development analysis, it is important to integrate the economic and social values in a coherent and standardized manner. But, it is difficult to synthesize quantitative and qualitative results because information is provided in a parallel way and not integrated into a final decision. For example, it is difficult to provide relevant judgment whether the project should be accepted or rejected when a certain project is highly acceptable from the point of backwardness of regions but is less acceptable from the point of economic feasibility point of view, which increases the risks for arbitrary decision-making. Faced with the problem, KDI has adopted the AHP (Analytic Hierarchy Process) method, a type of multi criteria analyses developed by Saaty (1980), on the basis of the analysis results by evaluation item. AHP is a well designed device by which to summarize the quantitative and qualitative elements of evaluation to suggest the overall feasibility of the project in numbers. In other words, AHP is a multi criteria decision-making technique to combine quantitative and qualitative elements of evaluation into a decision under a hierarchical structure. To put it concretely, AHP structures a complex decision problem into a hierarchy by grouping elements of decision and gives weight on each element through pair wise comparison. A group of eight experts including the PFS team members are involved in the decision-making and a project is evaluated as feasible, if the AHP score is 0.5 points or greater out of 1.0 points. Since 2005, the ranges of AHP weight were modified to reflect the aspect of balanced regional development and the weight for economic analysis ranges 40~50%, the weight for policy analysis ranges 25~35%, and balanced regional development analysis ranges from 15~30% for construction projects. Figure 1 10 illustrates the structure of AHP in the Korean PFS system.
As mentioned earlier, it is essential to secure detailed and elaborate analytical guidelines in order to ensure the transparency, consistency, and accuracy of the PFS result and KDI has made a great deal of effort to develop both general guidelines and standard guidelines by sector and update them in accordance to changes in the socio-economic environment. The guidelines are stated in very specific terms and are detailed and elaborate enough to support the successful operation of PFS. The guidelines improved the quality of decision-making by explicitly incorporating ‘social value' shared by people into the evaluation process and by allowing non- economic and qualitative factors to be incorporated into the evaluation in a formal way. Furthermore, the adoption of AHP method, a device by which used to summarize the quantitative and qualitative elements of evaluation to suggest the overall feasibility of the project in number, enhanced the objectivity of decision-making as the AHP method integrates
060 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia quantitative and qualitative results in a coherent and standardized manner. Compared to the Korean analytical guidelines, however, the Mongolian analytical guidelines, the Methodology for Formulating Investment Projects and the Methodology for Evaluating Investment Projects, appears to have a few weaknesses. First, the current guidelines are stated in too generic terms. It just simply introduces definitions, particularly regarding the financial or economic analysis, and there is no specific methodology for rigorous evaluation of the project in place. Second, the evaluation system may have some problems. For example, the evaluation is to be completed based on the qualitative score system, which may increase the risks for arbitrary decision- making. Furthermore, the criteria to form the evaluation committee are not clearly defined, which may increase the risks of being bound to political pressures. In this respect, the government of Mongolia would need to develop a more detailed and elaborate analytical guidelines and consider the adoption of the AHP method, which would increase the objectivity of the study and decrease the risks of being persuaded by political pressures.
Figure 1-10 | Structure of AHP in PFS
Overall Feasibility
Economic Analysis Policy Analysis Balanced Regional Level 1 Development Analysis
Consistency with Project-specific Project risk Level 2 higher level plan factor Attitude toward the project Consistency with higher level plan Preparedness Project-specific item (optional) Financial feasibility Environmental impact assessment Project-specific item (optional) Project-specific item (optional) Project-specific item (optional) Regional backwardness analysis Regional economic impacts Project-specific item (optional)
Level 3 1 2
Alternatives Project Implementation Status Quo
Source: KDI
In this way, it is important to secure detailed and elaborate analytical guidelines as well as appropriate comprehensive evaluation methods for the successful operation of PFS. But it is equally important to secure a good quality national and regional database for a successful operation of PFS because, for example, the accuracy of the travel demand forecast and its
061 Chapter 1 _ Improvement on the PFS System of Mongolia validity would not be secured without suitable databases such as travel demand data, statistical yearbook of traffic data, and geographical maps. In Korea, the basic database for travel demand forecast is KTDB (Korea Transport Database) published by KOTI (Korea Transport Institute), which is a state funded institute. The KTDB consists of interregional and metropolitan areas and includes; 1) O/D (origination and destination) data, that is, trips between two regions by passenger trips by purpose and mode and by freight trips by item and model and 2) network data that describes physical road and rail facilities. The current KTBD forecasts travel volume by every 5 years between 2011 and 2036, which is a must-item for forecasting. Basic data for validation of forecast are; 1) Statistical Yearbook of Road Traffic Counts and 2) Statistical Yearbook of Railroad. The former includes average daily traffic by road and vehicle type, checked regularly or occasionally as shown in Table 1-2 and the latter includes passenger/freight traffic, number(tons), passenger(tons) km by line and station, trip table between station (O/D), etc.
Table 1-2 | Road Traffic Count Survey
National Expressway National Highway Provincial Road
Korea Institute of Korea Express Local Survey Agent Construction & Corporation Government Technology
3rd Thursday, Oct. 3 times a year Occasional 3rd Thursday, Oct. (Mobile Equipment, (Mobile Equipment, Checks (Personnel) Survey Personnel) Personnel) Method Regular 24 hours, 365 days - - Checks (Fixed Equipment)
In this way, PFS needs a very extensive and well-structured national/regional level database, but Mongolia currently faces a desperate shortage of such databases, which are essential preconditions for conducting PFS. Although Mongolia has made a great deal of effort to develop the operational and analytical guidelines regarding PFS, it would be almost impossible to conduct PFS without adequate databases such as extensive traffic O/D data. In this respect, NDIC and the government of Mongolia should make a great deal of effort, not just to prepare for the essential analytical guidelines clearly specifying methodologies on economic analysis and comprehensive evaluations, but also to build an adequate national database system which is essential for successful PFS.
062 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia 4.4. Performance
The official establishment of the PFS system, subsequent legislations of the NFA and the Enforcement Decree, and the development of the operational guidelines and elaborate analytical guidelines, has surely contributed to the establishment of the objective evaluation system for large-scale public investments in Korea, along with the support from the intermediate evaluation systems such as TPCM, RDF, and RSF. The contribution and performance of PFS is as follows. First, PFS has contributed to enhancing fiscal efficiency by preventing non-feasible projects from getting launched. PFS has been conducted on a total of 436 large-scale fiscal projects between 1999 and 2009 and 180 projects were evaluated as ‘Not Feasible’. As a result, a great amount of the taxpayer’s money was allocated to other uses. Second, PFS has mitigated information asymmetry between MOSF and line ministries and led to better decision-making. Budget allocation involves bargaining between MOSF and line ministries. In the past, line ministries used to provide selective information to receive more budget. Therefore, MOSF used to cut or increase project budgets not always on a reasonable basis. However, PFS currently provides high quality information, which is not just for binary decision, but also policy suggestions to implement the project, for decision-making in budget allocation. Third, the performance of PFS has disseminated into other areas therefore many line ministries and local governments developed their own evaluation guidelines. Hence, they introduced ex ante self- verification analysis similar to PFS, even on the projects not subject to PFS, which contributed to the overall enhancement of public investment evaluation process.
Although PFS focused on infrastructure projects before the NFA, it has been expanding to non infrastructure projects. Now PFS is regarded as a necessary step in the process of budgeting. Most of the PFS results are directly reflected in the budget formulation and the results of PFS are important over the whole period of the project in the context of budgeting. In this way, PFS has contributed to enhancing fiscal efficiency by preventing non-feasible projects from getting launched. Table 1-3 and Table 1-4 show the number of PFS conducted by sector
063 Chapter 1 _ Improvement on the PFS System of Mongolia and proportion of feasible projects by sector between 1999 and 2009. 5. Conclusion and Policy Recommendations
The Mongolian economy has witnessed rapid growth in the past few decades and the economy is anticipated to grow more rapidly as the production of mining reserves such as Oyu Tolgoi starts. Having identified the necessity of public infrastructure essential to sustain further economic growth and the problems embedded in the current PIP system, the Mongolian government has made great efforts to enact the Concessions Law to attract private investment on public infrastructure provisions as well as to improve the fiscal investment evaluation system. More specifically speaking, the Mongolian government has been attempting to enact the IBL, which specifies the enforcement of PFS in order to reinforce the public investment evaluation system and has prepared for the Regulation of Public Investment Program, which specifies the operational process and relative analytical guidelines, which specify methodologies for the formulation, evaluation, and prioritization of the investment projects. Although it is anticipated that the public investment evaluation system will improve considerably if the IBL is enacted, there still remain some problems in the legal framework, institutional arrangements, and analytical guidelines, etc.
First, the legal framework lacks important components to keep line ministries from underestimating costs or overestimating benefits. Furthermore, the legal framework lacks an effective device to keep powerful political groups such as the parliament from avoiding PFS or hiding the projects in the budget although the projects fall under PFS. Moreover, the operational
064 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia guidelines are not detailed or elaborate enough to provide clear course of action. They do not elaborate the definition of new projects, unit of projects subject to PFS, and the standards related to the requirements for and procedures of exemption from PFS, etc., which may increases the propensity of interest groups to avoid a rigorous PFS and break down the project into smaller projects. Second, the institutional arrangements are still not clearly or appropriately defined in the new operational guidelines. It seems that lines ministries are expected to take charge of the preparation of investment proposals along with the PFS documents, NDIC is expected to take charge of the evaluation and prioritization of investment projects as a central agency for the PIP, and MOF is expected to take charge of budgeting. However, line ministries may not be capable of preparing for the project proposals or conducting PFS appropriately given the limited capability and the absence of detailed analytical guidelines formulated by NDIC, which may harm the consistency and accuracy of the PFS results. Furthermore, line ministries and local governments have direct interests in the project implementation, which may harm the objectivity of PFS. Third, the current analytical guidelines are stated in too generic terms. In other words, there is no specific methodology for a rigorous PFS in place. In addition, the current comprehensive evaluation system is based only on a qualitative method and the procedures for evaluation are not clearly specified yet, which may increase the risks for arbitrary decision making and thus harm the objectivity, which is one of the key components for the successful operation of PFS.
The policy implications of this chapter are as follows. First, the government of Mongolia should not only attempt to introduce the ex ante evaluation system such as PFS, but also needs to prepare for the intermediate evaluation systems such as TPCM, RDF, RSF, and an ex ante evaluation system such as Simplified PFS, which have been implemented in Korea and worked as effective measures to improve the PIM system. This is important because line ministries tend to overestimate benefits and underestimate costs. This is also important given that the authority that the Mongolian parliament has exercised regarding budgeting is too strong compared to international standards. It would be ideal if all large scale investment projects subject to PFS presented by the parliament also go through a rigorous PFS. Given the political structure of Mongolia, however, it may be very difficult to keep such powerful political interests groups, such as the parliament, from avoiding PFS or hiding the projects in the budget, only with an ex ante evaluation system as specified in the IBL. Second, the operational guideline prepared by NDIC is not detailed or elaborate enough to provide clear course of action regarding PFS. For example, the guideline does not elaborate the unit of projects subject to PFS and the requirements for and procedures of exemption from PFS as well as Ex Officio Selection, which has worked pretty well in Korea as effective measures to keep line ministries from breaking down large projects into smaller projects and to keep line ministries from deliberately underestimating costs to avoid PFS. In this respect, the Mongolian government and NDIC would need to make further efforts to refine the operational guidelines in a more detailed and elaborate manner while considering the establishment of the intermediate evaluation frameworks.
065 Chapter 1 _ Improvement on the PFS System of Mongolia Third, the rights and roles of line ministries, NDIC, and MOF are still not clear or appropriate and the government of Mongolia would need to consider rearrangements of division of roles of related institutions. For example, line ministries are supposed to take responsibility of preparation of project proposals and PFS for small-scale projects in the current arrangement. However, line ministries may not be able to conduct rigorous PFS given the limited capability and the project proposals may not be consistent across ministries and across sectors. Furthermore, line ministries are inclined to underestimate costs and overestimate demands in order to launch the project. To make matters worse, line ministries or local governments are generally direct beneficiaries, which may harm the objectivity of PFS. More importantly, the rights and roles between NDIC and MOF are not clearly defined. Considering that one of the key reasons for the Korean success is that the division of roles among KDI, MOSF, and line ministries has been clearly and appropriately set up, the government of Mongolia should clearly and appropriately specify the rights and responsibilities among line ministries, NDIC, and MOF.
Forth, the analytical guidelines prepared by NDIC is stated in too generic terms to provide clear methodologies for line ministries or local governments and thus analytical guidelines need to be refined in a more elaborate and detailed manner in order to ensure transparency, consistency, and accuracy of the PFS results. In addition, the evaluation methods are totally based on qualitative methods, which may harm the objectivity of the evaluation and the evaluation procedures are not clearly specified, which may increase the risks of being persuaded by political pressures. So, in a longer term, the government of Mongolia needs to consider the adoption of a coherent and standardized evaluation method, such as the AHP method implemented in Korea in order to increase the objectivity of the comprehensive evaluation by preventing arbitrary decision making, while, in a shorter term, clearly specifying the evaluation procedures such as the criteria to form the evaluation committee. Fifth, the government of Mongolia faces a desperate shortage of appropriate databases while the adequate data such as transportation O/D data are an essential precondition for conducting PFS. In this respect, NDIC and the government of Mongolia should put forth great efforts to build an adequate national database system which is essential for a successful PFS.
066 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia References
Eurasia Capital. “Infrastructure in Mongolia: Challenges and Opportunities.” April 2009.
Government of Mongolia. Resolution on Approval of the Action Plan of the Government for 2008 2012.
Government of Mongolia. Budget Law of Mongolia (in progress), 2010.
Government of Mongolia. Law of Mongolia on Concession, 2010.
Kim, Jay-Hyung. “What Made Public Investment management Reform Happen in Korea?” presented at the Make Reform Happen Conference at OECD, 2010.
Korea Development Institute, the General guideline for Preliminary Feasibility Studies, 5th Edition, 2008.
Korea Development Institute, the Standard guideline for Preliminary Feasibility Studies on Road and Railway Projects, 5th Edition, 2008.
NDIC. The Regulation of Public Investment Program, Annex to Government of Mongolia Resolution No. 123, 2010.
NDIC. Methodology for Formulation of Investment Projects Proposed for Inclusion of the Public Investment Program, Annex to Decree of Chairman of National Development and Innovation Committee No. 137, 2010.
NDIC. Methodology for Evaluation of Investment Projects Proposed for Inclusion of the Public Investment Program, Annex to Decree of Chairman of National Development and Innovation Committee No. 137, 2010.
NDIC. Methodology for Prioritizing the Projects Proposed for Inclusion of the Public Investment Program, Annex to Decree of Chairman of National Development and Innovation Committee No. 137, 2010.
Republic of Korea Ministry of Strategy and Finance. Enforcement Decree of National Finance Act, 2009.
Republic of Korea Ministry of Strategy and Finance. Operational Guidelines for the 2009 Preliminary Feasibility Study, 2009.
067 Chapter 1 _ Improvement on the PFS System of Mongolia Republic of Korea. National Finance Act, 2010.
Saaty, Thomas L., The analytic hierarchy process : planning, setting priorities, resource allocation, New York ; London: McGraw Hill International Book Co, 1980.
World Bank "Mongolia: Improving Public Investment Planning and Budgeting." April 2010.
World Bank "Mongolia Quarterly Economic Update." October 2010.
068 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia [Appendix 1] Integrated Budget Law (July 07, 2010 Version)
CHAPTER FIVE Budget preparation, submission and approval
Article 27 Budgetary Investment.
27.1. The following requirements shall be met by investment projects and activities planned and approved in the budget:
27.1.1. Propose investment project or activity with socio economic priority which has been reflected in the relevant sector's development strategic planning documents;
27.1.2. Proven to be economically and socially beneficial through feasibility studies and other relevant calculations and studies;
27.1.3. For investment projects or activities estimated over 30 billion tugrics, a state administrative body in charge of economic planning review their feasibility studies and determine their benefits;
27.1.4. Not possible to implement through a concession contract;
27.1.5. Analysis and design for new constructions and buildings are undertaken and their budgets are approved;
27.1.6. Present land certificate and technical specifications;
27.1.7. Respective cost estimation related with operational costs of a capital asset to be established through investment project such as recurrent expenditure, staffing and financing resources is made and assessment of its impact on the budget is carried out;
27.1.8. Prioritize all requests on projects and activities in terms of their benefits and implementation sequences and include those parts that are within the Medium term fiscal framework statement and annual budget ceiling for the concerned fiscal year.
27.1.9. Budget for investment project and activities to be placed within its relevant general budget governor's budget.
27.1.10. The particular fiscal year's allotment of the budgeted cost for new buildings and
069 Chapter 1 _ Improvement on the PFS System of Mongolia construction, investment projects and activities shall not be less than the amount evenly divided for periods of implementation.
27.2. The study specified in provision 27.1.3 shall not be applicable to the following projects and activities:
27.2.1. Investment projects or activities related to national security and defense; and
27.2.2. Projects or activities related to recovery from natural disaster,
27.3. Cabinet member in charge of budget and finance shall approve methodology to define benefits of projects or activities as specified by provision 27.1.3.
27.4. Regardless of financing resources entire investment projects or activities shall be included in the budget for approval.
27.5. In the following circumstances approved budgeted costs may be amended and reflected in the budget:
27.5.1. Influenced by unforeseen and natural disaster;
27.5.2. Price index of production's raw material increased twice the tariff used for approved budgetary estimation.
27.6. The condition as specified by provision 27.5.2 emerged due to faulty actions of contractors shall not be a justification for changing the budgeted costs.
070 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia [Appendix 2] Evaluation matrix for investment projects of less than MNT 10 billion
Criteria Quality criteria and score Score One. Project needs and demand (20)
Is there sufficient demand to Quality criteria no not sufficient sufficient Complete 1 implement the project? Score 0 3 7 10
Is this project consistent with Quality criteria no indirect direct 2 national high priority projects and programs? Score 0 5 10 Two. Compliance with goals and objectives of the development policy (40)
Does it meet the goals and Quality criteria no indirect direct 3 objectives of the national development strategy? Score 0 4 8
Does it meet the goals and Quality criteria no indirect direct objectives of the socio- 4 economic guidelines of Mongolia for 2010-2015? Score 0 4 8
Does it meet the goals and Quality criteria no indirect direct 5 objectives of the Government action plan? Score 0 4 8
Does it meet the objectives of Quality criteria no Indirect direct 6 the sector and regional development policy? Score 0 4 8
Does this project increase the Quality criteria poor moderate good 7 development index? Score 0 4 8 Three. Opportunity for implementing the project (40)
Is the project goal and Quality criteria no not sufficient sufficient Complete 8 objective clear and achievable? Score 0 3 7 10
Is the optimal option for Quality criteria no not sufficient sufficient Complete 9 project implementation selected? Score 0 3 7 10
Is the equipment and Quality criteria no not sufficient sufficient Complete 10 technological solution rational? Score 0 3 7 10
Is the project cost and benefit Quality criteria no not sufficient sufficient Complete 11 option optimal? Score 0 3 7 10 TOTAL SCORE OF PROJECT
071 Chapter 1 _ Improvement on the PFS System of Mongolia Criteria Quality criteria and score Score One. Project needs and demand (20)
Is there sufficient demand to Quality criteria no not sufficient sufficient Complete 1 implement the project? Score 0 3 7 10 Is this project consistent with Quality criteria no indirect direct 2 national high priority projects and programs? Score 0 5 10 Two. Compliance with goals and objectives of the development policy (30) Does it meet the goals and Quality criteria no indirect direct 3 objectives of the national development strategy? Score 0 3 6
Does it meet the goals and Quality criteria no indirect direct objectives of the 4 socio?economic guidelines of Mongolia for 2010?2015? Score 0 3 6
Does it meet the goals and Quality criteria no indirect direct 5 objectives of the Government action plan? Score 0 3 6 Does it meet the objectives of Quality criteria no indirect direct 6 the sector and regional development policy? Score 0 3 6
Does this project increase the Quality criteria poor moderate good 7 development index? Score 0 3 6 Three. Opportunity for implementing the project (20)
Is the project goal and objective Quality criteria no not sufficient sufficient Complete 8 clear and achievable? Score 0 1 3 5
Is the optimal option for project Quality criteria no not sufficient sufficient Complete 9 implementation selected? Score 0 1 3 5
Is the equipment and Quality criteria no not sufficient sufficient Complete 10 technological solution rational? Score 0 1 3 5
Is the project cost and benefit Quality criteria no not sufficient sufficient Complete 11 option optimal? Score 0 1 3 5 Four. Result of economic analysis (30) Quality criteria NPV<0 NPV= 0 NPV>0 12 Net present value of the project Score 0 5 15
Quality criteria ERR <0 0?10% 10%< 13 Economic rate of return Score 0 5 15 TOTAL SCORE OF PROJECT
072 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia [Appendix 3] National Finance Act of the Republic of Korea
Article 38 (Preliminary Feasibility Study)
(1) The Minister of Strategy and Finance shall conduct a preliminary feasibility study in advance to formulate the budget for a large scale project prescribed by Presidential Decree and submit a summary of the results to the Standing Committee of the National Assembly and the Special Committee on Budget and Accounts.
(2) Projects subject to preliminary feasibility survey pursuant to the provisions of paragraph (1) may be selected by the Minister of Strategy and Finance upon application by the head of a central government agency or at the discretion of the Minister.
(3) The Minister of Strategy and Finance shall conduct a preliminary feasibility survey on the project upon demand issued by resolution of the National Assembly.
(4) The Minister of Strategy and Finance shall prepare guidelines for the criteria for selection of projects subject to the preliminary feasibility survey under the provisions of paragraph (1), the institution that shall carry out the survey, the methods, procedures, etc. for the survey, and shall notify the head of each central government agency thereof.
073 Chapter 1 _ Improvement on the PFS System of Mongolia [Appendix 4] Enforcement Decree of the Republic of Korea
Article 13 (Preliminary Feasibility Survey)
(1) The term “large scale project prescribed by Presidential Decree” in Article 38 (1) of the Act National Finance Act means a new project that costs 50 billion won or more in total, out of which the financial aid by the State amounts to 30 billion won or more, and which falls under any of the following subparagraphs: Provided, That the project in subparagraph 4 refers to a new project that entails Treasury expenditure of 50 billion won or more according to the medium term project plan submitted under Article 28 of the Act National Finance Act:
1. A project in which construction works are included;
2. An informatization project under Article 15 (1) of the Framework Act on National Informatization;
3. A national research and development project under Article 11 of the Framework Act on Science and Technology Framework Act on Science and Technology;
4. Other projects in the field of social welfare, health, education, labor, culture and tourism, environmental protection, agriculture, forestry, ocean, fishery, industry, and small and medium enterprises.
(2) Notwithstanding paragraph (1), a project that falls under any of the following subparagraphs shall be exempted from the preliminary feasibility survey:
1. A project for construction or extension of public office buildings, correctional facilities, and facilities for elementary and secondary education;
2. A project for restoration of cultural heritage;
3. A project relating to national security or national defense that requires security;
4. A project pertaining to inter Korean exchanges and cooperation or a project promoted in accordance with conventions and treaties with other countries;
074 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia 5. A project for simple improvement, management and repairing of existing facilities to enhance their effects, such as managing and repairing roads, improving old water supply facilities, etc.;
6. A project urgently required to be promoted, such as prevention from a disaster, aid for restoration, securing of facility safety, safety of health and food, etc.;
7. A project to be established or promoted in accordance with Acts and subordinate statutes;
8. A project conducted for the purpose of simple transfer of income, such as direct payment in cash or in kind to beneficiaries like persons eligible for basic stability support, persons with disabilities, etc.;
9. A project having no practical use of the preliminary feasibility survey, such as support for personnel expenses and ordinary expenditures of government invested institutes and subsidiary organs, and lending business, etc.;
10. A project prescribed by the Minister of Strategy and Finance as necessary to promote as a policy for balanced regional development, response to urgent economic or social conditions, etc.
(3) The head of a central government agency who applies for the preliminary feasibility survey pursuant to Article 38 (2) of the Act National Finance Act shall submit to the Minister of Strategy and Finance a written request for the preliminary feasibility survey, clearly describing the name, overview, needs, etc. of the project.
(4) The Minister of Strategy and Finance shall, upon receiving written request under paragraph (3) or at his/her own discretion, examine whether the project conforms to the medium and long term investment plan pertaining to the project, whether it is urgently required to promote the project, etc., and shall decide whether to conduct a preliminary feasibility survey.
(5) Once the Minister of Strategy and Finance makes a decision to conduct a preliminary feasibility survey pursuant to paragraph (4), he/she shall determine whether the project is feasible, comprehensively taking into consideration economic effects, necessity in policy
075 Chapter 1 _ Improvement on the PFS System of Mongolia aspects, etc. and shall disclose the results thereof to the public.
