Document of The World Bank FOR OFFICIAL USE ONLY Report No. 19285-MOG IMPLEMENTATION COMPLETION REPORT MONGOLIA BANKING AND ENTERPRISE SECTOR ADJUSTMENT CREDIT (Credit 2947 MOG) June 25, 1999 Private Sector Development Unit East Asia and Pacific Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency Unit = Tugrik (Tg) 1992 $1 = 40.00 1993 $1 = 40.00 1994 $1 = 40.00 1995 $1 = 411.96 1996 $1 = 473.62 1997 $1 = 693.54 1998 $1 = 813.16 1999 $1 = 863.248 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank BESAC Bank and Enterprise Structural Adjustment Credit BELTAC Banking, Enterprise and Legal Technical Assistance Credit BOM Bank of Mongolia (Central Bank) CAS Country Assistance Strategy CIB Credit Information Bureau EDI Economic Development Institute ESAF Enhanced Structural Adjustment Facility FSPL Financial Sector Program Loan (ADB) FSTA Financial Sector Technical Assistance Project GDP Gross Domestic Product ICR Implementation Completion Report IDA Intemational Development Association IMF International Monetary Fund MARA Mongolian Asset Realization Agency MOF Ministry of Finance MOJ Ministry of Justice PFP Policy Framework Paper PHRD Policy and Human Resources Development Fund PSDC Private Sector Development Credit SPC State Property Committee TDB Trade and Development Bank Vice President Jean-Michel Severino, EAP Country Director Ngozi Okonjo-Iweala, EACSM Sector Manager Hoon Mok Chung, EASPS Task Manager Amanda S. Carlier, Private Sector Development Specialist, EASPS FOR OFFICIAL USE ONLY CONTENTS PREFACE ..................................... iii EVALUATION SUMMARY ......................................v PART I. PROJECT IMPLEMENTATION ASSESSMENT .....................................1..I A. Project Objectives and Description ................................................................I B. Achievement of Project Objectives ...........................,.,.,.,,,,,,,,,,,,,,,,.5 C. Implementation Record and Major Factors Affecting the Project ............... 10 D. Project Sustainability ...................... ,,.. 12 E. World Bank Performance ..................................12 F. Borrower Performance .................... ... 14 G. Assessment of Outcome .....................,,,,,,,,,,,,,,,,,,, 15 1-1. Future Operations .............. . . . .. . . . 15 I. Key Lessons Learned ....................,....,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,, 1 7 PART II. STATISTICAL TABLES .21 Table 1. Summary of Assessments ................. , , , .,. 21 Table 2. Related Bank Loans .................. 22 Table 3. Project Timetable ................ ........ 22 Table 4. Loan/Credit Disbursement: Cumulative Estimate and Actual,,. 22 'Fable 5a. Key Indicators for Project Implementation-Banking Sector Reform ......., , ,,. ... 23 Table 5b. Key Indicators for Project Implementation-Enterprise Sector Reform ....,..,......,,,....... 24 Table 6-a. Key Indicators for Project Operation-Banking Reform . , 25 Table 6-b. Key Indicators for Project Operation-Enterprise Reform .26 Table 7. Studies Included in Project ...,,.,,.,.,............ 27 Table 8a, Project Costs ........................ ... ....... 28 Table 8b, Project Financing .............,....,,,,..,,,,,..,,,..,,..,,.,,.,,,.,.28 Table 9. Economic Costs and Benefits .....................,,,, . ,,,.. 28 Table 10. Status of Legal Covenants .29 Table 11. Compliance with Operational Manual Statements . 29 Table 12. Bank Resources: Staff Inputs .30 T'able 13, Bank Resources: Missions .30 ANNEX A: AIDE MEMOIRE-SUPERVISION AND ICR PREPARATION MISSION . ............... 31 ANNEX B: BORROWER'S CONTRIBUTION TO THE ICR .40 Ibis document has a restricted distribution and may be used by recipients only in the perfomelance of their official dudeos. Its contents may not otherwise be disclosed uwithout World lBank authorization. iii IMPLEMENTATION COMPLETION REPORT MONGOLIA BANKING AND ENTERPRISE SECTOR ADJUSTMENT CREDIT (Credit 2947 MOG) PREFACE This is the Implementation Comipletioni Report (ICR) for the Banking and Enterprise Sector Adjustment Credit (BESAC) in Mongolia, for wilicih a Credit in the amount of US$10 million equivalent was approved by the Bank Board on May 1. 