Report No. PID6779 PID6779.TXT Project Name Mongolia-Private Sector Development (@+) ... Credit Region East Asia and Pacific Project ID MNPE49789 Borrower Mongolia Implementing Agencies Ministry of Finance (MOF) Bank of Mongolia (BOM) Participating Financial Institutions (PFIs) Appraisal Date November 1998 Board Date May 25 1999 Date of this PID April 12, 1999 Recent Economic Development The reform strategy of the Government of Mongolia comprises three key elements: establishing macroeconomic stability, reducing the size of the state sector, and fostering private sector development. Important steps have already been taken to liberalize and stabilize the economy, revamp the enterprise privatization process, and reorganize the banking sector. Prices and wages have been liberalized, all import tariffs have been abolished, and the exchange rate is fully market-determined. On the legal side, important laws have been passed. Visible success has been also achieved on the macroeconomic front, which is moving to create a conducive environment for private sector development. After four years of economic decline following Mongolia's transition to a market economy, growth resumed in 1994. It peaked at 6.3 percent on the back of the 1995 copper price boom, only to fall back to 2.6 percent, when copper prices fell by 25 percent in 1996. Growth edged up to 4.0 percent in 1997, driven by rapid expansion in the mining and services sectors. Tight monetary policy forced down CPI inflation. At end-1997 it dipped below 20 percent, down from over 50 percent as recent as June. Economic conditions deteriorated in 1998, as the Asian and Russian crises deepened, and export prices fell sharply. The terms of trade shock had a significant impact on external performance. The prices of Mongolian exports, especially copper, dropped. Imports surged, spurred by the decline in external import prices (as a result of the sharp devaluation of many East Asian currencies), the elimination of virtually all import duties, higher domestic incomes in US dollar terms, and a large expansion in short-term capital inflows. Given the severity of the external shocks and political crises, macroeconomic performance in 1998 was surprisingly resilient. Real GDP growth slowed only modestly, to 3.5 percent, and inflationary pressures continued to abate--consumer prices increased by just 6 percent in the year to December 1998. Sector Background Important steps were taken in the face of the 1996 banking crises to reorganize the banking sector. In December 1996, two large, insolvent and inviable banks were liquidated, and a Mongolian Asset Recovery Agency was established with funding from Government to purchase the assets of the two liquidated banks. The liabilities and the performing assets of these insolvent banks were transferred to two new institutions: the Savings Bank (which inherited all household deposits), and the Reconstruction Bank (which inherited all nonhousehold performing claims). Most nonperforming inherited and directed loans that were removed from commercial banks' balance sheets were replaced by interest-bearing government bonds. A central register of defaulting borrowers (Credit Information Bureau) was also established, and all commercial banks are now forbidden from extending new credit to defaulting borrowers. In addition, banks are required to adopt vigorous loan recovery measures, and recently they have set up loan work-out units. Despite these measures, the banking system is not yet stable, with many banks failing to meet BOM prudential requirements. The legal environment for credit remains fragile, although recent changes in the Insolvency Law have shifted power to creditors. Few alternatives to the banking system have developed: the stock market is highly illiquid, and insurance and leasing businesses are embryonic. There thus remains large impediments to an efficiently functioning banking system and financial intermediation continues to be stifled. Mongolian banks are unable to provide long-term finance. The current bank credit structure is such that more than 95 percent of loans have maturities of less than one year. A high-risk environment and the existence of supply constraints explain why Mongolian banks have not engaged in term finance. Mongolian commercial banks perceive lending to be a high risk activity because of the large number of defaulters, and because relationships between borrowers and lenders are still very young. Supply constraints relate both to lack of availability of funds as well as weak institutional capacity. Mongolian commercial banks have limited ability to select potential borrowers and design long term loans, and private entrepreneurs lack the skills to prepare 'bankable' projects. Commercial banking is a relatively new activity, and foreign banks, which are usually an important vehicle for transferring and promoting credit skills, are just about to enter the market. Short-term loans are uniformly given, and loans are usually documented by rudimentary credit agreements. There are now 16 commercial banks in Mongolia. In spite the number of banks, the level of financial intermediation remains low. The banking system is highly concentrated. There are five medium-large banks, Trade and Development Bank (TDB), ITI Bank (ITIB), Golomt Bank (GB), Agriculture Bank, and Reconstruction Bank, and three of them including ITI Bank, Agriculture Bank and Reconstruction Bank are insolvent. The remaining 11 banks are tiny in comparison, the combined assets of 11 small banks is smaller than the assets of the smallest large bank, and there is very little intermediation through the smaller banks. On the other hand, Mongolia's private enterprises, the bank's main borrowers, face numerous constraints. Foremost is the lack of affordable formal credit or other financial services, particularly from banks, and the limited reach of non-banks such as leasing and insurance companies, the shallowness of capital markets and the lack of institutional investors or other forms of venture capital. In rural areas, where credit facilities are almost non-existent, small and medium enterprises lack both investment and working capital. - 2- Further constraints to private sector development include: limited infrastructure which blocks domestic marketing channels and integration with international markets; lack of utility infrastructure; a weak legal and judicial framework for property rights, contract enforcement, insolvency, collateralization and execution of judgments; weak governance structures, and shortages of managerial, strategic planning, marketing and financial skills. Project Objectives The main objectives of the proposed Private Sector Development Credit are: to support the Borrowers efforts to promote private sector development to strengthen the institutional capacity of the banking sector. In particular, the project will: (a) promote private sector development