(6) The Minister of Strategy and Finance may request a competent specialized institution to conduct a preliminary feasibility survey under paragraph (5).
076 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Chapter 02
Improvement in Legal and Procedural PPP System in Mongolia
Summary 1_ Introduction 2_ Infrastructure in Mongolia: Issues and Challenges 3_ Public Private Partnerships 4_ Assessment of Mongolian Concession in Comparison to Korean PPP 5_ Policy Recommendations 6_ Summary and Conclusion Chapter 02 Improvement in Legal and Procedural PPP System in Mongolia
Kang Soo Kim (Korea Development Institute) Yoo Eun Koh (Korea Development Institute) Zayabal Batjargal (State Property Committee)
Summary
As Mongolia begins to emerge from the global financial crisis, the country's decision makers turn their attention to the plans, institutions and investments needed to support the country's tremendous growth potential. This chapter is concerned with the development of infrastructure facilities, which is required in order to support the nation's economic growth. Government budget alone will not be sufficient to construct, operate and maintain large scale infrastructure such as roads and railways especially when total estimated investment for the facilities nears US$3,000 million. It will be necessary to provide financing through the private sector, using Public-Private Partnerships scheme.
Mongolia succeeded in enacting the Law on Concessions in January 2010, opening up state and local properties for better investment opportunities. It is expected that the burden on the government to develop infrastructure is reduced and that improved social services are provided to citizens. In order for the expansion of infrastructure investments to yield the desired outcome, four policy recommendations were made in light of Korean PPP experiences.
First, complement and strengthen the current legal framework to be workable and implementable. The newly ratified Law on Concessions will no doubt be facing challenges of legal loopholes that allow circumvention or avoidance of some of the most critical regulatory stages, which must be addressed through detailed guidelines depending on the specific sector as well as different procurement procedures. Specific guidance for tendering, contracting, risk sharing and conflict resolution must be adopted.
078 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Second, build a transparent and competitive procurement process. Procurement of concession projects, bid, and evaluation methods suggest ways for optimal procurement for a transparent selection process, which contributes to fostering a competitive PPP market. Template documents for bidding that clearly and comprehensively address the contents of proposals, financing and reimbursement issues and standard evaluation methodologies would act as guidance to the possible concessionaires.
Third, adopt measures to attract private partner investment through incentives and risk sharing. Government support could be considered to induce the private sector’s active participation. Korea’s case of government incentives, in forms such as construction subsidies, infrastructure credit guarantees, tax incentives, and early termination payments are suggested as possible options. At the same time, the government needs to establish adequate fiscal capacity through fiscal management.
Fourth, build capacity of SPC and educate public sector officials through training. As advisory and project facilitating entity, staff of the State Property Committee require knowledge and expertise in the relevant field. Through active cooperation with foreign advanced PPP units, it may build inward capacity, which may be disseminated in the future, to other ministries and local government officials in charge of concession projects through training and education sessions.
1. Introduction
The issue of improving the infrastructure sector has become crucial for Mongolia as a particular result of economic and social development. Growing urbanization around the capital city, Ulaanbaatar and burgeoning of the mining industry, have caused a significant pressure on the supply of infrastructure. Also, existing physical capacities are outdated and, insufficient investments have been made to renew and expand them and to improve their quality. As a result, the current status of infrastructure is unable to meet the increasing demand and the lack of basic infrastructure is clearly a major factor constraining economic growth.
The Mongolian government has identified that the persistent underinvestment in infrastructure, is having a negative impact on economic growth, living standards, and transaction costs of businesses. As such, the Mongolian government made efforts to increase capital spending in power, transport and communication over the recent years. However, as other developing countries are facing with the same constraints, the fiscal resources have not been sufficient to provide the requisite investment to supply adequate infrastructure for economic and social development. Clearly, a new model to provide the investment needed to modernize and supply Mongolia’s infrastructure has been required, and the Mongolian government identified that properly structured Public-Private Partnership (PPP) was a key instrument to attract much
079 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia needed private investment for the development of infrastructure. Hence the Mongolian government has turned to the private sector as a partner in the provision of infrastructure services to reduce serious investment gaps by broadening financing options for infrastructure investments.
PPP for infrastructure development in Mongolia has just started in 2010, for which the process complies with State Policy and the Law on Concessions, enacted with the aim to promote and facilitate the implementation of privately financed infrastructure projects. Hence, the Mongolian legal framework is still in the course of development where many areas in terms of legal regulations and processes are yet to be covered. For example, several institutions have key roles in the PPP process but lack clear-cut functions and roles. Unstructured and informal nature of PPP process, that often does not follow a clearly documented and prescribed path to approval, may hinder coherent executions of a PPP project. To ensure transparent and accountable implementation as well as strengthened governance for increased public and private partnerships guidelines, documentation, and clear access to information seems necessary.
This chapter first analyzes the current state of infrastructure development in Mongolia, focusing mainly on challenges and investment needs. Given the quality of infrastructure that ranks among the lowest in the world and the need for roads and railways for its strategic economic development, infrastructure investment is an urgent requirement, and new investments are necessary in order to sustain productivity and growth of the country. This chapter then addresses the current concession scheme in Mongolia focusing on the legal framework, procurement, evaluation and fiscal risk incurred by its implementation. It then assesses the concession system in comparison to corresponding Korean PPP system, and finally, draws policy lessons and establishes strategic directions for the Mongolian government.
Korea has experienced challenges regarding PPPs in infrastructure at its development stage and has also attempted at overcoming obstacles through various strategic approaches. Some were proven successful and are now stabilized as policies that permeate through everyday lives of the Korean people, while others, including certain PPP market promotion policies have resulted in additional fiscal burden.
The PPP system, as in any other country development plan tends to evolve into its optimum form when reflecting country specific political, social, and economic circumstances, instead of blindly copying successful cases and best practices of other countries. Considerations for fundamental differences such as political environment need to be addressed and preceded before making any solid recommendations. Notwithstanding, the decade long undertakings of Korean PPPs have accrued valuable lessons and knowledge that may provide some insight.
Therefore, with Korean experience in mind, we draw policy recommendations that are organized around four main points: strengthening the existing legal framework by adopting
080 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia enforceable guidelines; building transparent and competitive procurement process with template documents for bidding and standard evaluation methodology; inducing private investment through various incentives such as exchange rate risk sharing, tax incentives and revenue guarantee mechanism; building capacity of SPC and provide education and training for public sector officials.
2. Infrastructure in Mongolia: Issues and Challenges 2.1 Overview Focusing on Transport Infrastructure
Mongolia is a landlocked country, sandwiched between China and Russia. The strategic location of Mongolia between the two global economies has increased demand for infrastructure, but the transport sector of Mongolia is unable to cope with increased demand, hence negatively impacting economic development of the country. Since China and Russia are vital for Mongolia's international trade, massive transport infrastructure development is required to connect large mining deposits to the two of its major trading partners.
Taking into consideration that mining is the main sector contributing to the recent growth of the Mongolian economy, discovery of huge mining resources will further stimulate the demand for transportation services and increase overall economic activity. Once mining deposits are developed, Russia and China not only will be among the biggest consumers of those minerals, but also will remain the only option through which international markets for the Mongolian goods can be reached.
Table 2-1 | Current Status of Transport Facilities Transportation Types Length (thous. km) Share (%) Road 49.308 96.4 Railway 1.815 3.6 Total 51.123 100.0
Source: Ministry of Finance of Mongolia, cited in Eurasia Capital. “Infrastructure in Mongolia: Challenges and Opportunities.” April 2009.
However, today's infrastructure capacities do not allow Mongolia to provide sufficient and quality to even basic public services. With the GDP per capita of US$1,560, only 67% of the population has access to power (electricity) and 35% to water. Roads are in poor condition, of which only 3.5% is paved and existing ones need capital repair. The railway network capacity does not match to growing export import cargo flows.1) As a result, the recently released World Economic Forum (WEF) Global Competitiveness Report 2010-2011 ranks Mongolia 137 out of 139 countries, ranked on the quality of overall infrastructure. The report also provides
081 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia additional details on indicators of quality of infrastructure; roads: 138, railroad: 69, port: 112, air transport: 129, quality of electricity supply: 111.2)
Such infrastructure status is expected to get worse starting from 2012, when the major mines start their production of minerals. Many jobs are to be created in the mining areas with most of the employees coming from other regions, that will lead to more burden on water, sanitation, electricity and heating supply in the southern regions. Furthermore, more roads and in particular railway constructions are needed to transport multimillion tons of the minerals for internal use and exports to Russia and China.
2.1.1. Road Transport
Mongolia's road infrastructure is weak with a mere 3.5% of paved roads, which is significantly lower than international standards. The total road network is 49,308 km, of which 11,218 km constitutes state roads and 38,100 km provincial or local roads.
Due to the country's large geographical area, road to area density is low and the road network does not provide adequate geographical coverage of its territory. Low traffic volume in most of the regions (except Ulaanbaatar) makes economic viability of expanding roads trivial. Many of the roads in the capital city of Ulaanbaatar are older than 20 years and are rapidly deteriorating. In such circumstances, there is an urgent need for construction of new roads as well as for upgrading and maintenance of existing roads.
To address these problems, the government has developed numerous strategies for the transportation sector that encompass long term goals and anticipated budgets. These strategies include the National Development Strategy 2007-2021, National Transport Strategy for Mongolia, Transit Mongolia Program, Mongolian Road Master Plan 2008-2020, and the 15 year investment program developed by the Ministry of Road, Transport, Construction and Urban Development. The projects aim to provide paved roads between Ulaanbaatar and all major cities in the country and to connect international networks to national roads. Most of the roads are planned to be asphalt paved, which is more capital intensive than other options.
1) GDP per capita is commonly taken as an indication of the overall economic strength of a country. When compared with the rankings by the Global Competitiveness Index on the quality of overall infrastructure, the relationship between the two can be seen more clearly. 2) World Economic Forum. The Global Competitiveness Report 2010-2011. Geneva. 2010.
082 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Figure 2-1 | International Comparative Road Network Indicators
Source: ADB, CARTEC, cited in Eurasia Capital. “Infrastructure in Mongolia: Challenges and Opportunities.” April 2009.
2.1.2. Rail Transport
The Mongolian railway system is 1,815km long and carries more than 90% of freight. It plays an important role in the Mongolian economy. Mongolian main export and import commodities such as coal, minerals, timber, petroleum and animal products are transported to and from Russia and China by rail. According to the Word Bank, it is estimated that Mongolia needs 2,000 km of additional rail tracks in the short term, to exploit the mining resources in the South East region of the county.
The existing main railway section is a 1,400 km trunk line between Sukhbaatar on the Russian border, through Ulaanbaatar to Zamiin Uud on the Chinese border. It is a transit route for cargo between China and Russia via Mongolia and carries most of the Mongolian cargo. The rail system is run by a vertically integrated 50:50 Mongolian Russian joint venture Mongolian Railways.
In March 2009, Russia and Mongolia signed a Memorandum of Cooperation, intending to improve the efficiency of Mongolian Railways, facilitate the technical renovation of rolling stocks, to introduce modern technologies and to substantially increase transit traffic. As a follow up to the agreement, Mongolia is establishing a state joint stock company with Russian Railways. Mongolia is represented by Erdenes and the shareholders are the Mongolian Railway companies. The company is engaged in construction and improvement of railway infrastructure and in attracting financing to railway infrastructure construction projects. It will also be able to
083 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia Figure 2-2 | International Comparative Railway Density Indicators
8 7
6
4
2 1.5 1.3 0.9 0.7 0.1 0 km/1000 people Mongolia Tajikistan Uzbekistan km/100 sq.km land Source: ADB, CARTEC, cited in Eurasia Capital. “Infrastructure in Mongolia: Challenges and Opportunities.” April 2009. run exploration and development of mining deposits in Mongolia through its subsidiaries.
Although programs on repairing and upgrading railway networks have been carried out, they are not sufficient to reverse the declining quality of the rail transportation system. It has significantly deteriorated from the lack of maintenance over long periods in the past and freight tonnage has increased further, exacerbating quality and short term capacity concerns.
The scale of and need for railways construction fully depends on the demand from coal and mineral producers. Most of the proposed railways connecting mining deposits are not commercially viable as rail construction costs US$2 million per kilometer on average, compared to road construction, which costs of US$0.5 million per kilometer. Despite this, there are already ongoing railway projects to be developed by mining companies. In July 2008, Energy Resources and MAK, both Mongolian companies, have been permitted licenses to develop railways. Energy Resources established a subsidiary to develop its railway and signed a Memorandum of Understanding with China's Shenhua Group, under which Shenhua provides rail connection from the Mongolia-China border to Huanghua port in China.
The emphasis on the construction of railway networks can be explained not only as local needs of regional transportation, but also as a strategic use for national economic development. Railway is necessary for burgeoning export of mineral products to Russia and China. It will act as a connection to Europe, Middle, North East and South East Asia through Russian ports of Bladivostok, Nahodka, Vostochnyi and Chinese ports of Tianjin and Dalian. The Transit Mongolia program, which the government adopted in May 2008 to be implemented in 2015, includes the following in terms of railways: construction of secondary railway lines;
084 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia electrification of railways; and construction of the Asian Highway Routes in Mongolia.
2.1.3. Air Transport
Because of the inadequate road network and vast distances, Mongolia depends on air transportation to connect its major towns and cities. It is an important mode of domestic transport serving the majority of tourist and business travelers. There are 44 airports, only 13 of which have paved runways. Genghis Khan International Airport, the major international airport, is a hub to all airports within the country. In 2008, the government announced its intention to build a new international airport in the Khoshigt Valley, 33.5 miles away from the capital. The project is to be financed by Japan through a 40 year US$270 million loan with a 0.2% interest rate. The construction is planned to commence in 2011 and is expected to be completed in 2015.
Genghis Khan International Airport is the only airport supporting scheduled international flights. There are three national airline companies in the country: MIAT Mongolian Airlines, Aero Mongolia, and Eznis Airways. MIAT Mongolian Airlines is a state owned enterprise that has regular flights to international destinations in Russia, China, Japan, Germany and South Korea. As the demand for air transportation is increasing in Mongolia, so does the burden on the government to finance air transport infrastructure.
Although the state owned MIAT generates substantial revenues, the mechanism of channeling these revenues back into civil aviation development has not been clearly defined. Lack of investment in the air transport sector poses constrains to tourism development, with limited flight schedules, public perception of poor air safety, and the underdeveloped domestic airport system. All but four domestic airports have limited passenger handling capacity, feature gravel or grass airstrips without lighting systems, and have primitive air traffic services.
Future plans in terms of air transport include restructuring of the civil aviation authority, privatization of MIAT and construction of new international and domestic airports. However, for actual implementation, the plans need further prioritization of the government.
2.2. Investment Gap
The government has increased capital spending in power, transportation and communication over the recent years. For instance, investments in infrastructure reached a record level in 2007 at 19% of total expenditures (10% of GDP), from 13% (4% of GDP) in 2001-2006. The public investments amounted to 10% of GDP in 2008, including the state budget finances of US$290 million.
However, public resources alone do not suffice in providing adequate public services. Over 1995-2005, loans, grants, private investment and the government's investments in infrastructure
085 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia Figure 2-3 | Investment in Infrastructure as % of GDP
30
25
20
15
10 Investment % GDP Investment
5
0 Telecoms Energy WSS WSS Transport Transport (Reduced) (Reduced) (Full) 2005-2015 1995-2005
Source: World Bank, cited in Eurasia Capital. “Infrastructure in Mongolia: Challenges and Opportunities.” April 2009. have averaged US$128 million per year, including grants consisting of 20.3% and loans of 68.7%, with government and private resources providing the rest.
To accommodate the required expenditures to reach all proposed investment programs from 2008-2015 in Mongolia, the total financial outlay estimates to be US$2,945 million. Compared with previous levels, annual road infrastructure investment alone will equal eightfold in absolute terms over the next decade and total investment needed equal to an annual investment of about 15% of GDP over the coming years.
Figure 2-4 | Investment in Road and Transport Sector (in million US dollars)
Road Construction Road Repair and Maintenance New Transport System Intelligent Transport System
Source: Ministry of Finance of Mongolia, cited in Eurasia Capital. “Infrastructure in Mongolia: Challenges and Opportunities.” April 2009.
Financial planning is required to ensure that adequate resources are available to implement
086 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia its infrastructure strategy. Estimating how much money the government is able to commit from its own revenues and how much it can mobilize donor resources will be an important starting point. Given Mongolia's current fiscal deficit, private financing of infrastructure is likely to be attractive.
Table 2-2 | Government Proposed Investment Program for Transport, 2008-2015 (World Bank, PPIAF estimates in 2007) Total Cost Project Length/Units (million US dollars) Roads Millennium road 600 120 Western Mongolia North-Road 800 160 Other north-south road 1,100 220 Completion of UB-PRC road 300 60 Southern road to Altai 225 27 Bridge maintenance 16 Road maintenance 24 Subtotal Roads 627 Railways New parallel railway 1,100 1,100 Other railway extensions 500 500 Mining railways 300 300 Rail maintenance 1,100 55 Subtotal Railways 1,955 Aviation New international airport 1 300 Upgrading domestic airports 4 40 Expansion of the navigation system 1 10 Subtotal Aviation 350 Urban Roads to aimags in UB 100 10 Interchanges for outer by pass 5 2 Traffic management in UB 1 1 Subtotal Urban 13 Total transport infrastructure investment 2,945
Source: Public Private Infrastructure Advisory Facility. “Foundation for Sustainable Development: Rethinking the Delivery of Infrastructure Services in Mongolia.”World Bank. June 2007.
087 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia Figure 2-5 | Estimated Annual Investment Gap
180 160 140 120 100 118 80 41 125
In US million 70 60 40 20 16 0 Energy Telecoms Transport Water
Loans Grants GoM Private Investment Unidentified
Source: World Bank, cited in Eurasia Capital. "Infrastructure in Mongolia: Challenges and Opportunities." April 2009.
3. Public Private Partnerships 3.1. The Need for Private Participation in Infrastructure Development in Mongolia
Core infrastructure projects require substantial capital investment, which significantly drains government finances. By engaging private sector capital, thus subsequently amortizing total costs over long concession horizons, Public-Private Partnership (PPP)3) structures can relieve such government burden. Considering Mongolia's prospective GDP in the future and the increasing need to build enabling infrastructure facilities as quickly as possible, the PPP scheme allows more simultaneous execution of projects.
Government decisions on infrastructure procurement would revolve around whether to produce infrastructure goods and services in-house or procure them from the outside, and if the government chooses the latter option, under what conditions it should contract it out. Infrastructure projects can consist of number of elements, such as planning, financing, construction, operation and maintenance, management, service provision, and ownership. While nationalization of infrastructure means bundling all the above under state ownership, PPPs represents dividing some of the tasks to the private sector.4) There are wide variations of PPP
3) PPP is part of a broader spectrum of contracted relationship between the public and private sectors to deliver a public service. Various modes of service delivery range from traditional public procurement to full private delivery. Public Private Partnership and concession occupies a middle ground between traditional public procurement and privatization, where a private entity finances and builds and operates a service and generally collects tariffs directly from consumers. The terms PPP and concession are used synonymously in this paper. 4) Estache, A., A. Iimi, and C. Ruzzier. "Procurement in Infrastructure: What Does Theory Tell Us?" Policy Research Paper 4994, World Bank, July 2009.
088 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia transactions, majority of which take a form of greenfield projects where private firms build and operate a new facility for the period specified in the project contract.
Since the 1990s the role of public sector in financing infrastructure projects has changed dramatically; it has started to shift from 'financier/owner/manager' of projects to 'regulator and guarantor', and its involvement in the productive economy has considerably shrank. At the same time, private sector initiative has started to invade areas that were previously considered in the exclusive domain of the public sector. Well structured and competitively implemented PPPs are an effective and efficient tool to mobilize private capital to develop badly needed infrastructure, economically viable public infrastructure, and to ensure efficient provision, operation, maintenance, and financing of these services over time.
The Mongolian infrastructure sector requires substantial investments to renew existing capacities and to build new ones. However, as was already discussed in the above section, the government alone does not have sufficient resources for infrastructure development. Taking into account 10% increase of GDP over the coming years and estimated annual infrastructure investment approaching 20% of GDP, the government and international donors are unable to meet the sustainable level without private investors. For instance, some part of the financing would inevitably come from mining companies as they are directly interested in transport infrastructure that would ensure adequate access from mining regions to Russia, China and other international markets.
The payment system characteristic of PPP projects provides visibility and predictability for the government on its future infrastructure expenses. By catalyzing knowledge and technology transfer through a collaborative approach between government procurers and private sectors, PPPs provide the Mongolian government with the benefit of learning that would be limited by traditional public procurement strategies. In this context, a PPP strategy can also support government to employ more local citizens in private sector companies. Therefore as a solution to the infrastructure shortage, Mongolian authorities at all levels are promoting the use of PPP schemes.
Public-Private Partnership scheme to build a strong logistics network to enhance the country's competitiveness has been taking steps with the establishment of its legal framework. Given that PPP projects usually involve significant investment by the private sector over a long period of time, insufficient legal protection of investors is among primary concerns. A sound legal framework is critical for successful PPPs, because it provides the legal coverage to enter into an enforceable contract that enables the private to finance, build, operate and collect revenues or service payments. Possible confusions involving obligations of parties, services, land acquisition, risk and profit sharing, pricing and handover of facilities could be averted through a firm legal framework. A legal framework may serve to reduce the level of uncertainty in PPP project deals and their implementation, thereby increase investors' confidence. It can
089 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia moreover promote and facilitate private involvement and issuance of various licenses and permits. Through legal instruments, responsibilities and functions of different government bodies may be specified, and implementation arrangements that details approval and procurement steps may be defined.
3.2. Mongolian Concession
Mongolia has been in the process of drafting the Law on Concessions since 2006 and succeeded in enacting the law in 2010. After adoption of State Policy on PPPs in October 2009, the Parliament of Mongolia started the process of discussing the Draft Law on Concessions, and after series of successive discussions, the Parliament ratified the Law on Concessions in January 2010, becoming effective on March 1, 2010. It is expected that the newly adopted law will open up state and local properties for better investment opportunities without them being privatized, reduce the government burden, whilst providing improved social services to citizens.
3.2.1. Legal Framework
State Policy on PPPs gives general directions and defines basic principle of introducing and implementing PPP, procurement types, public and private parties and their roles. Concession Law, as one component of the implementation plan of State Policy on PPPs, defines: �basic roles of line ministries and government agencies; �power of the state and local self governance and administrative authorities; �powers of the concessionaire and the concession financier; �general structure of preparation and approval procedure of concession item list; �and procurement types, application requirements, and tendering procedure.
3.2.2. Institutional Arrangements Defining Roles and Responsibilities of Key Players
Chapter two of the Concession Law of Mongolia defines powers of the state and local self governance and administrative authorities on concession:
The government has the following powers: �approve and revise the list of state property concession items; �decide on granting the concession and authorize the State Property Committee (SPC) to enter into an agreement of concession; �report annually to the Economic Standing Committee of the Parliament on the implementation of the legislation on concession.
The state administrative authority in charge of state property (i.e. SPC), the governors of provinces and the capital city have the following roles:
090 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia �prepare and submit to the government a draft list of concession items for state owned property; �research and prepare proposals for inclusion in the list of concession items; �announce publicly the list of concession items (solicited project list); �inform the public about the list of concession items; �provide methodological and expert assistance to other relevant authorities on matters related to granting and implementing concessions; �establish and maintain the national centralized registry and database on concessions; �adopt legally binding norms when specifically to do so by legislation; �devise the documents of the tender jointly with the relevant state administrative institution, and announce the tender, organize and evaluate it; �enter, with the concessionaire and other entities, into a concession agreements as contracts of the concessionaire to obtain financing; �provide professional and methodological assistance to relevant local authorities regarding concession; �adopt regulations on the methodology to prepare the cost-benefit analysis for a concession item.
Line Ministries (LM) and National Development and Innovation Committee (NDIC, state administrative authority in charge of investment) are responsible for the following: �LM and NDIC jointly submit to the SPC a proposal for a concession item with the cost and benefit analysis; �give related opinion of their respective matter for the local property concession items proposed by the governors of provinces and the capital.
The regulatory authority is responsible for the following: �grant permission and licenses required for the implementation of a concession; �determine prices and tariffs; �adopt and enforce rules and regulations pertaining to the concession item or services rendering by it.
The Ministry of Finance is responsible for the following: �give opinion to finalize the draft list of concession items to SPC.
3.2.3. Procurement Process
Procurement of concession projects in Mongolia can be divided into solicited projects and unsolicited projects. In the case of a solicited project tender, the process could be either a one- stage procedure or a two-stage procedure for submitting project proposals. The SPC organizes the submission of the project proposals into a two-stage procedure when, in view of the nature of the concession item and the industry in question, deems it impossible to reflect sufficient
091 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia detail in the tender documents the technical and economic feasibility, financing conditions and other requirements and criteria. When organizing the submission of the project proposals in two stages, a request will be sent to the participants to submit an initial proposal that contain the tender documents.