1997, signed on July 31, 1997, and became effective on November 26, 1997. The Credit was closed on December 31, 1998. It was fully disbursed in a single tranche on January 6, 1998. The ICR was prepared by Amanda Carlier, Private Sector Development Specialist. East Asiai and Pacific Region (EASPS), with assistance from Luca Papi, Consultant, and Robin Hartman, Team Assistant. It was reviewed by Gary Fine, EASPS. The draft ICR was communicated to and reviewed by the Governmenit, who had no substantial comments. Preparation of this ICR began during the IDA's Supervision/ICR preparation mission in November 1998. It is based on the inforimiationi and material gathered by the mission in Ulaanbaatar, Mongolia, and in the project file in Washiligtoni. The Borrower contributed to preparation of the ICR by providing their owIn evaluation of the Project's execution and Operating Plan (see ANNEX B), and reviewinig the draft ICR. v MONGOLIA 1BANKING AND ENTERPRISE SECTOR ADJUSTMENT CREDIT (Credit 2947 MOG) EVALUATION SIIMMARY I. Objectives. The Banking and Enterprise Sector Adjustment Credit (BESAC) aimed to support the banking and enterprise reform program of the Mongoliani Government and to assist the country in meeting the financial requirements of the reform programil. BESAC's objective was to restore functional efficiency and support the institutional developmenit of the banking sector, as well as to improve the economic performance of the enterprise sector. The maill structural problems were to be tackled using an integrated approach. On the bankiinig sector front, BESAC pursued the following key objectives: (i) supportinlg the implemilenltationi of the bank restructuring strategy; (ii) stepping up the commercial banki loan recovery effort; and (iii) assisting the Government in the adjustment of the bankinig sector needed to serve a new market-oriented economy. BESAC also supported the implementation of enterprise reform that complemented the banking sector strategy. The Project's key objectives in the enterprise sector were the: (i) imposing hard budget constraints on public enterprises; (ii) restructurilig or liquidating selected enterprises that were not economically viable; and (iii) contributinig to private sector development by accelerating privatization and strengthenlilng the economic legal framework. 2. The BESAC objectives were consistent with the 1995 Bank's Country Assistance Strategy (CAS) and with the Policy Framework Paper (PFP) for the period 1997-2000. There were also close synergies between BESAC and the Bankigig Enterprise and Legal Technical Assistance Credit (BELTAC). The BESAC objectives were important for the development of the Mongolian economy, and without BESAC, the stabilization program and the medium-term reform strategy would not have been sustainable and credible. In 1996. the banking sector was on the verge of collapse; measures taken within the BESAC program were timely and effective in tackling the bankinig crisis. BESAC's objectives were clearly specified, but too ambitious, too wide in scope, as well as very demandinlg both for the economily as a whole and for some of the agencies in charge of implementing the programil components. 3. Implementation Experience and Results. The BESAC program achieved many of its objectives by impactinlg positively on the banking and enterprise sector reform and generally helping to establish a more appropriate framework for a market economy. Good progress has been made in restructurinlg enterprises, imposing hard budget constraints, and also in improving thec legal enviromilelt. 4. The most important actions were taken prior to credit effectiveness, when the Government dealt directly with two major problem banks. Two nonviable banks were closed, and a large amount of non-performing loans was carved out to a newly-established special agency Mongolian Asset Recovery Agency (MARA). BESAC improved the debt workout capacity throughi the support of MARA and a special debt workout unit established in the Trade and Development Banik (TDB). To help stem the flow of bad loans, the BOM established new statistical surveys, which were intended to help banks in controlling credit risk. The legal environment was also improved. An insolvency law became effective in January 1998. Some amiendments to the banking law became effective in September 1998. As part of the BESAC vi program, the Government pursued a strict fiscal policy aimed at hardening the budget constraint for state-owned enterprises. Within the enterprise restructuring component, all BESAC conditions have been recently met. BESAC envisaged an economic analysis of two large state- owned enterprises (Darkhan Minimetal and Bagahangai Meat plants) in order to decide on either viable reorganization or liquidation of the two entities; restructuring plans of the two enterprises are now under way. Partial progress has been made on the privatization front. The majority of small firms and properties have already been sold. However, the biggest and most sensitive industries have not yet been privatized, and bank privatization is a long way behind schedule. 