by increasing the availability of commercial bank term loans to private enterprises; and (b) increase the institutional capacity of participating banks by strengthening their financial intermediation function and resource allocation capabilities, and ; (c) increase the institutional capacity of the Bank of Mongolia (BOM) by improving its bank supervision function. Project Description The first component of the Project will be to provide a credit line to private entrepreneurs. IDA funds will be provided to the Government, and onlent to participating financial intermediaries (PFIs), which will then relend the funds to private sector sub-borrowers in two windows: a foreign currency and a local currency window. Access to the funds will be on a first-come first- served basis. Commercial banks will make decisions with IDA approval regarding subloan applications. PFIs will select sub-borrowers according to the agreed eligibility based primarily on financial viability of the project, the financial condition of the sub-borrower, and presentation of satisfactory business plan. The success of the project will hinge on the ability of the PFIs to successfully implement the project and on the ability of the final borrower to make good use of the funds and repay them in a timely manner. It will also depend on effective supervision of the PFIs by the BOM. The second component of the Project is technical assistance for the institutional strengthening of PFIs, BOM and the project Counterpart Working Group. The TA component comprises of: Counterpart Working Group. The project would be the first credit line plus technical assistance credit which the Mongolian Government borrows from IDA. For the successful implementation of the project, the Government has agreed to establish a CWG. This subcomponent is to finance mainly the cost of a project coordinator, annual project audits, and CWG staff training. Bank of Mongolia. To enhance BOM's role in the implementation of PSDC, especially in continuous monitoring and supervision of PFIs, technical assistance would be provided to the training of central banking skills and the development of a credit information system administered by the Credit Information Bureau (CIB). Participating Financial Institutions (PFIs). At present, Trade and Development Bank and Golomt Bank have been found to be eligible to participate - 3- in the project as PFIs in accordance with agreed eligibility criteria, although other commercial banks could participate in the project if they meet the agreed eligibility criteria at some stage in the future. Trade and Development Bank (TDB). Technical Assistance to TDB is to build on a recently concluded twinning program under the Banking, Enterprise and Legal TA Credit. International expertise would be provided in the renewal of the credit processing and management system and the development of core curriculums in commercial banking. Cost of related short term training would be covered. The TA activities would be closely coordinated with the Asian Development Bank/Bank of Mongolia Project on Core Banking Accounting System Renewal. Golomt Bank (Golomt). Technical assistance to Golomt would focus on external audit, and the development and implementation of an institutional development program in the areas of strategic/business planning, MIS development, model branch development, term-lending capacity building, and human resource development. Training is an important component of the program. Procurement of goods under the project shall be conducted in accordance with the "Guidelines for Procurement under IBRD Loans and IDA Credits" published by the World Bank in January 1995 and revised in January and August 1996, September 1997 and January 1999. Recruitment of consultants shall comply with the "Guidelines: Selection and Employment of Consultants by World bank Borrowers" published by the World Bank in January 1997 and revised in September 1997 and January 1999. Benefits The main direct benefits of this project will derive from the creation of a market for medium and long term loans and support services for private sector enterprises. The target group for the line of credit are all eligible private sector enterprises. Simultaneously, the TA component will help to improve the institutional capacity of the PFIs. TA will be provided in a number of commercial banking areas, with special emphasis on developing a higher credit culture (encouraging PFIs in term lending and applying project-based evaluation techniques). The emergence of banks that have the resources and competence to support business activities will greatly improve the environment for private sector development. Risks Failure of Government in maintaining macroeconomic stability and in implementing its reform programs pose the largest risk for the proposed project. IDA, in coordination with the IMF, will maintain continuous dialogue with the Mongolian authorities to ensure the implementation of the Government's macroeconomic stabilization program. The political environment poses a secondary risk. In terms of financial intermediation and sub-loan performance, the risks stem from institutional weakness on the part of the PFIs, and the inexperience of private enterprises in preparing bankable projects. These risks are expected to be mitigated by assisting the PFIs in their institutional development, especially in their appraisal, credit analysis, and debt collection capabilities. Improved ability by the PFIs to discriminate credit risks should also help mitigate the risks. - 4 - Environmental Aspects In accordance with the Bank's Operational Directive on Environmental Assessment (OD 4.01, Annex E), the proposed Credit is placed in Category "B/FI" involving intermediary lending. Sub-projects to be financed under the line of credit would be screened for their environmental impact, if any, and appropriate actions taken in accordance with the existing environmental protection laws and regulations (see the attachment). Contact Point The InfoShop The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Telephone No. (202)458 5454 Fax No. (202) 522 1500 Amanda Carlier, Task Manager Telephone: (202) 458-7169 Fax: (202) 522-3454 E-mail: ACarlier@worldbank.org Note: This is information on an evolving project. Certain activities and/or components may not be included in the final project. Processed by the InfoShop week ending April 23, 1999. - 5- ANNEX Environmental Individual subprojects applying for investment finance under the line of credit will be required to obtained a certified approval from the Mongolian Environmental Protection Agency as part of their application to the PFIs. Compliance with all national standards and applicable laws and regulations of the government of Mongolia is one of the eligibility criteria for sub-loans which must be satisfied prior to sub-loan approval. Both the PFIs and IDA will ensure that this requirement is met. - 6-