Figure 2-6 | Procurement Steps of Solicited Projects (One-Stage)
SPC Announcement of tender
Submission of the proposal to from Private sector to participate in the tender SPC
Evaluation and Selection of the tender SPC participants Step 1.Selection of participants
Provision of the tender documents to from SPC to Private the participants sector
from Private sector to Submission of Project Proposals SPC
Evaluation and compilation of the list of qualified participants Step 2.Selection of the project
from SPC to Private Negotiation with the qualified sector particpants of the terms of the agreement Step 3.Negotiation
Government Contract award
Source: from Law of Mongolia on Concessions
Figure 2-7 | Procurement Steps of Solicited Projects (Two-Stage)
Same as one stage tender Step 1.Selection of participants
Request to submit an initial proposal on the from SPC to Private issues specified in Article 13.7 of the CL sector
from Private sector to Submission of Project Proposals SPC
SPC Finalize the tender documents Step 2.1.Selection of the project
Provision of the tender documents to the from SPC to Private participants sector
from SPC to Private Submission of Project Proposals sector
Evaluation and compilation of the list of SPC qualified participants Step 2.2.Selection of the project
Same as one stage tender Step 3.Negotiation
Same as one stage tender
Source: from Law of Mongolia on Concessions
092 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia The Concession Item List is a long list of PPP projects that the government updates each year.5) It is prepared by line ministries and government agencies and is reviewed by NDIC, MOF and SPC. It is then submitted to the Cabinet for approval. Unsolicited project proposals submitted by the private party to SPC and reviewed by NDIC and MOF, is to be submitted to the Cabinet.
Figure 2-8 | Procurement Steps of Unsolicited Projects
Submission of the proposal to conclude a concession from Private sector to agreement together whit the cost-ben efit analysis SPC
Line Ministry, NDIC, Opinions for project proposal Ministry of Finance
Decision, whether to recommended to include the SPC proposals in the list of concession items
Add to the list of concession items Government
Announcement of tender SPC
Submission of Project Proposals Private sector to SPC
Evaluation and Selection of the list of qualified participants SPC
Negotiation with the qualified participants of the between SPC and terms of the agreement Private sector
Contract award Government
Source: Law of Mongolia on Concessions
3.2.4. Financial Support and Risk Sharing
The law mentions government side support measures and risk allocation.
According to Article 30 of the Concession Law, financial support to the concessionaire that the state may provide include following: �issue a loan guarantee; �provide a portion of the financing for the concession;
5) The list of concession items for implementation under PPP principles, annex to government resolution in 2010 is provided in Appendix 1.
093 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia �provide tax exemptions and waivers in accordance with the relevant laws; �provide insurance; �issue a guarantee for the minimum amount of the concessionaire's revenues under the concession agreement.
Concerning risk allocation, the law stipulates as below in Article 31: �unless the concession agreement provides otherwise, the concessionaire shall fully bear the business risk associated with the implementation of the concession; �the concession agreement shall provide for risk allocation related to emergency situations caused by force majeure; �the concessionaire shall be fully responsible for losses and damages caused to others and liabilities to third parties that result from its own wrongful actions during the possession and operation of the concession item.
4. Assessment of Mongolian Concession in Comparison to Korean PPP
The government of Mongolia has started an ambitious program of public and private partnerships. Its concession list covers sectors that include energy, road, railway, housing, education, and health, many of which are to support core infrastructure development in the southern part of the nation, focusing on mega projects which will contribute to rapid economic growth. Taking into consideration the various government endeavors of the past few years in the PPP sector, it is laudable that the government of Mongolia has successfully launched an enabling environment with a supporting legal and institutional framework to facilitate private investment in infrastructure facilities and services. Nevertheless, as the program is now only emerging and the first PPP transactions are being prepared, refinements and amendments that address any gaps in the framework need to be further developed.
4.1. Legal Framework and Legislation
The legal framework of Korean PPP system was first designed in 1994 with the enactment of the Act on Promotion of Private Capital Investment in Social Overhead Capital. Overall revision of the Act into Act on Public-Private Partnerships in Infrastructure (PPP Act) took place in 1999 after the Asian financial crisis, where the revised Act strengthened risk sharing mechanisms, which greatly contributed to encouraging the private sector participation in infrastructure development. The PPP Act was amended again in 2005, when the Build-Transfer- Lease (BTL) method was first introduced. Before revision PPP projects mainly focused on transportation infrastructure, but since 2005 eligible facilities expanded to include social infrastructure facilities, such as education, culture, welfare, environment, and defense facilities. In addition, the Act established a PPP specialized agency, Public and Private Infrastructure
094 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Investment Management Center (PIMAC) within Korea Development Institute, to provide technical assistance to the Ministry of Strategy and Finance and the procuring authorities.
The annually updated Basic Plans for PPP provides PPP policy directions, details in PPP project implementation procedures, financing and refinancing directions, risk allocation mechanisms, payment schemes of government subsidies as well as documentation directions. In the Korean PPP system, the PPP Act, together with the Enforcement Decree of the PPP Act, Basic Plans, and detailed implementation guidelines according to different sectors, provide consistent, transparent, and flexible guidance that reflects market conditions.
The PPP Act and the Enforcement Decree, the principal components of the legal framework for PPPs, clearly define eligible infrastructure types, procurement types, procurement process, conflict resolution, termination mechanism, and the roles of the public and private parties, policy supports, etc. The Act is a special act that precedes over other Acts.
Hierarchy of the legal arrangements is as follows: �PPP Act �Enforcement Decree on the PPP Act �Basic Plans for PPP �Implementation Guidelines
Figure 2-9 | History of PPP Act
~1994 August 1994 December 1998 January 2005
Individual Laws The Act on Promotion of The Act on 2005 Amendment -Toll Road Act Private Capital into Public-Private of PPP Act II II II -Harbor Act Social Overhead Capital Partnerships in Investment Infrastructure
-Introduction of PPP legal -Government support -Introduction of BTL framework measures, risk sharing -Diversification of mechanism PPP project facility types -Expansion of investor profile
Source: Ministry of Strategy and Finance and Korea Development Institute. Building a Better Future through Public-Private Partnerships in Infrastructure in Korea. 2009
The recently established Mongolian legal framework on concession, namely, the State Policy on PPPs and Concession Law, are still generic with no amendments so far. The Concession Law, as part of legislation on concession that consists of the Constitution of
095 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia Mongolia, the Civil Code, the Law on Government, the Law on State and Local Property, and the Law on Foreign Investment (Article 2.1, Mongolian Concession Law), does not apply to matters related to certain articles of the Law on State and Local Property (Article 2.4, Mongolian Concession Law).
The Korean PPP Act, on the other hand, prevails over other related acts under Article 3(1). There are certain advantages to this, because this gives authorization and permission necessary to obtain in other related Acts (Article 17(1), Korean PPP Act). In other words, if a PPP project in Korea follows legal procedure as prescribed by the PPP Act, matters such as authorization and permission are “considered to have been granted’ (Articles 21(4), 22(3), Korean PPP Act), facilitating the implementation of the project.
In terms of its relation to other relevant laws, as for provisions on infrastructure facilities fund, for example (Section 5 of the Korean PPP Act), although regulated under the Capital Market and Financial Investment Business Act (Article 41(4), Korean PPP Act), the infrastructure fund is granted certain exemptions from regulations.6)
For the same matter, Article 29.2 of Mongolian Concession Law stipulates that the relevant license shall be granted to the concessionaire “as soon as possible” upon the conclusion of the concession agreement. However, certain priorities in relation to other laws and granting of relevant permissions may need to be given to concession projects to facilitate and expedite the implementation.
4.2. Institutional Arrangements
An important issue concerning the interplay among the budget ministry and the line ministries is that of fiscal discipline. The budget process has generally taken a highly centralized, strategic dominance based approach. As such, there is a need for a central government ministry responsible for managing the Concession Law with power to regulate fiscal expenditure, and this needs to be further defined and addressed in the Mongolian Concession Law, where the Ministry of Finance only seems to play a minimal role in the procedure.
Furthermore, there is a need for an entity that deliberates matters concerning the establishment of major concession project-related policies and key decisions in the process of implementing large scale concession projects. In Korea, the PPP Review Committee (PRC) mandated with such functionality, is organized and managed by the Ministry of Strategy and Finance (MOSF). The Committee members are composed of the Minister of Finance and
6) It is explicitly indicated in Article 44 of the PPP Act that some specific provisions of the Capital Market and Financial Investment Business Act are not applied to infrastructure funds (amended Aug. 3, 2007).
096 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Strategy (Chairperson), vice ministers of line ministries in charge of implementing PPP projects, and private sector experts with knowledge and experience in PPP.
According to the Korean PPP legal framework, roles and functions of different PPP related entities are defined as follows:
The Ministry of Strategy and Finance is responsible for: �managing the PPP Act, the Enforcement Decree, and the Basic Plan for PPP; �preparing the draft budget for PPPs; �budgeting, preparing and implementing PPP investment plans, among others.
Main responsibilities of PRC are deliberations on: �establishment of major PPP policies; �establishment and modification of the Basic Plan for PPP; �designation and cancellation of a large PPP project (total project cost with KRW 200 billion or above); �formulation and modification of the Request for Proposals for a large PPP project; �designation of concessionaire of large PPP projects; and �other matters which the Minister of Strategy and Finance proposes for the active promotion of the PPPs.
Public and Private Infrastructure Investment Management Center (PIMAC) plays a role of: �supporting the Ministry of Strategy and Finance in the formulation of the Basic Plan for PPP; �supporting the competent authorities and ministries in the procurement process such as assessment of feasibility and value for money for potential PPP projects, formulation of request for proposals, designation of concessionaire, evaluation of project proposals by private companies, negotiation with potential concessionaires, etc; �promoting foreign investment in PPPs through consultation services and other related activities, developing and operating capacity-building programs for public sector practitioners; �conducting policy research related to PPP programs and providing policy advice to MOSF and procuring ministries; �developing implementation guidelines for efficient and consistent implementation of PPP projects.
4.3. Procurement Procedure
The private sector may identify a needed infrastructure that may involve innovative proposals for management and offer the potential for sharing of new technology. For projects where the private operates for a specified period of time (e.g. Build-Transfer-Operate), the
097 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia private partner realizes a reasonable return on its investment by charging a user fee. For projects where the private rents for certain period of time (e.g. Build-Transfer-Lease), the private partner recovers its investment through payments made by the central or local government. Considering that BTO projects are highly dependent on user demand while BTL projects can operate irrespective of user fee, project risk involved for the BTL method is relatively low. If the private sector has an option to pursue BTL projects as unsolicited from the government, it could be over-motivated, resulting in reckless proposals of projects.
In Mongolia according to the Concession Law, Mongolian and foreign legal entities may submit an unsolicited project proposal to conclude a concession agreement (Article 18, Mongolian Concession Law). The Korean PPP Act, in this respect, states that project mode by which the concessionaire rents the facility for a specific period (e.g. BTL) shall not be implemented as an unsolicited project (Article 9, Korean PPP Act). The Mongolian government needs to address the fiscal risk incurred by unsolicited project proposals through improving the procurement process.
Table 2-3 | Comparing BTO and BTL Projects BTO(BOT, BOO) BTL Investment return User fee Government payment Schools, Military housing, Sewage Facility types Roads, Railways, Seaports, etc. pipes, etc. Project risks Relatively high Relatively low Return Relatively high Relatively low
Source: Ministry of Strategy and Finance and Korea Development Institute. Building a Better Future through Public- Private Partnerships in Infrastructure in Korea. 2009
PPP projects in Korea are categorized into solicited and unsolicited, depending on who initiates the project. For solicited projects, the competent authority, central or local government, identifies a potential PPP project and solicits proposals from the private sector. In other words, competent authorities develop a potential project after considering related plans and demands for the facility. They then weigh the procurement options in order to determine whether the PPP procurement is more efficient than the conventional procurement. For unsolicited projects, the private sector identifies a potential PPP project and requests designation of the PPP project from the competent authority. The private sector proposes a project that is in high demand but has been delayed due to government budget constraints. After considering factors, such as demand, profitability, project structure, construction and operating plans, and funding, the private partner creates a project plan and submits the proposal to the competent authority. The concessionaire is appointed under competitive bidding, although the initial proponent may obtain extra points in bid evaluation.
098 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia The procurement procedure is designed to secure or enhance value for money (VFM) of PPP projects. In the planning stage, VFM assessment of a potential project is carried out in order to ensure VFM of PPP procurement in comparison with traditional public procurement. In the bid selection stage, competitive bidding is mandatory both for solicited and unsolicited projects, which leads to further improving VFM of the project concerned by encouraging bidders to competitively propose heightened service qualities and reduced project costs.
In the case for BTO projects, after conducting a VFM test to evaluate its potential as a PPP project, competent authorities announce Request for Proposals (RFPs) and evaluate proposals for selection. RFPs includes project plan and implementation terms and conditions, such as the project outline, total project cost, operational profit, construction and operation plans, and government support.
Figure 2-10 | Procurement Procedure for BTO Project
Solicited Project Unsolicited Project Private Sectorơ Competent Authority Selection of PPP Project Submission of Project Proposal Competent Authority ^ ^
Competent Authority PIMAC Review PIMAC VFM Test VFM Test ^ ^
Notification of Project Competent Authorityơ Competent Authority Designation as the PPP project Implementation Proponent ^ ^ ^
Announcement of RFPs Competent Authority ^
Private Setorơ Submission of Project Proposals Competent Authority ^
Evaluation and Selection of Competent Authority Preferred Bidder ^
Negotiation and Contract Award Competent Authorityƥ (Designation of Concessionaire) Preferred Bidder ^
Application for Approval of Concessionaireơ Detailed Implementation Plan Competent Authority ^
Construction and Operation Concessionaire
Source: Ministry of Strategy and Finance and Korea Development Institute. Building a Better Future through Public-Private Partnerships in Infrastructure in Korea. 2009
A BTL project is initiated by the competent authority, reviewed by the Ministry of Strategy and Finance to decide on an aggregate investment ceiling for BTL projects, which is then approved by the National Assembly.
099 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia Figure 2-11 | Procurement Procedure for BTL Project
Selection of BTL Project Competent Authority ^
VFM Test & Application of Investment Ceiling Competent Authority, Review by PIMAC ^
Determination of Aggregate Investment MOSF Ceiling for BTL Projects ^
National Assmbly Approval National Assembly ^
Designation as the PPP project Competent Authority, Re ^ Same as Procedure forr BTO Solicited Project
Announcement of RFPs Competent Authority, Review by PIMAC ^
Submission of Project Proposals Private Sector ơCompetent Authority ^
Evaluation and Selection of Preferred Bidder Competent Authority ^
Negotiation and Contract Award Competent Authority ƥPreferred Bidder (Designation of Concessionaire) ^
Application for Approval of Cncessionaire ơCompetent Authority Detailed Implementation Plan ^
Construction and Operation Concessionaire
Source: Ministry of Strategy and Finance and Korea Development Institute. Building a Better Future through Public -Private Partnerships in Infrastructure in Korea. 2009
4.4. Facility and Objects Eligible for Concession
The eligible infrastructure facility or the objects eligible for concession are not explicitly referred to in the Mongolian Concession Law but are only documented in State Policy on Public-Private Partnerships on the Annex to the Resolution by the Grand State Assembly of Mongolia in 2009. According to the Concession Law, line ministries and National Development and Innovation Committee (NDIC) (“state central administrative authority in charge of the relevant matter and the state administrative authority in charge of investments”) jointly submit a proposal for a concession item together with the cost and benefit analysis to the authorized entity7) (Article 9.1, Mongolian Concession Law). The authorized entity submits the list of objects offered for transfer as concessions to the Citizen’s Representative Assemblies. In Korea,
7) The State Property Committee (SPC) is designated as the state administrative authority in charge of state property in the case of a state owned property that is a concession item; the governor of the aimag (Mongolian province) or the capital city is designated as authorized entity for a local property that is a concession item (Article 3.1.7, Mongolian Concession Law).
100 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia the eligible facility types are stated in Article 2(1) of the PPP Act and in Article 1-2 of the Enforcement Decree8); designation as PPP project and being implemented as such is thus limited to those facilities as stipulated in the Act and the Enforcement Decree.
4.5. Tendering and Direct Agreement
In Mongolia concessions may be publically tendered or in some cases directly negotiated with a firm. While Article 14.5 of the Concession Law specifies that the procedure of submitting project bids and that their evaluation shall be open to the public and shall be published in the daily press, Article 17 stipulates that a concession can be granted by concluding a direct agreement under certain circumstances. However, the award of projects without competition from other bidders may expose the government to criticism of the public, and, moreover to possibility of corruption. Prospective lenders such as foreign investors and multilateral financial organizations may have difficulty in lending for projects that have not been the subject of competitive selection proceedings.
4.6. Government Financial Support for Risk Sharing
In Korea, as measures to share or reduce private sector's risk and to vitalize the infrastructure markets for PPP projects, the government in its initial stage of PPP, has promulgated various kinds of policies that can facilitate infrastructure financing.
According to the PPP Act, the government may grant a construction subsidy to the concessionaire. The timing of the subsidy is determined in the course of the concession agreement and depends on the equity investment plan of the concessionaire. The amount of subsidy is determined in each individual concession agreement. The exact ratio of subsidy to construction cost is determined through consultation and is stipulated in the concession agreement.
In addition to the construction subsidy, the government provided an operational revenue subsidy through the Minimum Revenue Guarantee (MRG) and redemption agreement, up until the revision of the PPP Basic Plan in October 2009. The MRG system is a method for private participants and the government to share the revenue forecast risk. The higher the MRG level, the more the risk is transferred to the government from private participants. The MRG and redemption agreement is a two-part structure: if the operational revenue falls short of the lower limit, the government makes up the difference between the lower limit and the actual revenue. If, on the other hand, the revenue exceeds the upper limit, the government redeems the difference, and receives the excess revenue from the private.
8) Refer to Appendix 2 for complete text of the articles of the PPP Act and the Enforcement Decree.
101 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia The MRG payment provided support for private participant’s minimum revenue as projected in the concession agreement. The newly adopted risk sharing structure (October 2009) compensates for the private participant’s base cost. Under the new risk sharing mechanism, the government shares investment risks with the private company by compensating the base (raw) cost of the project,9) calculated as the sum of private investment cost and the interest rate of government bonds. While the former encouraged private participation but caused moral hazard because of the unreasonably low risk of the private participant, the latter decreases the investment risk for private participants as well as enhancing their motivation to make profit. Concurrent with the introduction of the new risk sharing structure, the MRG system was ended.
Foreign investors are encouraged to participate in Korean PPPs. They are granted the same incentives as domestic investors and are also entitled to additional benefits including tax credits and financial support. When foreigners invest more than US$10 million in a Foreign Investment Area, tax breaks (corporate tax, income tax, acquisition tax, registration tax, and property tax) are granted. When foreign exchange losses arise from loans in foreign currency for construction due to fluctuation in the foreign exchange rate, the government can offer subsidies or long term loans.
Figure 2-12 | Financial and Tax Incentives for Korean Public-Private Partnership Projects
Types Construction Period Operating Period
Subsidy: ‿@Construction Subsidy ⁀@Compensation for base (raw) Cost
Guarantee System: ⁁@Infrastructure Credit Guarantee via Infrastructure Credit Guarantee Fund
Tax Incentives: ⁂@Special Taxation, Corporate Tax, Local Tax, exception from charge
Early Termination ⁃@Guidelines for Early Termination
Source: Republic of Korea Ministry of Strategy and Finance. Basic Plan for Private-Private Partnership in Infrastructure 2010.
Compensation on early termination is a critical risk mitigating factor for private participants, because it enables the project company to fund debts at attractive rates. In Korea when the concessionaire cannot maintain the facility for various reasons, it may request the government to terminate the concession agreement and pay the predefined early termination payment. When
9) Refer to Appendix 3 for structure of new risk sharing mechanism.
102 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia this happens, the government takes over the right to operate the infrastructure facilities. The method of calculating the amount of payment and reasons for termination are stipulated in the concession agreement.10)
4.7. Fiscal Risk Management
Although PPPs can accelerate establishment of social infrastructure by addressing the problem of limited financial resources, it is not desirable to increase the amount of private investment without setting an upper limit. Private sector investment can merely indicate government lending from the future generation, and therefore a loan to pay off in the mid and long term.11)
In developing BTO projects in Korea, as discussed above, the government has provided subsidy during operations through MRG. Guarantees in such forms, unlike construction subsidies that involve fixed costs, creates higher fiscal risks due to difficulty in accurately calculating the revenue. For many of the BTO projects in Korea, the government bore more risk than the concessionaires, and the actual payment for minimum revenue guarantee significantly increased in recent years.12) As response to the growing fiscal burden, the government revised the policy in early 2006, abolishing MRG for unsolicited projects, to be abrogated for all PPP projects subsequently in 2009.
Concession types that involve government payment, especially projects that are under a financial lease arrangement (Build-Lease-Transfer), may be exposed to government fiscal risk. Legal mechanisms that sets limit to such payment needs to be explicitly indicated, as to identify, control, and mitigate unexpected fiscal risk that may involve in the process of lease payment during the concession period. In Korea, according to Article 7-2 of the PPP Act, the government has to submit the aggregate ceiling to the National Assembly, thereby limiting the amount of BTL projects to be conducted in the following year. The government submits to the National Assembly the total maximum amount, maximum amount by objective facilities, maximum amount of reserve funds for any unpredictable expenditure during the course of the promotion of the projects, and details of how the reserve funds for each objective facility have been used in the preceding year with regard to the BTL projects through deliberation of the State Council and approval by the president (Article 5-2 of the Enforcement Decree on the Korean PPP Act).
10) Articles related to financial support in the PPP Act are provided in Appendix 4. 11) Kim, Jay-Hyung "Estimation of Fiscal Commitment in Korean Public-Private Partnerships and Development of a Safeguard Guideline." Performance Evaluation and Best Practice of Public-Private Partnerships. Ed. Jay-Hyung Kim. Korea Development Institute. 2007. 12) Kim (2007)
103 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia 5. Policy Recommendations 5.1. Complement and Strengthen Legal and Institutional Framework
To effectively introduce and execute PPP projects in infrastructure, respective regulatory and institutional bases need to be ready. Considerable progress for PPP has been made with the establishment of its legal framework; the Law on Concessions has been prepared by the government and was ratified by the parliament on January 28, 2010 after the approval of Government's Policy on PPP in late 2009. A PPP unit was established within the SPC by the Prime Minister's order No. 31 in April 2010. However, it is also to be noted that the Law on Concessions is still generic and many areas in terms of legal regulations and processes are yet to be covered. It will no doubt be facing challenges of legal loopholes that allow circumvention or avoidance of some of the most critical regulatory stages, which must be addressed through detailed guidelines. Furthermore, more clear cut institutional arrangements specifying roles and responsibilities of key players need to be in place.
The first priority regarding the development of a countries' PPP legal framework is to formulate regulations for the actual implementation of the law. Detailed procedures and guidelines need to be put in place through government and ministerial decrees. In this regard, the issuance of guidelines needs speeding up to ensure the full implementation of the Law on Concessions. Although regulations on the competitive bidding process is in the process of being prepared, others need to be developed: rules and regulations on bid evaluation process; contract monitoring and enforcement; guidelines for preparing request for qualifications, request for proposals, and for performing cost and benefit analysis, value for money analysis, among others.
Whether a strict hierarchical legal arrangement is required (of Act- Enforcement Decree- Basic Plan-Implementation Guidelines, as in the case of the Korean PPP legal arrangement) is subject to the country's legal system, but establishing detailed guidelines according to the type of infrastructure project is strongly advised. Formulation of template documents to be adopted as standard written record as part of detailed implementation guidelines is thus recommended. In this regard, a comprehensive standard concession agreement is a prerequisite in assisting contracting institutions to reach the win-win situation with the concessionaire and the user of the project.
In order to successfully implement the bidding process, prequalification criteria should be based on the legal status, technical and financial capacity as well as conformity with the governments' investment strategy. The evaluation factor should be based on the best technical and financial proposals and PPP projects should be pursued only when they offer value for
104 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia money compared to the standard public procurement method. Also concession projects should be part of the government investment strategy and medium term fiscal framework in order to reduce investment plan to adequate levels and utilize other sources of finance. This would allow optimizing project impacts while raising profitability for a given level of investment.
Since many government or public sector stakeholders are involved in concession projects, a good institutional arrangement is also a key for success and to ensure that the process in its entirety goes smoothly. The government should determine the role and function of all the relevant ministries and institutions into the government decree on the implementation of the Law on Concessions to avoid duplicative functions and the conflicts of interest. Interplay among the budget ministry, the line ministries and PPP unit within SPC for regulating fiscal expenditure needs to be defined specifically. In the Mongolian PPP system, unlike many other countries, the Ministry of Finance seems to play a minimal role in the PPP procedure, and roles and functions of the Ministry of Finance do not seem precise enough. To ensure that the fiscal implications of concessions are fully taken into consideration in the government's medium term fiscal framework and the budget, concession projects should not be allowed to move forward outside the regular cycle of other investment projects. This, in turn, should be supported by the legal and institutional setup that handles concessions. Also the institutional arrangements have to regulate entity that has the power to enter into negotiations that can take decisions on all types of PPP infrastructure projects.
5.2. Build a Transparent and Competitive Procurement Process
There are certainly cost and time resources required in a transparent tender process. However there is no other way of ensuring that the public service is procured in a manner that stands the test of public scrutiny. In particular, transparent and effective procurement practice in developing countries carries as much importance as a sound legal framework because transparency has the potential to reduce opportunities for corruption.
Documentation opts for transparency, which induces fair competition in bidding. Also, clear access to information on the content of the project proposal, standard concession agreement, government support and guarantees should be opened to the public. It is also recommended that a standard bidding document be formulated, to be dispersed to those interested, whether domestic or foreign, in bidding for the project. A good standard bidding document will ensure that the selection process proceeds smoothly and transparently. This will help the contracting institution find the best concessionaire as a partner.
PPP procurement, bid, and evaluation methods suggest ways for optimal procurement for a transparent selection process, which contributes to fostering a competitive PPP market. Advocating a competitive bidding process is required for Mongolia, with standardized sets of processes and guidelines. Ways to promote competition for proposals include addressing
105 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia reimbursement issues of proposal preparation costs of unsuccessful proponents, announcing contents of alternate proposals when pursing unsolicited projects, designating two or more potential concessionaires, and simplified proposal documents.
The Mongolian government should focus on the transparent tendering process, and a well articulated RFP package can aid significantly in this respect. It is recommended that the government carefully evaluate the robustness of financing proposals at the time of a bid submission.
As discussed earlier in the chapter, particularities of the country must be considered prior to implementing an advanced private partnerships system. In this respect, transparency might not come as a priority issue in addressing the institutional setting. However, as foreign investors as opposed to domestic private partners, are expected to be involved for the time being, high level of certainty is indispensable. Political unrest and corruption threaten investment and changes in political priorities may undermine the economic viability of projects. Transparency in concession negotiations ensures that decisions are sustained from one government to the next.
5.3. Attract Private Participants through Incentives and Risk Sharing Mechanisms with Appropriate Fiscal Management
Considering the investment gap in infrastructure in Mongolia, several financing challenges need be addressed. The estimated investment needs of about US$3,000 million by 2015 is a huge challenge, in a country with a GDP of around US$5 billion and with borrowing constraints of about 10% of GDP per year.13) Prioritization within sectors and increase in the investment efficiency needs to be tackled. Given Mongolia’s sovereign credit rating at B+, which is below the investment grade, there should be continuous need to utilize its concessional and government guarantee capacity to meet much of its investment needs.
Private investment can only be secured if private investors are confident they will earn a reasonable return on their investments. In the infrastructure sector, this implies that tariffs should cover costs. Particularly for the initial PPP transactions, private infrastructure investors will require government guarantees in respect of certain classes of risks.
PPP projects should benefit from a fair risk allocation between government procurers and private sector participants. Adequate risk sharing is a key requirement if PPPs are to deliver high quality and cost-effective services. Successful PPPs require that the different types of risks be borne by the party that can manage it best. Construction and operating risks are typically borne by the private sector, whereas the political, regulatory, exchange rate, and residual value
13) International Bank for Reconstruction and Development. "Southern Mongolia Infrastructure Strategy." World Bank. 2009.
106 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia risks are generally borne by the public sector.
Again, in principle, those parties that are in the best position to manage and mitigate the risk should bear the risk. But in practice, and in many instances, this means that private sector developers should be responsible for construction and operation risks, while procurers should bear a certain level of demand risk, regulatory and force majeure risks.14) While unrealistic or over-ambitious expectations for risk transfer on behalf of government procurers may prove counterproductive by negatively impacting the private sector, properly incentivizing it, is also necessary to successfully deliver the needed infrastructure.
The urgent need to supply infrastructure facilities, which are in many cases located in uncertain markets and physical environments, render Mongolia to consider providing incentives, such as government risk sharing mechanisms, to attract private money. In order to attract sustainable private investment and involvement, there is urgency not only for policy and regulatory reforms, but also mechanisms to ensure a level playing field for private providers based on confidence that such a regime will extend into the long term.
Most infrastructure services are set to be natural monopolies under various state run agencies, but PPPs require delegation of power among state agencies and protection of private investor's rights. Cautious but innovative approach leading infrastructure business entities to a commercially sustainable footing in longer term, will be crucial for the successful development of Mongolia's infrastructure.
In order to attract sustainable private investment and involvement, Mongolia needs a readjustment of pricing policy to ensure a level playing field for private providers based on cost based tariffs. As far as tariffs for infrastructure services are concerned, road transport, power and water utilities services, particularly in Ulaanbaatar, are significantly under priced or below operating costs. Setting independently regulated cost recovery or market based tariffs combined with the central government funded subsidy mechanism, followed by a gradual introduction of transport pricing reform, is urgent in order to increase private sector involvement.
On the other hand, because guarantees come due only if particular events occur and involve no immediate cost to the government, such promises to the private may seem attractive to political decision makers. In light of Korean experiences on government guarantees, it should be noted that when the government makes guarantees it should ensure that it has the financial capacity. The government should report publicly on the guarantees that are given and the maximum liability of the government. In other words, if the government bears the risk and potentially faces high fiscal costs due to the explicit guarantees or incentives included in PPP
14) Vojc, Christoph, Jonathan Robinson, and Michael Cooper, "Infra Evolution Revs Up." Project Finance International. IFR/PFI Middle East Report 2010. Retrieved from
107 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia contracts, especially over the medium to long term, the fiscal implications of PPPs should be properly accounted for and reported. They should be fully disclosed and incorporated into medium-term policy analysis not to bypass expenditure controls. Public access to information ensures that government and potential private sector partners are accountable for agreed-upon outcomes
Fiscal management for PPPs needs to be taken into account, while incentives to promote PPPs are provided at the same time. Government guarantees often have potentially significant social consequences. A safeguard ceiling for PPPs may emphasize that even if the government drives large-scale infrastructure projects forward, the aggregate fiscal commitment should be limited to a sustainable level for maintaining fiscal soundness and stability.
5.4. Build Capacity of SPC and Provide Training for Public Sector Officials
PPPs require development of specific technical expertise within the government. In particular, the government has to be able to conduct thorough project appraisals and prioritizations, manage projects, and ensure that PPPs are consistent with broader fiscal and economic policy objectives. Also the government needs to negotiate and deal with the private sector in the most effective manner.
As PPP practice develops, knowledge in PPP procurement methods and its implications must be disseminated throughout relevant agencies through training, promotion and advocacy. Because PPP represents different approach to procurement of infrastructure services, generally, specialized teams are created in order to focus specialist skills on the development and management of PPP projects.
In this regard, the government of Mongolia established PPP and the Concession Department under the Concession Law in charge of PPP projects within the State Property Committee in order to undertake capacity building and education programs. It is needless to say that officials of all relevant ministries are trained to successfully implement PPP projects.15)
The problem, however, seems to be that even the current PPP unit lack manpower and expertise. It is recommended that the number of staff in the PPP unit be increased substantially, including additional financial specialists, accountants and engineers. Positioning of the experts in relevant fields in order to accumulate the necessary competence and capacity over time seems crucial for the department at this stage.
15) Due to the lack of capacity of line ministries and of proper guidelines, only a few projects included in the Concession Items List seem to have strong potential to be implemented through concession procedure set out in the Concession Law. Further steps should be taken to enhance quality of project proposals by the line ministries and to gather more information regarding those projects.
108 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Adequate and regular funding is a prerequisite. While PIMAC, as the sole PPP unit in Korea is funded by the government with additional funding from the fees levied upon competent authorities, SPC is funded by GTZ. Although it will be converted to state budget funding from January 2011, various activities, such as hiring of consultants, capacity building programs are financed by international institutions and donors.
Yet, there seems to be a lot of expectation from the government and private sector stakeholders, even at this early stage of PPP development, which may come as impediment to successful implementation of projects.
On the other hand, SPC should perform training and education for government officials in charge of concession projects to disseminate information that may include international experiences and customized guidance on the preparation processes, etc.
In Korea, the PPP Act mandates that PIMAC provides training and education programs and lays down the regulations on "developing and operating educational programs with respect to the implementation of PPP projects" in Article 23 of the Act and Article 20(8), of its Enforcement Decree on the duty of PIMAC. Training and education courses are provided for working group officials and decision makers in both public and private sectors.
Meanwhile, as the PPP program became increasingly more active, a number of foreign countries have requested capacity building programs to study the Korean PPP system from PIMAC as their benchmarking model. The Memorandum of Understanding signed in November 2010 between SPC and KDI states the importance of cooperation and exchange of information on PPPs. Efficient use of external sources such as experts from PIMAC would enable needed transfer of knowledge. KDI PIMAC has expressed willingness to assist SPC by providing capacity building programs and advisory services.
Furthermore, SPC is recommended to be supported by the central government for the initial transactions through a learning by doing approach. In the absence of experience and shortage of knowledge on PPP implementations, one or two pilot concession projects, as an attempt at minimizing the many trials and errors, seems appropriate. Pilot projects with support of international transaction advice are recommended. It then needs to prepare for the next transactions on its own by transforming the accumulative information from advanced foreign PPP units to knowledge that is specific to Mongolia.
109 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia 6. Summary and Conclusion
For governments in many countries, PPP provides a means to deliver key infrastructure projects as it limits pressure on both short term cash flows and reduces the need to borrow heavily. Once the cost benefits in terms of whole life costing and private sector efficiencies, PPPs may seem attractive. This provides governments with impetus in recognizing the role that PPPs can play in helping to bridge the infrastructure gap. The financial constraints that the Mongolian government is currently facing, provides the opportunity for PPPs and concession projects to deliver much needed infrastructure investments. Taking this opportunity will require the state to be courageous in continuing to invest in key infrastructure. In the long run, it will reap the benefits of higher GDP growth, improved standards of living for the citizens and higher levels of inward bound investment.
Time spent early may save exponentially later. Learning from the experience of other countries good or bad will facilitate refining of a program that is realistic and credible for the private sector and deliverable for government stakeholders. Mongolia's identification of a dedicated team to act as the principle driver of a PPP initiative and as liaison with various host government stakeholders was an effective start. Capacity building, transparency and, ultimately, strong stakeholder support from responsible ministries will be critical to embracing the PPP scheme.
The challenge for concession projects in Mongolia remains, as the scheme is yet untested and so many are categorized as priority projects. However, given the political willingness, the foundation laid out by the new Concession Law, and the burgeoning economy of the country, PPPs provide a viable mechanism that can deliver strong results in the long term.
Given various indicators, the lack of basic infrastructure clearly acts as a major factor constraining economic growth in Mongolia. Huge investment in the mining sector is putting increased pressure on the already inadequate infrastructure. New approaches to provide the investment needed to modernize Mongolia's infrastructure are required, and a well structured concession scheme and an internationally competitive legal and regulatory framework for concessions are key instruments to attract the much needed private investments as a partner in developing infrastructure.
The current infrastructure status and the regulatory system of concession scheme, together with its assessment in comparison to the Korean PPP system, leads us to policy recommendations that have, in our opinion, the utmost importance in settling down and refining the PPP based model in Mongolia. The policy lessons aim to establish strategic directions for the Mongolian government, based upon Korea's PPP experiences, now heading toward actual implementation of the scheme.
110 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Key policy recommendations, in particular, are as follows: establishing a solid legal and institutional framework; building a transparent and competitive procurement process; attracting private participants through incentives and risk sharing mechanisms; and educating public sector officials through training and capacity building.
With the big picture of the legal framework, along with the list of concession projects now in place, detailed guidelines according to specific sector and different procurement procedures of the program needs to be formulated before the actual implementation of concession projects. SPC, as an authority in charge of the tendering process, needs to quickly adopt guidelines specifying on project evaluation and requests for proposals. Each line ministry need harmonized feasibility and value for money study guidelines.
Much of the private sector involvement in public procurement is about transparency, and competition is incurred through fairness and transparency. Standard documents for bidding that clearly and comprehensively address the contents of proposals (or alternate proposals in the case of unsolicited projects), financing and reimbursement issues, would provide guidance for the proponents that intend to participate in the tendering.
Considering Mongolia's critical need to build infrastructure facilities in strategic mining areas and in improving citizens' lives, the governments' commitment to attract private party participants seems all the more urgent. Government support, in forms of financial subsidy or loan guarantees, could be considered to induce the private sector's domestic or international active participation. However, decisions about whether or not to rely on private finance must balance the fiscal pressures facing the government against a candid appraisal of whether the political system can provide a sufficiently attractive environment for private investment.
Hiring of experts and capacity building of SPC's concession department, which acts as the main institution for delivery of concession projects, is crucial. Advice and consultation from foreign advanced PPP units may come in handy at this initial implementation stage of concession projects. Public sector stakeholders including procuring ministries, needs training for the new delivery method using private finance in infrastructure building, and SPC has to be able to implement this training session.
Provided financial difficulties of both the public and domestic private parties of Mongolia, implementation of concession projects would involve significant amount of foreign investment. Future research should therefore concentrate on defining the role of foreign partners and setting up legal/institutional bases for foreign investors that are compatible to the Mongolian political and economic environment.
111 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia References
Business Council of Mongolia. “BCM's Comments on draft Concession Law." December 2009. Retrieved from http://www.bcmongolia.org/legislative-working-group/320-bcms- comments-on-draft-concession-law
Delmon, Jeffrey, Private Sector Investment in Infrastructure: Project Finance, PPP Projects and Risks, Second Edition. World Bank and Kluwer Law International. 2009.
Economic Policy Reform and Competitiveness Project. “Mongolia's Infrastructure Deficit, Public Private Partnerships and Concessions Law.” USAID. October 2009. Retrieved from http://www.eprc-chemonics.biz/index.php/news/44-mongolias-infrastructure-deficit- public-private-partnerships-and-the-concessions-law.html
Estache, A., A. Iimi, and C. Ruzzier. “Procurement in Infrastructure: What Does Theory Tell Us?” Policy Research Paper 4994, World Bank, July 2009.
Eurasia Capital. “Infrastructure in Mongolia: Challenges and Opportunities.” April 2009.
Frost Giles, “Changing Face of Investment.” Project Finance International. PFI Yearbook 2011. Retrieved from http://www.pfie.com/616302.
Government of Mongolia. Law of Mongolia on Concession, 2010.
Government of Mongolia. Resolution on Approval of the Action Plan of the Government for 2008-2012.
International Bank for Reconstruction and Development. “Southern Mongolia Infrastructure Strategy.” World Bank. 2009.
International Bank for Reconstruction and Development. “Southern Mongolia Infrastructure Strategy.” World Bank. 2009.
Kim, Jay-Hyung “Estimation of Fiscal Commitment in Korean Public Private Partnerships and Development of a Safeguard Guideline.” Performance Evaluation and Best Practice of Public Private Partnerships. Ed. Jay-Hyung Kim. Korea Development Institute. 2007.
Kim, Kang-Soo, Touch Eng. “Improvement on Legal and Procedural PPP System in Cambodia,” Microfinance and Public Private Partnership (PPP) Development in Cambodia, Ministry of Strategy and Finance and Korea Development Institute. April 2010.
112 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Ministry of Strategy and Finance and Korea Development Institute. Building a Better Future through Public Private Partnerships in Infrastructure in Korea. 2009.
OECD, Public Private Partnerships: In Pursuit of Risk Sharing and Value for Money. 2008.
Public-Private Infrastructure Advisory Facility. “Foundation for Sustainable Development: Rethinking the Delivery of Infrastructure Services in Mongolia.”World Bank. June 2007.
Regional Environmentally Sustainable Transport (EST) Forum. “Sustainable Transport: Challenges, Strategy of Mongolia.” Presentation in Seoul, Korea. 24 26 February, 2009.
Republic of Korea Ministry of Strategy and Finance. Act on Private Participation in Infrastructure 2010.
Republic of Korea Ministry of Strategy and Finance. Basic Plan for Private Private Partnership in Infrastructure 2010.
Republic of Korea Ministry of Strategy and Finance. Enforcement Decree on the Act on PPP 2010.
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World Economic Forum. The Global Competitiveness Report 2010-2011. Geneva. 2010.
113 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia [Appendix 1] LIST OF CONCESSION ITEMS FOR IMPLEMENTATION UNDER PPP PRINCIPLES
(Annex to the Government Resolution, 2010)
No. Project Name Projects for Construction of Apartment Blocks 1 Apartment blocks XIV 2 Infrastructure of apartment blocks XIV 3 “Zuun Selbe” (Eastern Selbe) apartment blocks 4 Infrastructure of “Zuun Selbe” (Eastern Selbe) apartment blocks 5 Apartment blocks VII 6 Infrastructure of apartment blocks VII 7 Apartment blocks in the vicinity of Mongolian National Broadcaster (MNB TV & Radio) 8 Infrastructure of apartment blocks around Mongolian National Broadcaster (MNB TV &Radio) 9 “Gandantegchilen Monastery’ apartment blocks 10 Infrastructure of “Gandantegchilen Monastery” apartment blocks 11 “Denjyn Myanga” apartment blocks 12 Infrastructure of “Denjyn Myanga” apartment blocks 13 Apartment blocks in the vicinity of Hanyn Material 14 Infrastructure of an apartment blocks in the vicinity of Hanyn Material 15 Infrastructure of “Buyant Ukhaa” complex apartment blocks 16 Infrastructure of “Bayangolyn Am” complex apartment blocks 17 Infrastructure of “Urgah Naran” apartment blocks 18 Infrastructure of “Shine Yarmag” (New Yarmag) complex apartment blocks 19 Infrastructure of “Ireedui” (Future) complex apartment blocks 20 Infrastructure of “Four Season’s Garden” complex apartment blocks Project on construction of new apartment blocks upon demolishing existing apartments in 21 some districts of the capital city 22 Infrastructure of “Golden Park” complex apartment blocks 23 Infrastructure of “Erin” complex apartment blocks 24 Apartment block # 19 25 Engineering infrastructure of apartment blocks # 19 26 Apartment block “Eermel” 27 Engineering infrastructure of apartment blocks “Eermel” 28 Apartment blocks along Narny road 29 Engineering infrastructure of apartment blocks along Narny road 30 Apartment block in the vicinity of Dund river 31 Engineering infrastructure of apartment blocks in the vicinity of Dund river 32 Project on Apartment blocks for lease 33 Engineering infrastructure of Project on apartment blocks for lease 34 Apartment blocks in Baganuur District
114 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia (Annex to the Government Resolution, 2010)
No. Project Name 35 Engineering infrastructure of apartment blocks in Baganuur District 36 Apartment blocks in Bagakhangai District 37 Engineering infrastructure of apartment blocks in Bagakhangai District 38 Apartment blocks in Nalaikh District 39 Engineering infrastructure of apartment blocks in Nalaikh District 40 Sub project on apartments for provincial centers 41 Engineering infrastructure of sub project on apartment blocks in province centers 42 “Inter-Soum Center” pilot project 43 Burgastai port building project 44 Shiveehuren port building project 45 Bulgan port building project 46 Gashuunsuhait port building project Road Projects Rood Projects 47 Road project on construction of Ukhaa Hudag-Gashuun Sukhait route 48 Road project on construction of Oyu Tolgoi-Gashuun Sukhait route 49 Road project on construction of Tavan Tolgoi - Khanbogd-Hangi route 50 Road project on construction of Naryin Sukhait-Shivee Khuren route 51 Road project on construction from Yarmag bridge to Bayanzurkh post 52 Road project on construction between Ulaanbaatar city to new airport 53 Road project on construction of Altanbulag-Ulaanbaatar route 54 Road project on construction of Ulaanbaatar-Zamyn Uud route 55 Road project on construction of Undurkhaan-Choibalsan route 56 Road Project on construction of Choibalsan-Ereentsav route 57 Road project on construction of Undurkhaan-Munhkhaan-Baruunurt route 58 Road project on construction of Baruun Urt-Erdenetsagaan-Bichigt route 59 Road project on construction of Undurkhaan-Norivlin route 60 Road project on construction a paved road of Norivlin-Bayan Uul - Country border route 61 Road project on construction of Ulaanbaatar-Mandalgobi route 62 Road project on construction of Mandalgobi-Dalanzadgad route 63 Road Project on construction of Dashinchilen-Bulgan route 64 Road project on construction of Khutag Undur-Teshig-Baga Ilenh route 65 Road project on construction of Tarialan-Moron route 66 Road project on construction of Ugyi Lake-Battsengel - Ikh Tamir route 67 Road project on construction of Tsahir - Tosontsengel route 68 Road project on construction from Tosontsengel to Nomrog-Songino soums
115 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia (Annex to the Government Resolution, 2010)
No. Project Name 69 Road project on construction of Songino soum-eastern bank of Hyargas lake route Road project on construction of eastern bank of Hyargas lake-Nomrog-Naranbulag- 70 Ulaangom route 71 Road project on construction of Nomrog-Tsagaan Tolgoi (Arts suuri) route 72 Road project on construction of Tosontsengel-Uliastai route 73 Road Project on construction of Uliastai-Altai route 74 Road project on construction of Altai-Bugat route 75 Road project on construction of Bugat-Burgastai route 76 Road project on construction of Altai-Darvi route 77 Road project on construction of Darvi-Manhan route 78 Road project on construction of Bayankhongor-Baidrag route 79 Road project on construction of Baidrag bridge-Altai route 80 Road project on construction of Bayankhongor-Bayanleg route 81 Road project on construction of Bayanlig-Gurvantes route 82 Road project on construction of Bayankhongor-Gurvanbulag route 83 Road project on construction of Gurvanbulag-Uliastai route 84 Road project on construction of Uliastai-Dorvoljin route 85 Road project on construction of Dorvoljin-Sarkhairkhan bridge route 86 Road project on construction of Sarkhairkhan bridge - Myangad bridge of Khovd route 87 Road project on construction of Khovd-Ulaangom route 88 Road project on rehabilitation of Ulaanbaatar city 89 Road project on construction in Ulaanbaatar city 90 Project on construction of foot bridges in 7 points/locations of Ulaanbaatar city 91 Auto Terminal Projectin Zamyn Uud soum, Dornogobi province 92 Ulaanbaatar Logistics terminal project 93 International airport in Dalanzadgad soum, Umnugobi province Railway Projects Railway Projects 94 First part of Railway development 95 To rehabilitate existing old railways of Sukhbaatar-Zamiin uud route Industrial Parks Industrial Parks 96 “Sainshand” industrial park Project Power Projects Power Projects 97 Tavan Tolgoi Power Plant 98 Power Plant # 5 99 Establish “Ikh Toiruu” loop grid network
116 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia (Annex to the Government Resolution, 2010)
No. Project Name 100 Increase of heat supply 101 Power Plant in Dornod province 102 Thermal Power Plant at Mogoi river 103 Shivee-Ovoo project 104 Overhead power lines for Ulaanbaatar-Mandalgobi route 105 Overhead power lines for Baganuur-Choir route 106 Overhead power lines for Choir-Tsagaan Suvarga route 107 Power Plant # 3 project 108 Erdenet Power Plant LLC Projet 109 Establishment of Orhon-Gobi Reservoir 110 Tuul-Songino Water Resources Complex 111 Producing energy out of waste processing Rehabilitation of Central Waste Water Treatment Plant of UB city and Pre-Treatment 112 Facilities Education Projects 113 University Campus and town of Information & Technology 114 Project “E-School” 115 Project “Food Factory” Health Projects 116 Telemedicine center 117 National Stadium 118 Project “E-health system” Environment Projects 119 Tuul and Selbe rivers development project Information Communication Technology Projects 120 Project “Unified/Consolidated Portal of the Government” 121 Project ”Management System of Business Records and Permissions”
117 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia [Appendix 2]
Republic of Korea Law and Regulations of Public Private Partnerships in Infrastructure for 2010
ACT ON PUBLIC-PRIVATE PARTNERSHIPS IN INFRASTRUCTURE
CHAPTER Ⅰ GENERAL PROVISIONS
Article 2 (Definitions)
The definitions of terms used in this Act shall be as follows:
1. The term "infrastructure facilities" means fundamental facilities which serve as the foundation of production, increase the efficiency of such facilities, and accommodate the convenience of users and in the lives of the public, and which fall under any of the following items: (a) Roads and appurtenances thereof prescribed in Article 2 (1) 1 and 4 of the Road Act; (b) Railroads prescribed in subparagraph 1 of Article 2 of the Railroad Enterprise Act; (c) Urban railroads prescribed in subparagraph 1 of Article 3 of the Urban Railroad Act; (d) Harbor facilities prescribed in subparagraph 5 of Article 2 of the Harbor Act; (e) Airport facilities prescribed in subparagraph 8 of Article 2 of the Aviation Act; (f) Multi purpose dams as prescribed in subparagraph 2 of Article 2 of the Act on Construction of Dams and Assistance, etc. to their Environs; (g) Waterwork systems as prescribed in subparagraph 5 of Article 3 of the Water Supply and Waterworks Installation Act and intermediate waterworks as prescribed in subparagraph 4 of Article 2 of the Act on Promotion and Support of Water Reuse; (h) Sewage systems as prescribed in subparagraph 3 of Article 2 of the Sewerage Act, public sewage terminal disposal facilities as prescribed in subparagraph 9 of Article 2 of the same Act, excreta treatment facilities as prescribed in subparagraph 10 of Article 2 of the
118 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia same Act, and facilities for the reuse of sewage and wastewater prescribed in subparagraph 7 of Article 2 of the Act on Promotion and Support of Water Reuse; (i) River facilities as prescribed in subparagraph 3 of Article 2 of the River Act; (j) Fishery harbor facilities as prescribed in subparagraph 5 of Article 2 of the Fishing Villages and Fishery Harbors Act; (k) Waste disposal facilities as prescribed in subparagraph 8 of Article 2 of the Wastes Control Act; (l) Telecommunication facilities as prescribed in subparagraph 2 of Article 2 of the Framework Act on Telecommunications; (m) Electric source facilities as prescribed in subparagraph 1 of Article 2 of the Electric Source Development Promotion Act; (n) Gas supply facilities as prescribed in subparagraph 5 of Article 2 of the Urban Gas Business Act; (o) Integrated energy facilities as prescribed in subparagraph 5 of Article 2 of the Integrated Energy Supply Act; (p) Information and communications network as prescribed in Article 2 (1) 1 of the Act on Promotion of Information and Communications Network Utilization and Information Protection, etc.; (q) Logistics terminals and logistics complexes as prescribed in subparagraphs 2 and 6 of Article 2 of the Act on the Development and Management of Logistics Facilities; (r) Deleted; (s) Passenger terminals as prescribed in subparagraph 5 of Article 2 of the Passenger Transport Service Act; (t) Deleted; (u) Tourist resorts and resort complexes as prescribed in subparagraphs 6 and 7 of Article 2 of the Tourism Promotion Act; (v) Off road parking lots as prescribed in subparagraph 1 (b) of Article 2 of the Parking Lot Act; (w) Urban parks as prescribed in subparagraph 3 of Article 2 of the Act on Urban Parks, Greenbelts, etc.; (x) Wastewater treatment terminal facilities as prescribed in Article 48(1) of the Water Quality and Ecosystem Conservation Act; (y) Public treatment facilities as prescribed in subparagraph 9 of Article 2 of the Act on the Management and Use of Livestock Excreta; (z) Recycling facilities as prescribed in subparagraph 10 of Article 2 of the Act on the Promotion of Saving and Recycling of Resources; (za) Specialized sports facilities as prescribed in Article 5 of the Installation and Utilization
119 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia of Sports Facilities Act and public sports facilities as prescribed in Article 6 of the same Act; (zb) Juvenile training establishments as prescribed in subparagraph 1 of Article 10 of the Juvenile Activity Promotion Act; (zc) Libraries as prescribed in subparagraph 1 of Article 2 of the Libraries Act; (zd) Museums and art galleries as prescribed in subparagraphs 1 and 2 of Article 2 of the Museum and Art Gallery Support Act; (ze) International conference facilities as prescribed in subparagraph 3 of Article 2 of the International Conference Industry Promotion Act; (zf) Intelligent transport system as prescribed in subparagraph 16 of Article 2 of the National Transport System Efficiency Act; (zg) Geographic information system as prescribed in subparagraph 2 of Article 2 of the Act on the Building and Utilization, etc. of National Geographic Information System; (zh) Super high speed information and communication networks as prescribed in subparagraph 13 of Article 3 of the Framework Act on National Informatization; (zi) Science museums as prescribed in subparagraph 1 of Article 2 of the Science Museum Support Act; (zj) Railroad facilities as prescribed in subparagraph 2 of Article 3 of the Framework Act on the Development of Railroad Industry; (zk) Kindergartens and schools as prescribed in subparagraph 2 of Article 2 of the Early Childhood Education Act, in Article 2 of the Elementary and Secondary Education Act and in subparagraphs 1 through 5 of Article 2 of the Higher Education Act; (zl) Residential installations for servicemen or their children and installations annexed thereto, such as official residences to be built inside or outside of military camps, from among the military installations as prescribed in subparagraph 2 of Article 2 of the Protection of Military Bases and Installations Act; (zm) Public rental housing, from among the constructed rental housing as prescribed in subparagraph 2 of Article 2 of the Rental Housing Act; (zn) Nursing facilities as prescribed in subparagraph 3 of Article 2 of the Infant Care Act; (zo) Residential care facilities for the aged, and medical care facilities for the aged and facilities for home care for the aged as prescribed in Articles 32, 34 and 38 of the Welfare of the Aged Act; (zp) Public health and medical service facilities as prescribed in Article 2 of the Public Health and Medical Services Act; (zq) Facilities subject to a new harbor construction project as prescribed in subparagraph 2 (b) and (c) of Article 2 of the New Harbor Construction Promotion Act; (zr) Cultural facilities as prescribed in Article 2 (1) 3 of the Culture and Arts Promotion Act; (zs) Natural and recreational forest as prescribed in Article 13 of the Forestry Culture and Recreation Act; (zt) Arboretums as prescribed in subparagraph 1 of Article 2 of the Creation and Furtherance of Arboretums Act;
120 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia (zu) Infrastructure of ubiquitous cities as prescribed in subparagraph 3 of Article 2 of the Act on the Construction, etc. of Ubiquitous Cities; (zv) National core intermodal transfer centers, metropolitan intermodal transfer centers, and general intermodal transfer centers as prescribed in Article 45 of the National Transport System Efficiency Act; (zw) Other facilities prescribed by Presidential Decree that meet the purposes of this Act;
ENFORCEMENT DECREE OF THE ACT ON PUBLIC-PRIVATE PARTNERSHIPS IN INFRASTRUCTURE
CHAPTER 1 GENERAL PROVISIONS
Article 1 2 (Infrastructure Facilities)
“Facilities determined by Presidential Decree" in subparagraph 1 (zw) of Article 2 of the Act on Public Private Partnerships in Infrastructure (hereinafter referred to as the "Act") means any of the following facilities: 1. Welfare facilities for the disabled under Article 58 of the Welfare of Disabled Persons Act; 2. Facilities for new or renewable energy under subparagraph 2 of Article 2 of the Act on the Promotion of the Development, Use and Diffusion of New and Renewable Energy; 3. Bicycle tracks under Article 3 of the Promotion of the Use of Bicycles Act. [This Article Wholly Amended by Presidential Decree No. 21933, Dec. 31, 2009]
121 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia [Appendix 3] Mechanism of Risk Sharing Structure (Amendment of Basic Plan, October 2009)
Interest rate of government bondsb Share of investment risk = private investment costa ᴧ 1-(1+interest rate of govt bonds)-operation period
a private investment cost = total private investmant cost - construction loan interest b average interest rate of 5-year government bond during construction period
Actual income Estimated revenue of Redemption of agreement Excess Revenue
Actual income
Redemption of Amount of share of share or investment risk expenses
No payment of Payment of 50% of the share of share share investment risk
Actual income Actual income
n n+1 n+2 n+3
n = operational period in concession agreement
Source: Republic of Korea Ministry of Strategy and Finance. 2009. Basic Plan for Private Participation in Infrastructure.
122 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia [Appendix 4] Financial Support Related Articles in Public-Private Partnership Act
Law and Regulations Contents
[Article 53 (Financial Support)] If it is necessary for the efficient implementation Act of projects of Revertible Facilities, the State or a local government may grant a subsidy or extend a long term loan to the Concessionaire, only where prescribed by the Enforcement Decree.
[Article 37 (Financial Support)] ① In the event falling under any of the following subparagraphs, the State or local governments may grant any subsidy or long term loan to the Concessionaire within the scope of the budget after deliberation of the Committee pursuant to the provisions of Article 53 of the Act. However, the Enforcement Decree deliberation of the Committee shall not be required where the subsidy is granted from the local government's budget or a project for which the Competent Authority is the local government is granted the State subsidy in the amount less than 30 billion won:
1. Where it is inevitable to prevent dissolution of the corporation; 2. Where it is an inevitable to maintain the user fees at an appropriate level; 3. Where inducement of private capital is difficult due to low profitability of the project as a result of a considerable expenditure disbursed to compensate for the use of the land; 4. Where the actual revenue during operation (referring to the amount obtained by multiplying the user fees by the volume of the facility use) falls considerably short of the estimated operational revenue provided in the Concession Agreement and the normal operation of the facility is difficult; 5. Where a PPP Project contains a facility which has low profitability but, if implemented as a part of the entire project, can considerably reduce the construction period or the construction cost of the entire project, and such PPP Project is difficult to actively implemented should the said facility not be granted the subsidy or a long term loan in advance; and 6. Where the losses occur due to the excessive exchange rate fluctuation with respect to the foreign currency denominated loans which have been financed for the construction cost. ② In granting a subsidy under the provisions of subparagraph 5 of paragraph (1) above, the State or a local government shall calculate the amount required for the implementation of the project by applying mutatis mutandis the method of determining the estimated price and the method of adjusting the contract price under the provisions of Chapters II and V of the Enforcement Decree of the Act on Contracts to Which the State is a Party, or Chapter VII of the Enforcement Decree of the Local Finance Act, and shall grant the subsidy within the scope of the amount calculated as aforesaid.
Source: Republic of Korea. Act on Private Participation in Infrastructure, Enforcement Decree on the Act on PPP
123 Chapter 2 _ Improvement in Legal and Procedural PPP System in Mongolia
Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Chapter 03
A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia
Summary 1_Introduction 2_Financial System in Mongolia 3_Financial Crisis and Depositor Protection 4_The Transfer to Limited Protection 5_Deposit Guarantee Scheme in SCU Industry Chapter 03 A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia
Jae-Youn Lee (Korea Institute of Finance) Seungkon Oh (Korea Deposit Insurance Corporation) Bayarkhuu Tsookhuu (Ministry of Finance) Battulga Ulziibat (Bank of Mongolia)
Summary
In Mongolia, the State Bank, as the only nationally authorized bank in the country, used to provide the functions of both a central bank and a commercial bank. In this unique model under a socialist planned economy, the bank allocated funding to state-owned companies in accordance with the plans developed by the central government. When Mongolia made the transition to a market economy in 1990, however, the State Bank was split into a central bank and five commercial banks. Under this two-tier banking system, many commercial banks and other financial institutions were established.
Since then, Mongolia has gone through three financial crises. During the first decade since the transition to a market economy, many banks eventually became insolvent and were closed due to a lack of expertise, poor management, the absence of a proper legal infrastructure for a market economy and inadequate supervision. As a result, many depositors lost their money as well as confidence in the banking system. The banking industry started to show signs of stabilization in 2000, but then the country was hit by the global financial crisis right in the midst of an economic boom. The savings and credit union (SCU) industry also faced a crisis in 2006 because of fraud, poor management, lax supervision, etc. The number of SCUs decreased from a peak of over 800 to about 200.
In response, the Mongolian government provided protection for some depositors of banks and SCUs. During the 2006 SCU crisis, the government paid compensation for half of the depositor claims to reduce losses to individual depositors. Again, during the recent financial
126 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia crisis, the government adopted a temporary blanket guarantee in late 2008 that would be in place for four years in order to prevent bank runs and maintain the stability of the financial system. The blanket guarantee system helped stabilize the financial system by protecting all deposits, but also increased moral hazard of banks and depositors.
The Mongolian government planned to terminate the blanket guarantee system by November 2012. To ensure a successful transition to a limited coverage, some preconditions should be met in order to enhance public confidence in the banking industry. In particular, since depositors in Mongolia once lost their money due to bank failures, they may withdraw all their deposits for fear of loss if the blanket guarantee is removed.
The preconditions for terminating the blanket guarantee system are as follows: (1) The banking industry has been restructured sufficiently and there has been such progress in the reform of regulatory and accounting systems that the public has now regained confidence in the soundness of banks; (2) The economy has recovered sufficiently; (3) Strong policies are in place for dealing with weak and failing banks; and (4) The public has received enough advance notice (usually one to two years) of the pending change.
The macro economic environment in Mongolia has improved rapidly. For instance, the economic growth rate returned to pre crisis levels in 2010. The inflation rate, however, remains high and the government needs to take measures to lower it. The asset growth rate of the banking industry has also returned to pre crisis levels. But government deposits and borrowing from the central bank still account for a large share of banks' funding. In order to increase their capital base, the banking industry should make efforts to improve their financial health and win the public's confidence. For asset allocation, Mongolian banks need to expand their loan portfolios and lower the ratio of non performing loans (NPLs).
The market share of SCUs has decreased and their total asset size also fell from December 2009 to July 2010. These facts reveal that SCUs have lost competitiveness vis-a-vis banks, especially because banks were protected under the blanket guarantee system. Thus, a deposit protection scheme should be introduced for SCUs to promote balanced development between banks and SCUs.
A deposit protection scheme for SCUs requires government guarantees, which would strengthen protection for small depositors of SCUs and put SCUs on an equal footing with banks as bank deposits are already protected by the government. However, should a large number of SCUs go bankrupt at once and the deposit insurance fund prove not to be sufficient to cover all claims, the government will have to use taxpayers' money to protect depositors of SCUs. Thus, the SCU industry should be restructured first before the government provides
127 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia guarantees for SCU deposits.
Mongolia also needs to consider creating a single deposit insurance scheme for banks and SCUs. This will help to reduce operating costs through economies of scale. At the moment, however, regulation and supervision of SCUs are not rigorous enough to enable an efficient operation of a single scheme for both banks and SCUs. Moreover, if separate protection schemes are adopted, it will be very difficult to combine them later. Thus, it is urgent to strengthen regulation and supervision of SCUs with the aim of building a single protection scheme.
1. Introduction
Mongolia transformed from a socialist planned economy to a market economy in 1990 and experienced numerous changes in financial sector. In Mongolia, the government-owned State Banking Committee formerly conducted not only commercial banking business, but also central banking business as a unique bank. But when the State Banking Committee was split up into a central bank and five commercial banks following the transition to the market economy, many financial institutions such as commercial banks, security companies, insurance companies, etc. were established, which are necessary in the market economy.
Mongolia has gone through three financial crises. The banking industry had two financial crises in mid 1990s, and 2008. Savings and credit union (SCU) had a financial crisis in 2006. During the financial crises, many depository financial institutions failed and many depositors lost their money.
During the financial crises, the Mongolian government protected some depositors. It established two successor banks to receive deposits from the two large failed banks in the first banking crisis. The goverment could only compensate half of the depositors’ loss of SCU because the loss of depositors was enormous. When the banking industry had another financial crisis in 2008, the government introduced a blanket guarantee system for the banking industry, temporarily for four years. As a result, the banking industry was stabilized rapidly even though the fourth and fifth largest banks failed.
The Mongolian government plans to terminate the blanket guarantee system by November 2012. As the blanket guarantee system caused moral hazard problems for depositors and banks, it must be terminated as soon as possible. Mongolian government is preparing to introduce the limited deposit protection scheme when the blanket guarantee scheme is terminated.
This research deals with two subjects on the foundation for introducing the limited deposit protection scheme. The first subject to be reviewed is the preconditions to be fulfilled for a successful transfer from the blanket guarantee scheme to the limited protection scheme. When
128 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia the blanket guarantee scheme is terminated without fulfilling the preconditions, Mongolian banks could experience bank runs. This research attempts to lay out the preconditions and review whether they might be fulfilled or not. The second subject, is the type of the protection scheme for depository institutions, such as a consolidated or separate scheme. This research examines the necessity of introducing a deposit protection scheme for SCUs and the possibility of consolidating deposit protection schemes for SCUs and banks. While consolidated protection scheme for depository institutions has an advantage of reducing costs, separated protection schemes for banks and SCUs will cause numerous difficulties to be consolidated in the future.
2. Financial System in Mongolia 2.1. Overview of Financial Industry
Although the structure of the financial sector of Mongolia is not complex compared to developed countries, it has developed rapidly in parallel with economic growth in the past couple of years. The financial sector of Mongolia consists of the following sectors:
¥ Banks ¥ Non bank financial institutions (not non banking) ¥ Savings and credit unions ¥ Securities companies and brokerage firms ¥ Insurance companies
Source: Ministry of Finance, Bank of Mongolia, Financial Regulatory Commission
129 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Strong macroeconomic performance in the last several years, except 2009, has stimulated parallel rapid growth of the financial sector. Especially commercial banks remain the dominant institutions in the financial sector (Table 3-1).
2.1.1. Banking Sector
As can be seen in Table 3-1, the banking sector of Mongolia has a commanding height in the financial system recently. In fact, more than 95 percent of the entire financial system asset belongs to the banking sector since 2003. In the first quarter of 2010, 14 commercial banks offered products and services, ran business activities and operations, and provided customer services. Total assets reached 4.7 trillion Mongolian tugrik(MNT). Total assets of the banking system grew from 23.1 percent of GDP in the year 2000 to 40.1 percent in 2002, 71.9 percent in 2007 and 73.1 percent of GDP in 2009. The banking system deepness indicator(Total assets/GDP) increased by 3.1 times in the past 10 years compared to 23.1 percent in 2000.
Responding to the dynamic growth and prospects of the banking sector as well as timely, innovative and progressive products and services, the number of banking clients and private sector loans is increasing dramatically. For instance, the number of borrowers reached approximately 500 thousand, the total number of depositors reached 1.4 million, the number of current account holders reached 2.7 million, and the amount of total outstanding loan was 2.7 trillion MNT at the end of March 2010. However, NPL ratio increased from 3.2 percent in 2007 to 17 percent of total loans outstanding in 2009 as a result of rapid growth of loans outstanding.
Table 3-2 | Mongolia: Main Indicators of the Banking System (by percentage) 2000 2002 2004 2006 2007 2008 2009 2010.5 M2/GDP 26.4 38.2 46.8 48.4 52.7 37.8 42.5 49.6 Loan/GDP 6.8 18.9 35.9 40.6 45.9 43.9 44.7 47.7 Total assets/GDP 23.1 40.1 59.5 68.4 71.9 59.5 73.1 77.2 NPL Ratio 23.5 7.2 6.0 4.7 3.2 7.4 17.0 17.0
Source: Ministry of Finance, Bank of Mongolia
Total deposits as of the end 2009 stand for 60 percent of total assets reaching 2.5 billion MNT of which 29 percent is current accounts and 71 percent is savings accounts. Current accounts in foreign currency account for 51 percent of current accounts while 49 percent stands for current accounts in domestic currency. 64 percent of total savings accounts are time savings accounts while 36 percent stands for demand savings accounts.
130 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia 2.1.2. Non Bank Financial Institutions
There were 177 non bank financial institutions (NBFIs) operating in 2009 with 96.4 billion MNT of assets, which accounted for 2.1 percent of total asset portfolio of the financial sector. Furthermore, 55.5 billion MNT of outstanding loans and 66.3 billion MNT of owners' capital in the non bank financial sector accounted for 2 percent and 25.9 percent of that of the banking sector, respectively.
9 foreign invested NBFIs and 27 operating in rural areas were registered during the period covered by the report, and non-performing loans accounted for 5.7 percent of total loan portfolio of NBFIs.
To improve the legal environment for non bank financial operations and to bring it up to the level of international standard, collection of financial reports and data through consolidated network, consolidated supervision of financial unions, as well as development of infrastructure necessary for extension of the services to rural areas are necessary.
The most noticeable difference between non bank financial institutions and banks in Mongolia is that non bank financial institutions are not allowed to take deposit. Hence, the upcoming deposit protection schemes might not include non-bank financial institutions into its deposit guarantee.
2.1.3. Savings and Credit Unions
Savings and credit unions with total membership of 24,665 have operated in 2009, having 41.7 billion MNT in assets which constitute 43.2 percent of total assets of NBFIs. Outstanding loans totaled at 32.3 billion MNT, with 2.2 billion MNT in NPLs which account for 6.7 percent of the total portfolio. Total of 212 savings and credit unions were registered to have operated in 2009.
The difference between savings and credit unions and non bank financial institutions is that savings and credit unions are allowed to take deposits from both individuals and entities. Therefore, one could claim that savings and credit unions are similar to banks in Mongolia even though their size and clients are much smaller than the banking sector. Hence, it is important that savings and credit unions be under the classical deposit protection scheme sooner or later.
In future, there is an urgent need to introduce periodic reporting of savings and credit unions, improve quality of information, enhance the legal environment for savings and credit unions, and strengthen the supervision system on them.
131 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia 2.1.4. Insurance and Reinsurance
There are 18 insurance companies including National Life Insurance-the only one engaged in life insurance in the Mongolian insurance industry. Total revenue from insurance premiums was 23.4 billion MNT, 5.5 billion of which were used for compensations. The ratio of insurance compensation to total premiums is 23.5 percent, which is relatively low compared to that of developed countries. Premium revenues represent 0.39 percent of GDP and per capita value is 8,700 MNT, and such parameters indicate potential of a big market in the future.
In 2009, domestic insurance companies paid out 5.9 billion MNT to major international reinsurance companies, which included insurance coverage for MIAT aircraft, Mobicom, Mongolian Railways and Erdenes Mining Corporation. According to government policy, reinsurance of the most risky sector, for example agriculture, shall be considered in the near future.
Mongolia has an experience in reinsurance between 1960s and 1990s. During those period, reinsurance had been used for risk management in agriculture, particularly for the livestock industry. As livestock was a social property, payment of insurance premiums and compensations was managed by the state-owned insurance institutions on a compulsory basis. However, after privatization of livestock in 1990, consolidated system for livestock insurance collapsed and livestock reinsurance activity ceased. In recent years, although the number of livestock has been increasing, the frequency of natural calamities has been increasing as well. During 1999 and 2002, approximately 11 million heads of stock was lost to zud1), which significantly affected the nation's economy and livelihood of families. The Government of Mongolia holds a policy of promotion of and support to any initiatives on insurance and reinsurance in the livestock sector.
Considering the long term contracts of life insurance, compensation schemes should be introduced in order to protect contractors of life insurance, in the case that the life insurance company fails and thereby to keep confidence in the life insurance industry.
2.1.5. Securities Companies
There were 48 securities companies operating in 2009 with 21.2 billion MNT of assets, which accounted for 0.46 percent of total asset portfolio of the financial sector. In fact, between 2002 and 2005, sales in securities were somewhat inactive in Mongolia, whereas in the last three years the transactions intensified with a positive increasing trend for the future.
Stock market capitalization has grown, however, a few stocks account for nearly all the market capitalization and active trading. Bond trading activities (government and corporate bonds) are very
1) Zud is a Mongolian term for an extremely cold winter.
132 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia limited. Capital market activities are also limited since at this point there are almost no institutional investors in Mongolia, which can invest in the equities market.
The bonds and securities invested by the customers need not be protected because they are kept separately from the security companies under the name of customers even though security companies fail. But customer’s deposit on the securities companies should be protected.
2.2. Banking Industry
2.2.1. Transfer to Two-tier System
Before 1990 when Mongolia began to transfer to the market economy, it had kept a mono banking system in which the State Bank was unique. Like in other socialist planned economies, the State Bank had conducted not only central bank businesses such as printing money, currency control, etc. but also commercial bank businesses, such as making loans to companies, etc. The amount of loan was determined according to the economic policy by the central government. The bank made a loan without screening, evaluating collateral, and posting risk management. In the socialist planned economies, commercial banking business meant distributing the government funds to state owned companies.
The banking system of Mongolia changed from the mono banking system to the two tier banking system when the“ Banking Law”and“ About Establishing Commercial Bank and its Common Rule of Activity”had been approved in 1990 and 1991 respectively.
Table 3-3 | Differences between Commercial Banks and Central Bank
Commercial banks Central Bank
�Conducts its activity under the“ Banking Law” �Conducts its activity under‘ Central Bank �From a total 14 banks, 13 are private banks, (The Bank of Mongolia) Law’ 1 is state-owned � Entity founded by state �For profit organization �Has a right to issue nation’s currency notes and �Doesn’t have a right for emission and implement monetary policy monetary-policy making �Its current account owners are commercial banks �Draws savings and current accounts from and the state fund joint account’s owner is the individuals and private entities government itself �Gives out long-term, short-term loans to �Arranges interbank payments individuals and private entities �Reports its operations to the Parliament �Doesn’t have a right to arrange interbank payments �Reports its operations back to share-holders
Source: Bank of Mongolia , www.mongolbank.mn
In 1991, the Bank of Mongolia was established as a central bank that took over a central bank
133 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia business from the State Banking Committee. The State Banking Committee was divided into five commercial banks. The Agricultural Bank took over most of the assets and businesses in rural areas. Trade and Development Bank took over the corporate and international business. People’s Bank, Investment and Technology Renovation Bank, and Uildveriin Huvi Niiluulsen Bank took over general banking business in three cities respectively. These banks became commercial banks, but remained as state owned banks because their stocks were given to state owned companies and cooperatives during the separation process from the State Banking Committee.
2.2.2. Structure of the Banking Industry
The first commercial bank was established in 1990, and a total of 34 bank licenses were issued by 2010. Of these, 14 are currently in operation and 2 are in the process of liquidation. Banks mainly perform traditional financial services such as deposits and loans, and investment banking operation is limited by the Banking Law.
Between 1990 and 1991, five commercial banks were established and took over different commercial businesses from the State Bank. In 1992, nine small commercial banks including Mongol Post, Ardenh, Export Import, Central Asia, Mercury, Selenge, Autoroad, and Bayanbogd were established. The five banks separated from the State Bank remained as state owned banks and their market share was overwhelming. These five banks took 94% of total deposits and 89% of total loans, while the market share of other private commercial banks was below that of the smallest state owned bank.
After the mid 1990s, foreign participation banks began to be established. Golomt Bank, the first foreign participation bank, was established in 1995 and MM Invest Bank, the second one, was established in 1999.
Table 3-4 | Market Share of Banks (as of Dec. 2009) Bank MS Nank MS Khan 25.9% Savings 4.8% Golomt 24.0% UB city 3.8% TDB 19.1% State 3.2% Xac 7.6% Chinggis 2.7% Capitron 2.4% NatInv 0.5% Capital 2.0% Credit 0.2% Erel 0.3% Trans 0.3% Sum 97.0%
134 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Table 3-5 | Historical List of Mongolian Banks Date of license Date of license # Name Notes issued revoked 1 Agricultural 1991-12-06 Renamed to: HAAN 2 Savings 1996-01-14 3 Golomt 1995-03-06 4 Trade and Development 1991-01-11
Transport and 5 1997-01-22 Renamed to: Trans Development
6 Renovation 1991-12-05 Renamed to: Capital 7 Credit 1997-12-19 8 Erel 1997-10-21 9 Ulaanbaatar city 1999-11-15 10 Chinggis khan 2003-10-31 11 Capitron 2001-11-13 12 Xac 2001-12-27 13 National Investment 2006-10-18 14 State 2009-11-23 15 MM Invest 1996-07-22 1999-04-20 16 Central Asia 1992-06-01 1996-07-05 17 Selenge 1992-04-19 1994-09-15 18 People's 1991-12-06 1996-12-13 19 Ikhza 1991-12-05 1995-03-06 20 Insurance 1991-12-05 1996-12-13 21 Bayanbogd 1992-12-23 1999-09-01 22 Ulaanbaatar 1998-04-16 1999-09-01 23 Asian Investmen 1997-06-04 1999-09-01 24 Mongol Cooperative 1991-12-05 1994-09-15 25 Business 1993-03-16 1998-09-24 26 Ediintenger 1993-06-17 1998-09-25
Investment and 27 1992-01-22 1999-12-24 Technology Renovation
28 Sergeenbosgolt 1996-12-14 1999-12-24 29 Exim 1993-06-12 1999-12-27 30 Inter 2001-07-25 2006-06-30 Merged with Capitron Bank Restructured to National 31 Menatep 2001-11-20 N/A Investment Bank 32 Anod 1999-04-07 in liquidation 33 Zoos 1998-07-29 in liquidation
Assets and liabilities were 34 Post 1992-03-12 2010-05-03 transferred to Savings Bank.
135 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Out of 14 currently operating banks, 8 banks have foreign participation, but there are no foreign bank branches in Mongolia. There is one state owned bank, and other banks are privately owned. The banking sector is somewhat concentrated, as three of the biggest banks comprise about 70 percent of banking sector assets.
The financial crisis of 2008-2009 hit some banks very hard, and Anod Bank and Zoos Bank, which were the 4th and 5th biggest banks at the time correspondingly, became insolvent. After the crisis, Khan Bank and Xac Bank, which mainly perform microfinance operations, emerged relatively better. Khan Bank is now the biggest bank in Mongolia. Golomt Bank and Trade and Development Bank, which are the 2nd and 3rd biggest banks, concentrate mainly on lending to big borrowers.
3. Financial Crisis and Depositor Protection 3.1. Banking Crisis and Blanket Guarantee Protection
3.1.1. 1st Banking Crisis
Background
The Mongolian economy experienced significant difficulties for ten years since 1990 when it began transitioning to market economy. In the early 1990s, Mongolia had shown decrease in production and high inflation as the price was liberalized, which most transitioning countries had also shown.
During the transition period in the 1990s, Mongolian banks deteriorated. The main reason was that the government kept exerting its influence on the government owned banks to make loans to inefficient government owned enterprises, even though these banks became commercial banks. Furthermore, many managers of banks did not have the appropriate skills for operating commercial banks and were not able to conduct proper risk management. They made loan without screening the borrower's repayment capabilities or evaluating, as they used to do in the past. Concerning supervision, a system of supervision over commercial banks did not work properly and a legal system required for collecting of lenders' default was not established.2)
Furthermore, the five largest banks, which had 90 percent of the total asset in the banking industry, were owned by the government even after they separated from the State Bank. Many of their stockholders neglected monitoring over management because they did not have an interest in bank management.
2) Bank of Mongolia, Annual Report 2001, p.65.
136 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Process3)
In the process of transitioning, commercial banks had deteriorated because of the lack of various operating conditions, such as lack of employees’expertise, lack of management capabilities and experiences, lack of the government's knowledge about the market economy and supervision. Therefore, the money kept leaking from the banks and the money outside the banking system expanded.
The Mongolian government restructured banks in trouble. The government asked two large banks to merge with two small banks in difficulties and gave loans to the merger banks as subsidies in order to cover the merging cost. In the summer of 1996, two other banks became bankrupt and massive withdrawing of deposits followed. Coping with the situation, the Bank of Mongolia provided massive liquidity to the banks, but the credibility of customers on the banking industry has weakened.
Figure 3-1| Management Performance of the 1st Banking Crisis
50.0% The banking system faced 80.0% Currency in circulation outside 45.0% financial disintermediation the banking system increased 40.0% 60.0% 35.0% Deposits/GDP 30.0% 40.0% 25.0% 20.0% 20.0% 15.0% 0.0% 10.0% 1991 1992 1993 1994 1995 1996 5.0% 0.0% Currency Outside bank/2 Currency Outside bank/M1 1991 1992 1993 1994 1995 1996
16 Liquity within the banks decreased. Requiring banks to increasingly rely on 14 25 Govermemt deposits and BOM credit. 12 20 10 15 8
3) Refer the Financial Sector Reforms in Mongolia (1998).
137 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Figure 3-2| Soundness of Bank Loans (1996)
Loss 17%
Doubtful 18% Pass 49%
Substandard Overdue 7% 9%
In late 1996, 50 percent of total bank loans became insolvent and liquidity ratio sharply reduced from 11 percent in late 1995 to 5 percent in 1996. Only one bank in Mongolia was able to deposit a proper reserve fund while other banks relied on funding from the Bank of Mongolia
As the crisis in banking sector became serious, the government received financial support from other countries and began to conduct a bank restructuring strategy in November of 1996. As the first action, it closed two large banks4)-People's Bank and Insurance Bank-in December, and established the Savings Bank and Reconstruction Bank as successor banks, respectively. Furthermore, it established Mongolian Asset Recovery Agency (MARA) as a resolution agency to take over bad assets of insolvent banks.
Following the Central Bank Law and the Bank Law (1996), the Mongolian government protected all deposits of individuals but partial deposits of corporations of the two bankrupt banks. The Savings Bank mainly took over retail deposits from the bankrupt banks and was asked to invest only in safe assets, such as government bonds and the central bank's bond. The Reconstruction Bank took over sound assets from two bankrupt banks and was asked to give loans only to the sound business firms.
The Mongolian government improved soundness of banks by taking over the bad loans from these two bankrupt banks and providing government bonds to them. The government provided 20.5 billion MNT of government bonds to Savings Bank and 5.6 billion MNT of government bonds to the Reconstruction Bank, while taking over 21 billion MNT of bad assets. Including
4) The four bankrupt banks in 1996 took 50% of total assets of the banking industry.
138 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia this amount, the total cost paid by the government is estimated over 115 billion MNT.
3.1.2. 2nd Banking Crisis
The 2nd banking crisis began with the outbreak of global financial crisis while conducting stabilization policies to ease the overheated economy in the second half of 2007.
Background
From 2004, the Mongolian economy expanded balance of trade, fiscal revenue and foreign exchange reserves, through price increases of mineral resources-gold, copper, etc. which were the main exports in Mongolia. Most of the fiscal revenue had been used for increasing wages of the public sector employees and expanding social care spending in order to stimulate household consumption. During this period, the Mongolian government had taken a fiscal expansion policy and a monetary expansion policy. However such policies caused inflation on the demand side. Along with this, import of oil and food increased dramatically. The price increase in the international market caused inflation in Mongolia on the supply side.5) Inflation began to increase from third-quarter of 2007. Annual inflation rate was recorded 15.1 percent in December 2007 and the highest rate of 33.7 percent was recorded in October 2008.
Thus the Bank of Mongolia took a tight monetary policy to control inflation. It raised interest rates on 7-day Central Bank Bonds in October and November 2007 by 1 percent points respectively and set it to 8.4 percent.
Also, the BOM set the reserve ratio to 5.5 percent by raising 0.5 percent points and reduced money supply from the second quarter of 2008. As a result, annual average growth rate of M2 supply decreased from 40 percent to 15 percent during the rest of the period. This policy contributed to decrease in inflation rate to 8 percent but caused credit and liquidity crunch of financial institutions. Furthermore, import increased because Mongolian people did not trust tight monetary policy of the BOM and expected higher inflation.
The Mongolian economy was significantly exacerbated by the influence of the global financial crisis which began in the U.S in June 2007. The global financial crisis began to affect emerging countries through finance and trade channels. The amount of trade and production decreased and a demand on raw material also decreased. The Mongolian economy was influenced seriously by the abrupt decrease of copper prices. Mongolia had a huge trade deficit from third quarter of 2008 because export revenue was lowered by a large amount as a result of abrupt decrease of copper prices and the increase of imports.
5) Bank of Mongolia, Quarterly Monetary and Financial Review, Fourth Quarter, 2007
139 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia The trade deficit increased the demand of foreign exchange, which caused depreciation of the Mongolian currency. The BOM used 40 percent of foreign exchange reserves in order to defend the depreciation of tugrik and stabilized its value by the end of 2008. However, when the BOM stopped defending the value of tugrik, depreciation of the currency restarted. The value of tugrik depreciated by 33 percent from Otober 2008, with the highest value reached in March 2009.
Process
As the 1st banking crisis, which occurred in the mid 1990s, relieved in 2000, banks expanded their business to various activities to raise fees alongside the deposit taking business. Hence, the BOM strengthened risk based supervision. Based on the Financial Sector Assessment Program (FSAP), which was conducted jointly by the IMF and the World Bank in order to assess the stability and supervision level of the Mongolian financial sector, the Mongolian financial system was evaluated as being well managed in 2007.6)
However, the demand for bank funds had increased as inflation soared to 15 percent in 2007, which had kept the single digit rate except in 2004, and BOM kept an expansionary monetary policy. Since 2004, growth rate of bank loans had been about 40 percent but it increased to 68 percent in 2007 due to the dramatic expansion of loans to the private and individual sector.
Note : ( ) is growth rate Source: Bank of Mongolia, Annual Report, 2009
However, rapid expansion of loans in a short period caused negligence of loan screening and follow up control. Finally it brought about an increase of nonperforming loans (NPL) and low quality of loaned assets. Among the loans, NPL ratio was around 5 percent in 2000, but it expanded to 7.2 percent at the end of 2008, 20.7 percent in November 2009 and 17.4 percent at the end of 2009.
Also, due to the high inflation rate and depreciation of the Mongolian currency, the business environment of banks deteriorated dramatically. Because of the high inflation, real interest rate of deposits with Mongolian currency became a negative value. It led the movement of funds from deposits with domestic currency to foreign currency deposits since the mid 2008. However, as major
foreign currency supply became insufficient and the government distributed foreign currency, a significant gap between the official exchange rate and the market exchange rate of BOM occured. It caused outflow of funds not only from the domestic currency deposits but also from the foreign currency deposits.7) The amount of bank deposits of Mongolia began to decrease from August 2008. Thus the demand account at the end of 2008 recorded 615.9 billion MNT, falling by 2 percent, and savings deposit recorded 1.3743 trillion MNT, falling by 7.7 percent.
As the deposit of banks had been withdrawn, banks competed each other to receive more
7) The World Bank, Mongolian Economic Respective, 2008-2010, 2010, p.5
141 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Table 3-8 | Bank's Liabilities and Capital Structure 2004 2005 2006 2007 2008 2009 Demand deposit in DC 8.7% 8.5% 7.7% 10.7% 9.5% 9.0% Time savings and demand 70.1% 63.5% 63.4% 63.4% 48.3% 54.5% deposit FC Foreign liability 5.0% 3.2% 3.6% 7.1% 12.1% 9.4% Long foreign liability 1.0% 0.8% 0.4% 0.2% 0.3% 0.6% Government deposit 4.8% 7.5% 5.9% 5.0% 11.7% 11.3% Credit from central bank 2.7% 1.3% 1.0% 0.7% 6.8% 4.9% Capital 18.7% 15.1% 15.5% 13.2% 10.1% 5.6% Other -11.1% 0.0% 2.4% -0.3% 1.2% 4.7%
Source: Bank of Mongolia, Monthly Statistical Bulletin, 2010. 9
liquidity and had a tendency to set higher interest rates without relevant risk assessments. Furthermore, in order for banks to secure more liquidity, they received funds from other banks, especially from the BOM. The share of the loans from the central bank out of total liabilities recorded 6.8 percent and 4.9 percent respectively in 2008 and 2009. As a result, the ratio of high cost funding increased.8)
The BOM strengthened on-site examination and found two problematic banks. It began the resolution process for the two banks. The fourth largest bank, Anod Bank, misclassificd loans and concealed massive loss in 2008 and was put into conservatorship under the BOM. In addition, the fifth largest bank, Zoos Bank, violated a credit limit on a single borrower and expanded bad assets. This bank could not meet the request of money withdrawal from depositors and went under conservatorship under the BOM as well.
3.1.3. Blanket Guarantee Protection
Introducing Blanket Guarantee Scheme in 2008
The current global financial crisis is characterized by liquidity problems and a crisis of confidence in banking institutions around the world. Many of the steps recently taken by governments to help restore confidence in the banking system involve actions associated with deposit insurance. To restore confidence, Mongolian government approved the blanket deposit insurance scheme. The‘ Law on Blanket Deposit Guarantee’was approved by the Mongolian Parliament in November 2008.
8) Bank of Mongolia, Annual Report, p.34
142 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia According to the law, its purpose is to govern relations arising from the government guarantees on bank deposits aimed to ensure financial sector stability. The government guarantee shall apply not only to deposits but also to accounts at commercial banks that are duly licensed to engage in deposit taking activities in Mongolia. Moreover, the guarantee shall be valid for 4 years upon the effective date of the law, which means the law will expire in November 2012.
Effect
Stabilizing financial market
Since the mid 2008, the depositors no longer withdrew the deposit based on increased confidence. Futhermore, the amount of deposit did not outnumber withdrawals even though Zoos Bank had went through bankruptcy in December 2009.
Figure 3-4| Demand and Savings Deposit (million MNT)
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
- 08.1 08.3 08.5 08.7 08.9 08.11 09.1 09.3 09.5 09.7 09.9 09.11 demand deposit in DC time sav&dem deposit In FC total deposit Source : Bank of Mongolia, Monthly statistical Bulletin, 2010. 9
Expansion of government burden
The loss of guaranteed deposits and account was 225 billion MNT by the end of 2010 and total loss is estimated as 300 billion MNT. The government will bear any loss of depositors according to the blanket guarantee scheme. Given the condition that the Mongolian budget has been in deficit since 2007, compensation for the loss of depositors put enormous burden on the budget.
Expansion of moral hazard
Blanket guarantee may induce moral hazard of banks and depositors. The banks offering higher interest rates to attract liguidity would be bankrupt and may cause a systemic banking
143 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia crisis. While depositors are protected, the scheme would exert a moral hazard to depositors to choose banks that offer the highest interest rate without considering the soundness of it. If bad bank is not resolved at the beginning, its loss would increase and the governments’ burden would also increase under the blanket guarantee scheme.
Moving funds between financial sectors
The blanket guarantee scheme contributed to increased competitiveness of protected financial institutions against the unprotected ones. In Mongolia, total asset of banks increased even though two large banks were bankrupt due to the introduction of the blanket guarantee scheme by the government. On the contrary, the total asset growth rate of SCUs, which also take deposits, was 6.9 percent in 2009, decreasing by 10 percent points compared to that of the end of the previous year. Total assets of banks in July 2010 decreased by 0.7 percent compared to that of the 2009.
Note: ( ) is growth rate. Source: Bank of Mongolia, inside information
Amendment of Blanket Guarantee Scheme
The Mongolian government was approved to reintroduce an amendment of the Law on the Blanket Deposit Guarantee Scheme by the parliament. The main contents of the amendments are as follows.
- Savings and accounts of bank related people are excluded from the Guarantee - Interbank deposits are excluded from the Guarantee. - Bank should pay annual fees of 0.5% of the total of deposits until establishment of typical deposit insurance.
Furthermore the draft of law on partial protection was prepared by the Deposit Insurance Working Group, which consists of BOM, Ministry of Finance, Ministry of Justice and other relevant agencies. The draft contains basic elements for the protection of deposits, but it lacks some important elements. Hence, a new working group, was made to improve the draft of
144 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia deposit insurance. The group consist of BOM, MoF, the Ministry of Justice, Financial Regulatory Commission, and NDIC. The new working group will determine details on the deposit insurance system.
3.2. Crisis of SCUs and Depositor Protection
3.2.1 Background
SCU in Mongolia was established after the Parliament of Mongolia enacted a Law on Cooperatives (unions) in 1998. Since 1998, over 800 SCU's have been established, but 3/4 of them have been closed down. The total number of SCUs had increased by more than fifty times just within 8 years from 1998 to 2005. However, the number suddenly declined to a quarter in a single year in 2006.
The origin of the SCU crisis was heavily related to the inappropriate legal environment and a number of loopholes in the law on unions. First of all, there was no detailed provision regarding the SCU sector on the law of 1998. According to the law, at least 9 people could establish their own SCU without any financial inspection from authorities. They were required to register to the State Registration Authority prior to starting their own financial company.
In 2002, based on the increasing number of SCUs, the Parliament of Mongolia amended a SCU's chapter of the law on unions. The chapter was expanded and became relatively clearer for all the stakeholders to understand what credit unions really meant. Nevertheless, the biggest weakness of it was that there was no single word on the supervisory regime of SCUs. Because of this lax regulation, the number of SCUs expanded up to 570 in 2004. According to the amendment, SCUs could have enough opportunity to take deposits from their members and lend them without any financial and operational control by supervisory authorities. In fact, the only difference between commercial banks and SCUs was the size of deposits and loans at that time in terms of financial activities.
In early 2004, the SCU industry began to show initial signs of financial fraud and difficulties. Hence, the Parliament amended the law again in late 2004 with one single sentence, which states that the Bank of Mongolia is responsible for supervising all the credit unions. But at that time the Bank of Mongolia did not have enough capacity and human resources to supervise them, considering the huge number of SCUs and numerous uncertainties on their real, but hidden financial activities.
Following several on site inspections by the supervisory department of the Bank of Mongolia together with the tax authority of the Ministry of Finance on the selected credit unions in early 2004, it became clear that there were not only financial difficulties but also fraud on the balance sheet of several SCUs, mainly due to their top-level mismanagement. As a result,
145 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia public awareness on SCUs increased based on these worrisome results and policy makers established the Financial Regulatory Commission to resolve such problematic issues.
The number of SCUs had already reached its maximum of 845 in 2006. In fact, many of the credit unions had already proceeded malicious crimes. Total assets of the entire SCUs increased six fold from 2001 to 2006. At its highest level, the total asset was equal to 105.1 billion MNT, which was about 5 percent of the entire banking sector asset at that time.
By late 2006, the bubble of SCUs finally bursted. By statement of the Financial Regulatory Commission, the total asset of SCUs dropped by a third within a year and stayed at around a mere 35.6 billion MNT as a whole in 2007. After the burst, it was clear that almost ten thousand deposit holders lost their financial fortunes.
3.2.2 Origin of Crisis
Inadequate Management on Financial Services
In fact, many top level managers and their staffs were barely trained with general financial knowledge on financial transactions. It is true that most of the CEOs of the bankrupt SCUs had college degrees such as in engineering, history, or even with only high school education. Therefore, it was very difficult to find a credit union that had standardized accounting as well as financial book keeping in their shelves or computers. Moreover, their internal auditing was almost broken due to a ‘close’ friendship with high-level managers.
Too High Interest Rate
Before the crisis, several SCUs frequently made TV and radio advertisements to the general public in order to attract deposits with unreasonably high interest rates.
The weighted interest rate of the SCU sector was about 24 percentage points higher than that of the banking sector in terms of domestic currency deposits. The gap between them was also almost the same in terms foreign currency deposit. It is assumed that there are two reasons for this. First, given the higher risk profile on SCUs rather than the banking sector in Mongolia, SCUs promised much higher returns on deposits to attract deposit holders and compete with banks. Second, because the competition between SCUs was quite intense at the time, they raised deposit rates in order to increase the market share.
146 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Table 3-10 | Interest Rates of both SCUs and Banks
№ Interest rates Domestic Foreign 1 Range of SCU’s interest rate on deposits 36.0-.42.0 24.0-36.0 weighted interest rate 39.0 30.0 2 Range of bank’s interest rate on deposits 6.0-19.2 1.4-11.2 weighted interest rate 15.0 6.3 3 Range of SCU’s interest rate on loans 60.0-72.0 48.0-60.0 weighted interest rate 66.0 54.0 4 Range of bank’s interest rate on loans 18.0-30.4 8.0-24.0 weighted interest rate 24.2 15.9
Source: Bank of Mongolia, inside information
Moreover, as long as they drew financial resources with high interest rates, they needed to lend their money with much high interest rates as a loan portfolio to borrowers. Hence, weighted interest rates of SCUs on loans were amazingly high, up to 66 percent. The interest rate was over 40 percent points higher than the banking sector. Therefore, one could easily argue that it was barely possible to find business projects which had a return of 70 percent a year. Therefore it was not possible to sustain their financial statements with positive profit levels in the long run.
Extremely Low Public Awareness on SCU
Due to the new financial characteristics of SCU, many Mongolians didn't know what SCUs were, how they operated, and who would be responsible in case of bankruptcy or financial difficulties. Many deposit holders wrongly assumed that they operated like banks. Hence, they believed that a deposit on SCUs would be safe. However, given almost no control of their members, deposit holders and government authorities, managers were given almost full liberty to do whatever they wanted to do. In fact, a great majority of these managers spent members' money and deposits to finance their own or related parties' businesses, and to buy an immovable asset with inflated prices, as well as just simply to spend it for their own needs.
Poor supervision
The supervision on SCUs was not conducted properly. SCUs were regulated by the law on unions as the SCU Act was not yet established. Even though SCUs were established in 1998, the first supervision on SCUs was made by the BOM in 2004.
However, supervision on SCUs was not conducted sufficiently because the BOM did not have enough supervisory capability on SCUs and the required personnel. The full scale supervision on the SCUs was conducted by the Financial Regulatory Commission (FRC) after it
147 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia was established in 2006.
3.2.3 Depositor Protection
The government enacted a special law on a repayment to the victims of CUs in August 2008. According to the law, the victims were compensated for half of the loss by the government, and the compensation itself must be refinanced by the asset management companies in the future. This unavoidable measure was considered unfair for using tax momey. The loss of depositors of the five large bankrupt SCUs reached 64 billion MNT and the amount of government’s compensation was exactly 32 billion MNT. The total amount of government's compensation was over 40 billion MNT. These losses were more than public investment in 2006.
4. The Transfer to Limited Protection 4.1 Conditions for the Transition to a Limited Coverage
4.1.1 Reasons for the Transition to a Limited Coverage
Many countries implemented the blanket guarantee system to maintain the publics confidence in the financial system at times of crisis. However, the blanket guarantee system also had negative impacts such as moral hazard of banks whereby the expected payout for a loss unintentionally encouraged excessive risk-taking and over leverage for high returns and undermine market discipline, as depositors have fewer incentives to monitor bank performances. Thus, there have been calls, from the academia as well as from the public sector, that countries should adopt a limited coverage deposit insurance system as soon as circumstances permit.9) Moral hazard always exists when the total expected return on asset portfolio is greater than the sum of deposit insurance premiums and the implicit regulatory costs. To curb moral hazard, both ex ante and ex post measures are needed. Ex ante measures include licensing of and restriction against entry into the banking business, prudential regulation and supervision.
Examples of ex post measures are prompt resolution of failed banks and prohibitions against bailouts of shareholder. Deposit insurance removes more restraints on risk than the government regulators can identify. Accordingly, deposit insurance must specifically be designed to include risk-reduction features. In addition, there should be incentives to encourage large depositors, shareholders, and other creditors to monitor their banks.
9) See IADI (2010) and Gropp and Vesala (2004).
148 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Placing limits on deposit insurance guarantees-including the types of institutions or financial products that are covered and the insurable amount-is a common technique used by insurers to control risk. In particular, it is important to consider not insuring interbank deposits, in order to encourage monitoring by fellow banks.
The implementation of extended insurance coverage should be accompanied by a comprehensive bank restructuring strategy including measures to improve prudential regulation and supervision, legal framework, and accounting and disclosure regimes. Other important factors to be considered include the length of time the extended coverage is required to be in place and the speed of the transition.
4.1.2 Preconditions for the Transition and Related Issues
In general, before making the transition from a blanket guarantee to a limited coverage, policymakers should consider a set of preconditions including: economic and financial environment, financial safety net infrastructure and public policy objectives of the deposit insurance system. In addition, other interrelated components of the domestic financial system should also be considered, including whether or not there is strong prudential regulation and supervision, the effectiveness of the legal framework, the soundness and transparency of the accounting and disclosure regimes, and the ability of the deposit insurer to undertake prompt reimbursement to depositors in the event of a failure.
Economic and Financial Environment
Prior to the transition to a limited coverage, it is desirable to conduct an analysis of the macroeconomic conditions including fiscal and monetary policies. The structure and soundness of the banking system, including a detailed evaluation of the conditions of banks' capital, liquidity, credit quality, non performing loans, concentration of credit granting, leverage, asset quality, position in foreign exchange and risk management policies and practices should also be included in the analysis. Also the level of public confidence in the stability of the financial system is important. In some countries and jurisdictions, deposit insurance and cross border issues should be taken into consideration as well.
Financial Safety Net Infrastructure
When considering the transition to a limited coverage, policymakers should clearly define and distribute the mandates and powers of the financial safety net in order to facilitate interactions between authorities, define their responsibilities, and avoid overlapping roles. A situational assessment of the financial safety net infrastructure which takes a look at prudential regulation and supervision of banks' business conduct, measures to foster market discipline through accounting and disclosure regimes, early intervention for at-risk institutions and the
149 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia resolution mechanism for a prompt, orderly and cost-effective wind-down of failed institutions is essential. Coordination and cooperation among financial safety net members regarding the transition plan and transition timeline is also needed. For countries with a high level of capital mobility or regional integration like EU members or some Asian countries, cross-border cooperation is an important issue.
Public Policy Objectives
The general public policy objective regarding deposit insurance is to maintain public confidence in the stability of the financial system. Public policy objectives, however, should also take into account other factors so as to enhance sound risk management in banks; mitigate moral hazard; limit disruption to depositors; and enhance consumer protection and education. The introduction or maintenance of an early intervention and failure resolution policy to mitigate future losses is another important factor. When transitioning to a limited coverage by lowering coverage, etc., the public should be provided with information about the details of the coverage limit reduction through a widespread public awareness campaign in order to avoid any misunderstanding.
A plan should be developed in advance to decide who will be responsible for carrying out the transition plan and coordinating actions among the different members of the financial safety net. Otherwise, the transition may cause confusion in the general public and thus have negative impacts on the transition process. According to IADI (2010), six of the respondents-Austria, Jordan, Korea, Malaysia, Taiwan, and the U.S.-said that the deposit insurer could be the institution charged with commencing the transition to a limited coverage.10) Countries like EU member states that are highly integrated with neighboring countries in the region or see frequent movements of capital across borders should develop a well established mechanism in advance for cross border coordination and cooperation to mitigate deposit insurance arbitrage.
Amount and Scope of Coverage
Before the transition to a limited coverage, the amount and scope of coverage should be newly determined. The new coverage should be sufficient enough to win public confidence so that fluctuations of deposits can be reduced. But the coverage limit should not be so high as to cause risk of cross border deposit insurance arbitrage. When asked if they were considering establishing a higher-than-standard coverage for banks deemed“ too-big-to-fail,”most survey respondents gave a negative response.
10) On the other hand, Australia, Hungary, Spain, Turkey and others have planned that the finance/treasury minister should have this charge, while other countries such as Japan, Kazakhstan, Taiwan, Thailand and the U.S. have considered that all the members of the financial safety net should be responsible for recommending or commencing the transition to a limited coverage.
150 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Determining the Coverage Level
Factors that should be taken into consideration in determining the coverage amount include: the ratio between the coverage limit and the per capita deposit size; the coverage amount provided by other insurers from neighboring jurisdictions in the region; and the distribution of depositors and amounts of deposits. Other relevant aspects taken into account are: GDP per capita, inflation, deposit insurance fund sufficiency and the average income of households.
Funding Sources
It is necessary to have a clear mechanism which ensures that the deposit insurance system has access to an adequate funding during and after the transition, taking into account that the cost of a limited coverage deposit insurance system should be paid by, or shared with, insured institutions through deposit insurance premiums. In deciding premiums, the policymakers should consider the ability of the banking system to fund the new limited coverage; the financial condition of insured financial institutions; the balance of the deposit insurance fund; the power of the deposit insurer to increase the premiums or to levy special premiums; the financial situation of the deposit insurer; the policies and procedures required to obtain government support, among other factors. In most cases, the increased cost from coverage expansion is paid by insured financial institutions who are the main beneficiaries and by the government with tax revenues.
Communication to the Public
By communicating the changes to the public through various channels, policymakers can minimize the adverse effects of the transition. A strong public awareness campaign should be launched immediately so that its effectiveness can be evaluated at an early date and that it can reach the planned objectives.
Timing of the Transition
It was found that Japan, Thailand and Turkey opted for a gradual process for implementing the transition to a limited coverage while Australia, Korea, Taiwan and the U.S. chose an immediate transition. The gradual elimination of a blanket guarantee will give the banks sufficient time to adapt to the necessary institutional changes. However, one big disadvantage of gradual transitioning is that the time frame could be seen too long and this could cause moral hazard as depositors start to doubt the government's commitment to remove the coverage. It is considered that the gradual approach must establish strict controls in order to reduce moral hazard. For example, policymakers could adopt a differential premium system or give supervisory authorities sanctioning powers.
151 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia 4.2 Cases of Transition to a Limited Coverage and Implications for Mongolia
4.2.1 Cases of Transition to a Limited Coverage
The most direct response a deposit insurer can make to a financial crisis to maintain public confidence in the financial system is to either adopt a blanket guarantee or to increase the coverage amount. According to IADI (2010), 19 jurisdictions provided temporary blanket guarantees for bank deposits during the 2007/2008 financial crisis. When the Asian financial crisis hit the region in 1997, Korea, Japan and several others adopted a blanket coverage system.
In this section, cases of Korea which carried out the transition to a limited coverage as previously mentioned, and Japan where such transition was delayed due to the deterioration of macroeconomic conditions, are discussed. Furthermore, the implications that these cases have for Mongolia's adoption of the deposit insurance system are presented.
Korea's Case
The Korean government enacted the Depositor Protection Act (DPA) in December 1995 to remove the nervousness in the financial system caused by the financial liberalization measures that began in the 1990's. The Korea Deposit Insurance Corporation (KDIC) was established in June 1996 and started to provide protection for bank depositors up to 20 million won in January 1997. The 20-million-won limit was 2.8 times per capita GDP in 1994, which was from the review period for the system's adoption. This was enough protection to cover 97% of all bank depositors and 22~50% of deposits at individual banks. However, as the Asian financial crisis hit the country in late 1997, the Korean government had to adopt a blanket guarantee in November 1997 that would cover not only banks, but also insurers, securities firms, merchant banks, savings banks and credit unions. It was a temporary measure that would remain in place until the end of 2000.
The adoption of a blanket guarantee inevitably led to increased moral hazard: depositors moved their money to high yielding, but risky products and financial institutions took on added risks in pursuit of high returns. Thus, the government revised the Enforcement Decree of the DPA in July 1998, providing protection for up to 20 million won in principal and interest for deposits made after October 1, 1998.
Prior to the transition to a limited coverage in 2001, the government and KDIC started a thorough review of conditions as early as mid-1999. First, the Korean economy was back on a rapid recovery path based on strong exports right after the Asian financial crisis. With a growth rate of 11.1% in the first half of 2000, it seemed that macroeconomic conditions had become favorable enough for the transition to a limited coverage. However, uncertainties in the
152 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia macroeconomic climate continued due to the economy’s sensitivities to overseas market volatilities, the credit crunch triggered by the meltdown of Daewoo Group in July 1999 and the continued restructuring of corporate and financial sectors after the Asian currency crisis. In response, the Korean government continued to make efforts to resolve the credit crunch and remove uncertainties by carrying out corporate and financial restructuring, introducing new financial instruments like bond funds and tax free funds and promoting the issuance of primary CBOs.
Figure 3-5| Changes in Real GDP Growth of Korea
Real GDP Growth of Korea Average annual growth in Percentage 15
Secondly, the painstaking restructuring efforts that began in the wake of the 1997 Asian crisis brought some stability to the financial market. The Korean government raised 64 trillion won and 40 trillion won in public funds11) in May 1998 and December 2000, respectively, with the aim of resolving and restructuring failed companies and financial institutions. As Table 3-11 shows, out of 2,102 financial institutions that existed before the Asian financial crisis, 554, or 26.4%, were closed down by March 2001. The amount of non performing loans (NPLs) held by financial institutions was estimated at 112 trillion won at the end of March 1998. But, by the end of 2001, 176.5 trillion won12) worth of NPLs were resolved through restructuring and financial assistance, after which some 35 trillion won of bad debts still remained. Thanks to the widespread restructuring, financial institutions got back on a sounder footing and the BIS capital adequacy ratio of commercial banks that once dropped to 7.04% during the Asian
11) The amount of public funds that the Korean government raised from the start of the Asian financial crisis until the end of June 2010 was 168.6 trillion won, of which 110.9 trillion won was financed by the KDIC, 38.5 by Korea Asset Management Corporation (KAMCO) and 19.5 trillion won by the government and other sources. 12) By the end of 1999, 92 trillion won in NPLs was resolved. Furthermore, another 84.5 trillion won worth of NPLs, out of the new bad debts of 99.5 trillion won, was resolved by the end of 2001.
153 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Table 3-11 | Financial Restructuring in Korea since 1997 (as of May, 2001) (Number, %)
*Bridge Banks, Suspension of Business, Bankruptcy, etc. Source: Financial Supervisory Services (FSS) financial crisis recovered to 10.81% by the end of 2001 and the financial market regained pre crisis stability.
Thirdly, since the transition to a limited coverage should be accompanied by a reorganization of financial regulation and supervision to ensure market discipline. The Korean government improved the disclosure regime in October 1998 to meet the requirements of international accounting standards. In addition, to provide consumers with accurate information about the soundness of financial institutions, the government adopted the new BIS capital ratio and the forward looking criteria (FLC), and made improvements to loan loss provision requirements, prompt correction actions (PCA), etc.
Fourthly, in order to deal with the movement of funds expected as a result of the transition and resulting uncertainties in the financial market, the government and KDIC closely monitored capital movements in each institution, sector and region, and developed four scenarios to respond to all anticipated situations. The scenarios and corresponding measures were: 1) liquidity support (by the Bank of Korea) or failure resolution (by KDIC) to eliminate liquidity concerns for regional banks experiencing bank runs; 2) announcement of measures to stabilize the financial market, in case deposit movements in some sectors reach a serious level; 3) expansion of coverage or adoption of a blanket guarantee for existing deposits if all financial
154 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia sectors start to see bank runs; and 4) postponement of the transition to a limited coverage for a certain period of time in the event of a depositor stampede in all financial sectors.
Table 3-12 | Changes in Total Deposits by Financial Sector (1999~June 2000) ( hundred million won, %)
However, in a monitoring of deposit movements prior to the transition to a limited coverage, it was found that the financial market remained rather stable apart from a small amount of withdrawals from merchant banks and savings banks. Thus, the government made the transition to a limited coverage in January 2001 as was originally planned at the time of the blanket coverage’s adoption. At that time, it was decided that protection would be provided for the same type of financial institutions: banks, insurers, securities firms, merchant banks, savings
Table 3-13 | Deposits by Accounts (as of June 2000) (%)
less than 20 20~30 million 30~50 million over 50 million Section million won won won won Depositors 96.6 2.2 0.6 0.7 Banks Amount of 24.2 9.4 5.7 60.7 Deposits Depositors 39.7 27.6 7.7 25.0 Merchant Banks Amount of 1.5 7.4 3.0 88.1 Deposits Depositors 91.2 3.9 2.3 2.6 Mutual Savings Amount of Banks 37.5 5.9 6.5 50.1 Deposits Depositors 91.3 7.8 0.6 0.3 Credit Unions Amount of 53.8 34.5 4.8 6.9 Deposits
Korea Deposit Insurance Corporation(2000)
155 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia banks and credit unions-but that the coverage limit would be raised from 20 to 50 million won in a bid to prevent withdrawals by large depositors and to maintain financial stability. The 50- million won limit was deemed sufficient to prevent confusion among depositors since it covered 99.3% of all bank depositors, 97.4% of savings bank depositors and 99.7% of credit union depositors as of the end of June 2000 as indicated by Table 3-13.
Table 3-14 | Deposit Insurance System in Korea (as of the end of 1997)
Korea Deposit Securities Credit Insurance Credit Union Section Insurance Investor Management Guarantee Fund Corporation Protection Fund Fund Guarantee Fund Establishment June 1996 April 1997 April 1989 May 1983 July 1983 Date Credit Depositor Securities and Insurance Credit Union Legal Basis Management Protection Act Exchange Act Business Act Fund Act Cooperation Act Merchant banks, Insured Domestic and Life and Non-life Securities firms mutual savings Credit unions foreign banks insurers Institutions banks
Deposit Payment insurance, Deposit Deposit guarantees for financial insurance, and Guarantees for insurance, and Function customer assistance, financial insurance payout deposits for resolution, and financial assistance securities trading savings bank assistance inspection
Membership Compulsory Compulsory Compulsory Compulsory Compulsory Coverage 20 million won 20 million won 50 million won 20 million won 10 million won
Note: Blanket guarantee provided during November 19, 1997 ~ December 31, 2000
Another crucial implication from Korea is that even though only banks were covered when the deposit insurance system was first implemented in 1997, the system was later expanded on April 1, 1998 after the Asian financial crisis to cover securities firms, insurers, merchant banks, savings banks and credit unions as well as banks. The deposit insurance funds that had existed for each type of financial institutions prior to the change were all integrated into one and are now managed as separate accounts of a single fund. Table 3-14 shows the deposit insurance system at the end of 1997 before the adoption of an integrated system.
Also, products that received temporary protection such as foreign currency deposits, CDs and bank bonds were excluded from coverage with the transition to a limited coverage. Table 3- 15 shows how the scope of insured products changed after the transition.
156 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Table 3-15 | Insured Financial Products in Korea (as of the end of 2000)
Insured Insured till Dec. 31, 2000 Uninsured
Foreign Currency Deposits Demand Deposits, Time and (including Foreign Bonds), CD, Savings Deposits, Principal- Performance-based Trusts, RPs Banks Development Trusts, Bank Converted Trusts, Secondary Debentures, RPs Purchased Purchased after July 25, 1998 Bills before July 24, 1998
Corporate Insurance Policies Reinsurance Policies, Surety Insurance Individual Policies, except for Severance Benefits, Policies Signed after August 1, Firms Severance Benefits Policies Surety Policies Signed before the End of July, 1998 1998
Cash Balance of Customer Consignor Deposits, Guarantee Securities, Bonds Issued by Deposits for Securities Securities Deposits in Fiduciary Loans, Securities Firms, Tax Liability Trading or Other Dealings, RPs Purchased before July 24, Firms Cash Balance in Securities Withholdings, RPs Purchased 1998 Savings Accounts after July 25, 1998
Bills Sold Excluding Collateral Bills Receivable, Cover Bills, Bils Sold (Issued after Sept. 30, Merchant Endorsed Collateral Bills Sold - 1998), Beneficiary Certificates, Banks (Issued Before Sept. 30, 1998), CMAs Bonds Issued by Merchant Banks, CPs, RP Mutual Ordinary Deposits, Savings Savings/Time/Installment - - Banks Deposits, Cover Bills Credit Contributions, Deposits, - - Unions Installment Savings
Japan’s Case
Japan saw the need for depositor protection with the launch of financial liberalization measures in the 1970's. As a result, the Deposit Insurance Act was enacted in April 1971 and the Deposit Insurance Corporation of Japan (DICJ) was established three months later. At the time, the coverage limit was set at one million yen considering: the non-taxable amount under the tax exemption for small deposits system (1 million yen); the deposit ceiling for postal savings (1 million yen); and the average balance of deposits per household (998,000 yen including postal savings and 808,000 yen excluding postal savings). The coverage was later gradually increased to 3 million yen in June 1974 and to 10 million yen in July 1986 in consideration of inflation and the growth in deposits.
The collapse of the bubble economy in Japan in the 1990s, however, resulted in a sharp increase in NPLs held by mortgage service providers and other financial companies. In response, the Japanese government amended the Deposit Insurance Act in June 1996 and
157 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia adopted a blanket guarantee as a temporary measure that would have effect until March 2001 in order to remove the nervousness in the financial system and protect innocent depositors. Even though the Japanese economy showed signs of recovery until early 2000 after the Asian financial crisis, the economy started to slow down again as bankruptcies increased and loan defaults surged rapidly, which made investors increasingly worried about the financial system. Moreover, recognizing that the general public was not sufficiently aware of the limited insurance system, the Japanese government extended the blanket coverage for one more year until March 2002 in another amendment of the Deposit Insurance Act in May 2000. However, as the nervousness in the financial market continued in 2002, with the Nikkei falling below 9,000, the government decided to provide extended blanket coverage to current deposits, ordinary deposits and miscellaneous deposits until March 200513 while limiting protection for term deposits and installment deposits to 10 million yen in principal and interest starting in April 2002.
Figure 3-6 | Changes of Deposit Insurance Coverage in Japan
Current (Note) Deposits Deposits Payable Limited on Coverage Full Coverage Demand Ordinary (JP¥ 10 mil) Deposits. Provisional period Limited etc. � �← Coverage (JP¥ 10 mil) Time Deposits
(Note) Permanent full coverge is applied for deposits of bearing no interest/payable on demand/ providing settlement services since April 2005
Source: Deposit Insurance Corporation of Japan
To take a closer look at Japan’s case where the transition to a limited coverage had to be delayed, one of the reasons for the postponement was that the Japanese economy entered a long downturn after the burst of the bubble in the 1990s. In particular, as real estate prices continued on a downward trajectory from 1994 to 1996, non bank subsidiaries of some bank holding groups and mortgage service providers became insolvent, which shed light on the seriousness of the problem involving NPLs. As part of effort to deal with the problem, the blanket coverage
13) The Japanese government decided to provide permanent blanket protection to settlement deposits that are non interest bearing, payable on demand and available for settlement purposes even after April 2005.
158 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia was introduced as a temporary measure that would have effect until March 2001. Despite such steps, however, the Japanese economy faced another threat due to the 1997 Asian financial crisis and an increase in consumption tax from 3% to 5%, which drove many financial institutions into bankruptcy. With deflation continuing and NPLs surging, the Japanese government launched a program aiming at restoring the health of the financial industry. The program included a concurrent restructuring of corporate and financial sectors, strict application of asset quality standards for major banks and nationalization of companies with public fund injections. As nominal GDP growth rate was in the negative territory in 2001 (-1.2%) and 2002 (-1.5%), the government had to delay the transition to a limited coverage, which was originally planned to take place in March 2001.
Figure 3-7 | Changes in Real GDP Growth of Japan
Real GDP Geowth of Japan Average annual growth in Percentage 4 3
2 1 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -1 -2 -3 Real GDP Growth of Japan
Another reason for the delay was that the financial environment continued to deteriorate in the 1990's as macroeconomic conditions worsened. In particular, the number of failed financial institutions ballooned from a mere 19 during 1991 and 1996 to 161 in 2001. In response, the Japanese government provided a total of 10.4 trillion yen to banks to strengthen their balance sheets by the end of March 2002, starting with an injection of government funds into seven failed mortgage service providers in 1996. In March 1998, 21 banks received 1.8 trillion yen of public funds under the Financial Functions Stabilization Act and, after March 1999, another 8.6 trillion yen of public funds were provided to 32 banks under the Early Strengthening Act. Table 3-16 indicates how financial structuring in Japan has been carried out since 1996.
As shown in Figure 3-8, the growth in bankruptcies and NPLs in the wake of the 1997 financial crisis made the financial market uncertain and volatile. The necessary conditions for the transition were not in place as evidenced by the Nikkei's falling below 9,000 for the first time in 19 years in October 2002. As such, the Japanese government extended the blanket
159 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Table 3-16 | Bank Recapitalization through Public Fund Injections in Japan (as of March 2002) (Number, hundred million Yen)
Preferred Number of Subordinated Bond Law Period Stock Total banks Purchase and Loans Purchase Financial Functions 21 1998. 3 3,210 14,946 18,156 Stabilization Act 1999. 3~ Early Strengthening Act 32 70,493 15,560 86,053 2002. 3 Total 53 - 73,703 30,506 104,209
Source: Deposit Insurance Corporation of Japan guarantee until March 2003 and, later again, until March 2005, for current deposits, ordinary deposits and miscellaneous deposits. As for settlement deposits14, the government decided to provide a permanent blanket coverage.
Figure 3-8 | Corporate Bankruptcies in Japan
(100 million yen) Corporate Bankruptcy Debt 300,000 25,000
Japan’s case shows that certain preconditions-for example, an enabling economic and financial climate, public confidence and improved depositor sentiment should be met in advance to ensure a smooth transition. In addition, a comparison between the level of protection before the adoption of a blanket coverage and after the transition back to a limited coverage should be made and, if needed, an expanded scheme should be adopted. That is, the Japanese
14) Settlement deposits refer to deposits that are non interest bearing, payable on demand, and available for settlement purposes.
160 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Figure 3-9 | Nikkei Stock Index
Nikkei Stock Index Nikkei Stock Index 18934 16111 13786 11489 10543 10577 8570
1999 2000 2001 2002 2003 2004 2,005
government delayed the transition to a limited coverage instead of proceeding with the transition as planned because the financial market remained uncertain and the public in general was unaware of the deposit insurance system. A particular worry was that a transition to a limited coverage might cause large depositor withdrawals, credit shortages and, in some regions, even a systemic crisis since the restructuring of small, local financial institutions like credit unions or savings banks remained unfinished.
Other Cases
During the recent global financial crisis, many countries adopted a blanket guarantee or an expanded coverage to prevent bank runs and to stabilize the financial system. According to IADI & IMF (2010)’s survey, 19 jurisdictions out of 27 respondents were reported to have adopted a blanket insurance of deposits. Among them, Germany, Greece, Hungary, Iceland and Portugal provided implicit blanket guarantees under government commitments, instead of legal protections, while the rest 14 jurisdictions15) instituted blanket protection of bank deposits, etc. in law. Table 3-17 shows the time schedules of blanket coverage systems of surveyed nations. Most of the countries plan to transit to a limited coverage within four years of adopting the blanket coverage system.
4.2.2. Implications for Mongolia
During the recent global financial crisis, the Mongolian government also adopted a blanket
15) Ireland, UAE, Mongolia, Slovenia, Kuwait, Slovakia, Austria, Denmark, Hong Kong, Jordan, Malaysia, Singapore, Thailand, and Taiwan
161 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Table 3-17 | Transition Schedule from Blanket Guarantee to Limited DI 2009 2010 2011 2012 August Thailand 8/10 September Germany 9/27 Denmark 9/30 October UAE 10/12 November Mongolia 11/25 Austria 12/31 Hong Kong 12/31 Greece 12/31 Ireland 12/31 Malaysia 12/31 Portugal 12/31 December Jordan 12/31 Singapore12/31 Slovenia12/31 Taiwan 12/31 Total(15) 4 6 4 1
Source: IADI & IMF (2010) insurance of deposits in November 2008 as a temporary instrument with a four-year limit to deal with increasing insolvency in the banking sector. Providing a blanket guarantee helped to prevent bank runs and other associated risks in the financial system. Nonetheless, like in other countries, the blanket coverage system triggered a competition for high returns and increased moral hazard, encouraging banks to engage in high-risk, high return strategies. In response, an amended bill was proposed at the Parliament of Mongolia in July 2010 to withdraw protection for interbank deposits and deposits used as collateral to secure loans, to limit the protection for high interest deposits to principal and interest calculated at the base rate (11%) and to collect deposit insurance premiums (0.5% of total deposits per year) from banks.
Therefore, as Table 3-17 shows, the blanket guarantee system in Mongolia is scheduled to expire on November 25, 2012, so there is an urgent need to design a proper limited coverage system before then. As was mentioned above, there is a set of preconditions to be met before the transition to a limited coverage. The preconditions can be summarized as follows:
First, macroeconomic and financial conditions should be restored to stability. Even though the Mongolian economy has improved since 2009, there should be more progress in resolving NPLs held by banks and the restructuring of banks to strengthen their financial health. Also, putting a system in place to continue the restructuring even after the transition to a limited coverage will help create a sound financial environment.
Secondly, to ensure market discipline after the transition, the transparency and quality of accounting and disclosure regimes should be enhanced. There is also a need to improve financial regulation and supervision to encourage financial institutions to commit to sound management. That is, the government should encourage banks to strengthen capital base on the basis of the BIS capital adequacy ratio and enhance the asset classification criteria and loan loss provision requirements.
162 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Thirdly, there should be bold policies to provide assistance to failed institutions or, if needed, shut them down. Measures must be put in place to provide assistance to financial institutions facing temporary liquidity shortages prior to the transition to a limited coverage. As for failed financial institutions, a legal basis and an implementation framework must be developed in advance to wind them down in a decisive and prompt manner.
Fourthly, there must be a financial safety net to maintain the stability of the financial system. The financial safety net can be divided into seven categories according to their functions: business license review; prudential supervision; license withdrawal; prevention of bank runs and serial bankruptcies, lender of last resort and minimization of follow-up losses. For each of the functions, it should be clearly defined who, among the government, central bank, financial supervisory authority and the deposit insurer, will be responsible for the function and how to ensure cooperation among related agencies.
Lastly, there must be sufficient communication to the public of the detailed changes in the coverage. Besides basic matters like insured institutions, insured products and the coverage limit, the public should be informed about how they can be reimbursed for deposits in the event of a failure, etc. through various channels.
4.3. Review of Fulfillment of the Preconditions
4.3.1. Macroeconomic Environment
Growth of Mongolia’s Economy
The growth rate of Mongolian economy decreased to -1.6% dramatically in 2009, which was
Figure 3-10 | Economic Growth Rate of Mongolia
10.2 8.9 7.5 8.6
2006 2007 2008 2009-1.6 2010(forecasting)
Economic growth rate, %
163 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia affected by falling price of main export goods and export volume. Since then, the Mongolian economy has become stable with an economic stimulus program by the government and support from international organizations. The growth rate of Mongolia is expected to be 6.1% in 2010. This rapid economic recovery attributed also to the outbreak of the global economic recovery, massive demand from China and rising price of copper. Agricultural production decreased under effect of ‘Zud’ in the fourth quarter of 2009.
The National Development and Innovation Committee (NDIC) and the Ministry of Finance forecasted 7.5 % of real economic growth rate in 2010 on the Midterm Fiscal Framework and Socio-Economic Guidelines for 2011. The actual economic growth rate is estimated as 6.1 %, which is lower than the estimated level.
Inflation
Inflation decreased from 23.2% at the end of 2008 to 1.9% in 2009 due to an abrupt fall of the economic growth rate. But as the economy recovered in 2010, the inflation rate had increased to the annual rate of 12.6% in June. It decreased to 10.9% in September by the efforts of government. This was higher than the 7.8%, which was set on the Midterm Fiscal Framework and socio Economic Guidelines for 2010. In Mongolia, supply led inflation occurs by food shortages and oil import prices.
Figure 3-11 | Inflation Rate of Mongolia
25 Inflation rate 20
15
10
5
2002 2003 2004 2005 2006 2007 2008 2009 2010.9
164 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia 4.3.2. Conditions of Banking Industry
Growth
As the Mongolian economy began to recover after the global financial crisis, asset growth of the banking industry also recovered to the pre crisis level. The ratios of total asset and deposit of bank to GDP were 72% and 49% respectively at the end of 2007 and lowered abruptly to 5.6% and 38% respectively at the end of 2008 as a result of the banking crisis. However, these ratios increased to 75.7% and 49% respectively and recovered to the pre crisis levels in 2010 with expanding deposits as the economy began to recover.
The other factors which contributed to increase deposits, were high nominal interest rate and policy rate. Facing liquidity difficulties, banks kept deposit rates high in order to attract liquidity. Even though real deposit rate was negative considering the high inflation rate, deposits with domestic currency increased because depositors expected that the Mongolian currency would be appreciated in the future. Also deposits with foreign currency increased reflecting the continued perception of risk by the market.
However, the composition of funds has not recovered to that of pre crisis levels, in spite of recovery of the asset growth. In 2007, deposits took 71%, foreign liability 7.3%, government deposits and central bank loans 5.7% out of total fund. But at the end of 2008, when the banking crisis broke out, share of deposits decreased to 57.8%, reflecting outflow of deposits and share of government and central bank lending expanded to 18.5% reflecting support from the government. In September 2010, share of deposits expanded to 71% and share of government and central bank deposits decreased to 12.0%, which was a higher ratio compared to that of pre crisis levels.
165 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Figure 3-13 | Bank's Deposit
The composition of assets has not recovered to that of pre crisis levels. In 2008, the share of loans was 78.0% and share of Central Bank Bonds (CBB) was 3.6%. However, in September 2010, share of loans decreased to 62.0% while shares of CBB, foreign assets and government loans grew to 13.4%, 11.2% and 2.4%, respectively. Especially the amount of the CBB and government loans, which are risk free assets, enlarged from 112.7 billion MNT and 2.5 billion MNT respectively at the end of 2008, to 492.1 billion MNT and 78.1 billion MNT respectively in September 2010. Banks do not enlarge loans because they want to enlarge liquid assets such
as CBB with high interest rates and have low demand for loans due to the uncertain economic outlook.
Bank’s soundness recovered almost to the level of pre crisis, excluding two bankrupt banks; Anod Bank and Zoos Bank. NPL ratio of the banking industry decreased from 20.7%, recording the highest in November 2008, to 14.3% in 2010 and was 6.7%, excluding bankrupt banks. While the capital adequacy ratio (CAR) was 14.2% in 2007, it decreased to 11.4% in 2008 and 5.5% in 2009 reflecting failure of two banks in 2008 and 2009. But excluding two failed banks, CAR of the banking industry was 15.3% in 2008, 14.0% in 2009 and 16.2% in 2010. Furthermore, regulated capital increased from 393.8 billion MNT to 623.0 billion MNT.
167 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia Figure 3-15 | Capital Adequacy
In 2010, total interest revenue is 533.7 billion MNT with an increase by 18.6% and total interest cost is 332.0 billion MNT with an increase by 5.4% in a year. While the share of interest revenue out of total revenue is 82.5%, interest cost out of total expenditure is 60.0%. Thus bank profitability is reversed from net loss (234 billion MNT) in 2009 to net profit (71.0 billion MNT) in 2010.
The reason for the high profitability of Mongolia's banks was that they have a high net interest margin based on high deposit and loan rates. The banks keep around 12.0% of deposit rate in order to attract funds facing liquidity difficulties and keep a 18-24% loan rate reflecting high deposit rates.
Even though deposit and loan rates have not changed much, average lending rate measured as the average weighed loan rate decreased from mid 2007 to December 2009 reflecting the increase of non performing loans. However as NPL ratio decreased from January 2010, average lending rate and net interest margins have increased.
High loan rates will contribute to increase the profitability of banks, but cause difficulties in expanding loan. Currently, interest rates remain high in Mongolia, due to not only the higher policy rates but also the high and unstable inflation.
168 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Figure 3-16 | Bank's Net Interest Margin (Percent)
Average lending rate Average deposit rate Net interest margin
4.3.3. Infrastructure
Regulation
The Bank of Mongolia (the Central bank) is responsible for regulations and supervision of banks. BOM tries to ensure disclosure and transparency of operations of the banking sector, further enhance bank supervision, enforce good governance principles at banks, and tighten financial discipline in the sector.
The Banking Law forms basis of bank operations, and relevant regulations are exerting for supervision on banks. The Banking Law was renewed in January 2010 in order to ensure disclosure and transparency. Main changes include new definition of related parties of banks, consolidated supervision, prompt corrective actions, and updated requirements on banks’ ownership and governance. The revised Banking Law includes the adoption of good governance principles and appointment of independent members to the Board of Directors.
Furthermore, the Banking Law regulates financial aspects and includes Banks Prudential Ratios Regulation, Banks Assets Classification Regulations, and Banks Accounting Regulations. Prudential Ratios Regulations and Assets Classification Regulations were renewed in July 2010 and August 2010 respectively. The revised Banks Prudential Ratios Regulation contains new provisions that improve the calculation of the regulatory capital, estimates operational risk, and
169 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia upgrades controls on liquidity risk. The revised Banks Asset Classification Regulation includes a new criteria by which existing loans can be classified.
The Bank of Mongolia increased minimum capital adequacy ratio from 10 percent to 12 percent in 2009 in the face of the crisis. Also, provisioning rates for substandard and doubtful loans were decreased to 25 percent and 50 percent respectively, from 40 percent and 75 percent, to allow banks to use higher provisioned reserves accumulated during the pre-crisis era.
Regulation on Implementation of Corporate Governance was approved in May 2010. This regulation includes strengthening requirements for corporate governance of banks to the level of international best practices.
Accounting Systems
The General Accounting Law of Mongolia states that international accounting standards(IAS) should be applied to the accounting systems of organizations. Following this law, banks must use IAS for their accounting, except they do not have enough data and market prices
The Bank of Mongolia receives financial reports from banks on a monthly basis, monitors the compliance of prudential norms and regulations and takes actions when needed. Banks' reports are checked during on-site inspections. The Bank of Mongolia implemented an online reporting system for banks, and now receives reports automatically.
Public Awareness
According to“ State Guarantee on Banking Deposits Law”, blanket guarantee will expire by the end of 2012. A joint working group to revise the draft law on deposit insurance is working to get the deposit insurance law approved by mid 2011. Planning and implementation of public awareness campaigns are expected to start by the second half of 2011, but the actual time may vary depending on the timeframe imposed by the Parliament.
Public awareness campaign is a very important phase for the transition from the blanket guarantee scheme to the partial protection scheme. Currently, not much has been done regarding public awareness.
170 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia 4.3.4. Policy Proposals
Mongolia's macro economic environment is improving rapidly. Economic growth rate of Mongolia is expected to be close to the target rate of 7.5% in 2010 as the global economy began recovering and demand for mineral from China is expanding. But as inflation rate is expected to exceed the target rate, government must try to lower the inflation rate below 10%.
The performance of the banking industry recovered to pre-crisis level as the Mongolian economy began recovering. As deposit of banks increases, total asset also increases. But the share of government deposits and central bank loans, out of the total funds, remained high even though it decreased from 18.5% in 2008 to 12% in 2010. Thus it is necessary to lower the share of government deposits and central bank loans and increase the share of deposits out of total fund. To achieve this, banks must improve soundness and gain confidence from the depositors.
The amount of loan still has not recovered to the pre-crisis level. Banks can't expand lending due to uncertain economic forecasting and low demand of loans, while they kept safe and liquid asset including central bank bond with high interest rate. Many companies borrowed money from foreign financial institutions with lower interest rates. But if exchange rates change abruptly, borrowers may have immense difficulties in repaying the money. Thus it is necessary to extend loans. NPL ratio decreased significantly and the current NPL is 6.7% excluding bankrupt banks. However, current NPL ratio is lower than the ratio of 20.0% in 2009, but it is still higher than the ratio of 3.2% in 2007. Therefore, effort to reduce NPL is needed
Banks in Mongolia have high profitability based on high net interest margins and high policy rates. High interest rates contribute to expanding the net interest margin, but may cause a decrease and insolvency of loans. Thus it is necessary to lower interest rates. It is important to introduce advanced supervision and accounting systems. What is more important is the question of how to imply them.
5. Deposit Guarantee Scheme in SCU Industry 5.1. Role of Deposit Guarantee Scheme
5.1.1. Protecting Small Depositors
Depositors should make deposits at a sound financial institution and keep monitoring it in order to keep their deposits safe. Large depositors who have much information about financial institutions will withdraw their money from the financial institutions if those have insolvency problems. Thus it is thought that large depositors who keep their deposits in ailing banks play a moral hazard to receive high interest rates on them.
171 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia On the contrary, small depositors have difficulties in assessing whether their banks are sound or not because they do not have sufficient information about banks and financial skills to assess it. Furthermore, for the small depositors, deposits in the banks take a large share of their properties. So it is necessary to protect them when their financial institutions fail.
5.1.2. Stabilizing the Financial System
Deposit taking institutions, such as SCUs and banks, can not distinguish depositor’s money and bank's own money from their total funds. Thus when these financial institutions fail, depositors of these institutions receive a dividend from a bankrupt's estate because most assets of failed institutions move to a bankrupt’s estate. In this case, the depositors might not even recover their principal and it will take a considerable amount of time to receive bankruptcy dividend from the bankrupt estate.
Therefore, if the deposit is not protected in case of bankruptcy, most depositors rush to banks for withdrawals of their deposit when they find a symptom of bankruptcy. This kind of bank run may accelerate deterioration of insolvent institutions and undermine financial stability with stimulating bank run of other deposit taking institutions. The reason why bank run occurs on the deposit taking institutions, such as banks and SCUs, is that depositors can withdraw the deposit by the principle of 'first come first served' as long as bank has liquidity. Thus depositors may take part in bank run in order to withdraw the money before the liquidity of bank is consumed.
Thus, deposit protection needs to be introduced in order to protect depositors and stabilize the financial system. In the case of SCUs, many SCUs failed during the restructuring process in 2006. As many depositors were expected to have suffered huge losses, the government compensated for half of them.16)
5.1.3. Facilitate Resolving the Insolvent Deposit Taking Institutions
The authorities should resolve insolvent financial institutions as soon as possible in order to minimize the loss of depositors when it cannot be recovered. Insolvent financial institutions tend to conduct moral hazard with a policy of a high-return and high cost in order to make big profits. If these financial institutions go bankrupt, loss of customers could expand further.
The supervisory authority cannot initiate restructuring of insolvent banks if it caused huge loss on the depositors. Especially deposit taking institutions have a high possibility of bank run because the first come and first served principle is applied. However, if the deposit protection
16) In most cases, the assets of failed banks are not enough to return deposits to the customers because their assets excluding NPL are smaller than the liabilities. Thus it needs to use outside bank funds.
172 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia scheme is applied, the supervisory authority can resolve insolvent institution more easily because most depositors of failed institutions could be protected. In 2006, the reason why bank run of SCUs occurred was that the deposit protection scheme was not made for depositors of SCUs.
5.1.4. Stimulate Development of SCU
Deposit protection system can contribute to improving competitiveness of SCUs by protecting depositors and increasing their confidence on them. Deposits on the deposit taking institutions are safer than investment through investment companies. However deposit taking institutions do not operate depositors' funds separately from their own Funds. Thus when they become bankrupt, customers' deposits would be returned as bankrupt dividends. It may take a long time to receive money from the bankrupt estates. At times, depositors cannot receive their full amount of deposits if it is not protected. In order to solve these problems, it needs to introduce a deposit protection scheme that reserves funds and protects depositors.
Currently, while Mongolia adopts the blanket guarantee scheme for banks, it does not introduce the deposit protection scheme for SCUs. The blanket guarantee scheme on banks could lower the competitiveness of SCUs against the banks. Reflecting low competitiveness of SCUs, the share of SCUs among deposit taking institutions decreased from 1.1% in 2008 to 0.9% in July 2010. Moreover, total asset of SCUs decreased from 44.57 billion MNT in 2008 to 44.27 billion MNT in July 2010.
Therefore, a deposit protection scheme needs to be introduced for the SCUs in order to ease the difference of competitiveness, which is caused by other factors except efficiency, and thereby create a more balanced growth between banks and SCUs.
5.2. Deposit Guarantee Scheme
5.2.1. Government Guarantee
The Role of Government Guarantee
A deposit insurance scheme will protect customers' deposits when deposit taking institutions go bankrupt. Thus it needs a fund paid by the members in order to protect deposits. There are two ways to collect funds. The first one is to accumulate required funds in advance and the second one is to collect necessary funds after bankruptcy of a financial institution. Each country chooses its funding methods considering its characteristics, but pre-accumulation of fund is more popular for depository institutions.
When small and medium financial institutions fail, it might be possible to return insured
173 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia deposits only with the burden of financial institutions. However when the large sized financial institutions fail, accumulated deposit insurance funds might not be enough to cover the costs or the necessary funds might not be collected right away because the size of the necessary fund is enormous. Furthermore, in case of bankruptcy of ultra large financial institutions, it is impossible to protect depositors only by burden of financial institutions. If such situation occurs, customers’ credibility on deposit taking institutions and the deposit protection scheme might collapse. Hence, the deposit protection scheme cannot perform its role properly.
Therefore, in order to solve the problem of shortage of funds, a deposit protection scheme should have various funding sources. Especially for the deposit taking industry, the deposit protection scheme needs to be guaranteed by the government. In the deposit taking industry, there are ultra large financial institutions and important financial institutions to stabilize the financial market.
Necessity of the Government’s Guarantee
There has been discussion on whether a deposit guarantee scheme needs a government's guarantee or not. The opinion that government's guarantee is not required considers the special characteristics of customers of the credit unions. Customers, who want to use services of a credit union, should be a member of the union as the objective of it is to share the financial resources among members. All members participate in operating it and take responsibility of its management. Since each member is responsible for its operation, it is said that government does not need to guarantee the protection scheme.
On the other hand, the argument that the government should guarantee the protection scheme for a credit union arises from the fact that a credit union is not fundamentally different from other deposit taking institutions, such as banks. The objective of a credit union is to share the financial resources among members and expand opportunities to use it. Moreover customers can become a member of a union without strict restriction. Furthermore, general members of a union have low possibilities of moral hazard with which they avoid depositor's responsibility intentionally, because they do not have sufficient information of its operating situation unlike a management group. A government’s guarantee on deposit protection fund can foster fair competition against banks by increasing the credibility of SCUs. In Mongolia, as depositor went through huge amount of loss in 2006 without a deposit protection scheme, the government repaid for half of the loss with the government budget.
Government Guarantee in Other Countries
In Korea, deposits of credit cooperatives (credit union) are protected by its own protection fund without government guarantees. But before 2003, a protection fund for the credit cooperatives had been integrated as a separate fund account in the deposit insurance fund
174 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia managed by the KDIC (Korea Deposit Insurance Corporation) and was guaranteed by the government.
In 2003, the government excluded credit cooperatives from the protection by KDIC, considering the special status of depositors as explained above. But it has been said that another reason for excluding credit cooperatives from protection by KDIC was the poor soundness of them. On the other hand, in most countries applying a deposit protection scheme, such as US, UK, Canada, Japan, Australia etc., the deposit protection scheme for credit associations is guaranteed by the government.17)
Policy Proposal
The government needs to guarantee the protection fund for SCUs following the objective of the deposit protection scheme. Deposit of SCUs is not different from that of banks and other deposit taking institutions because any one can make a deposit at the SCU by becoming a member. A government guarantee on the protection scheme for SCUs will strengthen the protection for small depositors and contribute to balance the competitiveness between banks and SCUs.
However, it needs to restructure and strengthen the SCUs before the government guarantees the protection fund for SCUs. The protection scheme might give wrong signals to the managers, shareholders, and customers of SCUs and cause moral hazard problems. Customers might prefer the ailing financial institution, which have higher interest rates. Management of ailing financial institutions might choose a high risk, high return strategy to increase the profitability abruptly. If the government guarantees the protection scheme before restructuring SCUs, the government might spend a huge amount of the budget when many SCUs fail.
Therefore in order to guarantee the protection fund by the government, a supervisory authority needs to improve supervisory skills and abilities and restructure SCUs. The most important point is that SCU Act is passed and enacted as soon as possible.
17) See Table 3-20 for more examples
175 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia 5.2.2. Consolidated Protection Scheme
Advantages and Disadvantages
There are several types of deposit taking industries, such as banks, credit cooperatives, savings banks, etc. A deposit protection scheme can be built separately for each deposit taking industry or commonly for the group.
A separate protection scheme can strengthen the soundness of funds because it can manage the risk of funds considering the characteristics of an individual industry. The deposit protection agency can induce improvement of soundness of member institutions by charging different premiums and ordering corrective actions based on the different soundness of them. Each deposit protection agency can estimate the risk that may cause loss for the fund and charge different premiums according to the risk of member institutions. Separate protection schemes can contribute to strengthen the soundness of member institutions and protection funds because the supervisory authority can standardize the level of soundness and classify the assets and apply them.
On the contrary, a consolidated protection scheme contributes to minimize administration costs. Especially for the deposit taking industry, which conduct similar business and have a small number of institutions, consolidated management can achieve economies of scale on the management and reduce costs. Also, the deposit protection agency can improve efficiency to manage and resolve the impaired assets, which are obtained instead of repayment of deposits integrating them. As businesses of different deposit taking industries become similar because of deregulation and consolidation of business, the advantage of the separate protection scheme is gradually disappearing.
Consolidated Protection Scheme in Other Countries
Most countries have built a consolidated deposit protection scheme for the group of deposit taking institutions except several countries, such as the US, Canada, etc. In the US, there is a separate deposit protection scheme for the credit cooperative in the NCUA (National Credit Union Administration), which is the federal agency and protects small depositors. In Canada, there are 10 regional deposit insurance agencies under guarantee of a local government, which protects depositors in each region.
In Korea, association of credit cooperatives built a separate fund to provide financial aid and deposit protection service to the members in 1983. This fund was merged with the deposit insurance fund managed by KDIC after consolidating several protection schemes for most financial industries in 1997. However, the deposit insurance fund built five separate accounts for each of the five financial industries when it was created. Credit cooperative was excluded
176 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Table 3-20 | Insured Financial Institutions in Countries Nation Type of institution Nation Type of institution
Banks Commercial Banks Australia Building Societies Vietnam People's Credit Funds Credit Unions Financial Companies
Banks Banks Credit cooperatives Shinkin Banks Credit departments of farmers' and Taiwan Japan Credit Cooperatives fishermen's associations Labour Banks Foreign bank branches in Taiwan Federations Agricultural Bank of Taiwan
Commercial Banks India Indonesia Banks Cooperative Banks
from the protection by KDIC and a separate fund was bulit to protect its own depositors.
Policy Proposal
Most countries except the United States, Canada, Korea, etc. have a consolidated deposit protection scheme for deposit taking industries. In order to figure out whether the consolidated protection scheme is desirable for banks and SCUs, regulation for soundness and the supervisory ability needs to be compared between banks and SCUs.
It is difficult to make a consolidated protection scheme for banks and SCUs at this point because the soundness of regulations and supervisory abilities in SCUs are below those of banks. Even though the SCU industry was restructured by closing down 50% of them in 2006, it is said that restructuring was not enough to gain customers’confidence. In order to restructure SCUs, regulation and supervision for the SCU industry needs to be strengthened and SCU Act18) needs to be enacted.
However, if a separate protection scheme is to be built for banks and SCUs, there will be numerous difficulties in the future with regard to merging them. When difference of reserve ratios between banks and SCUs are large, the fund with higher reserve ratio will not want to merge with the other fund. Thus it is important to improve the soundness of SCUs and supervisory skills on SCUs to build a single protection scheme including banks and SCUs.
18) Currently SCUs have been regulated by the Law on Cooperatives (union), which has one chapter for SCUs.
177 Chapter 3 _ A Study on the Foundation for Introducing Limited Deposit Protection Scheme in Mongolia It is not possible to apply the same level of regulations on SCUs as in the banking industry. But it needs to introduce prudential regulations and accounting regulations, which are appropriate for SCUs. Prudential regulations include capital adequacy requirement, loan loss provision, asset classification regulation, credit limit to one member, etc. Accounting regulations includes periodic financial reporting based on accounting standards of Mongolia. If these two regulations are introduced on SCUs, it would better to build a single protection scheme for banks and SCUs.
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180 Public-Private Infrastructure Investment and Deposit Insurance in Mongolia Public-Private InfrastructureInvestmentandDepositInsurance inMongolia
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www. Investment and Deposit Insurance in Mongolia ksp .go.kr
2011
Ministry of Strategy and Finance, Republic of Korea Government Complex 2, Gwacheon, 427-725, Korea Tel. 82-2-2150-7732www.mosf.go.kr
Korea Development Institute 130-740, P.O.Box 113 Hoegiro 49 Dongdaemun-gu Seoul Tel. 82-2-958-4114www.kdi.re.kr
Knowledge Sharing Program Center for International Development, KDI 2011 ● P.O. Box 113 Hoegiro 49 Dongdaemun-gu Seoul, 130-740 MINISTRY OF STRATEGY ● Tel. 02-958-4224 AND FINANCE Korea Development Institute ● www.ksp.go.kr