5. Results in the macroeconomic stabilization process were patchy, but all in all, they can be considered positive and supportive of the BESAC program. The creation of a stable environment for economic growth received strong support from the declining inflation rate, and from reallocation of credit towards the private sector. However, the amount of credit extended by commercial banks to private enterprises is still limited and insufficient for the strong growth of private investment. Bank interest rates have been particularly sticky, and have remained extremely high despite the strong reduction of inflationi: the higih levels of bank interest rates constituted the main impediment against souLid credit demand, and hence, against private sector development. Under these conditions, demand for credit has originated mainlly among very short- term-oriented traders, and adversely selected borrowers, for whom the probability of default is extremely high. 6. BESAC intended to help place the Mongolian bankinig sector on a sustainable path to eventual full recovery and sound functioning. Durinig the last two years, however, the Mongolian banking sector has achieved mixed results. Compared to 1997, the general situation of the sector deteriorated during 1998 in terms of loan quality, capital adequacy and profitability. Bank governance has not made significant progress. A chanice to privatize a major bank in trouble was recently missed, and much of the system is still ulider state control. A bank restructuring and privatization strategy recently discussed by the Mongolianl authiorities, envisages privatization within a relatively short period of time. Given the recent political stalemate and the financial difficulties of some major banks, the privatization schedule appears highly ambitious. At this juncture, it is difficult to state that the banking sector is on a soutid trajectory. While the sector is less vulierable today than it was before BESAC, the system as a whole remains fragile. 7. Project Design and Implementation. Thle general assessment of the project design is marginally satisfactory. The BESAC design benefited fromi its twin project, BELTAC. Risks and constraints for the project were adequately identified, but some questions can be raised concerning the structure of the operation. BESAC was a single-tranichie operation; it envisaged actions to be taken prior to Board presenltationi and credit effectiveness, but there was no real additional conditionality once the loan was disbursed. BESAC was implemented almost according to the planned schedule; a delay occurred in project effectiveness because of the time spent on ratifying the agreement by the Mongolianl Parliamenit. The program was also hampered by two severe shocks to the terms of trade, and by political events which ended in prolonged political stalemate in 1998. 8. The Borrower's performance was mixed. The Borrower performed satisfactorily- during project preparation. Despite various constrainits, including limited human resources, the authorities can take credit for a number of significalnt and positive actions. Areas where Borrower performance could have been more effective include: implementation; adequacy of monitoring; and evaluation of the project. vii 9. World Bank performance was satisfactory. The bank restructuring plan implemented prior to credit effectiveness was a prompt and appropriate move which tackled a very urgent problem. At the same time, it was a good idea to focus BESAC actions on supporting the only viable bank at that time. Minor criticisms can be made concerning insufficient coordination with other donors during the supervision phase, and concerning the assistance provided to the implementing agencies in dealing with possible solutions to the flagged problems. 10. BESAC's outcome as a whole can be rated as satisfactory. With a few exceptions, BESAC aclhieved most of its objectives. Many of the most important actions were taken prior to loan efl'ectiveness, when reasonable results were achieved in solving the 1996 banking crisis. The enabling environment for the private sector made good progress by reducing inflation significantly, privatizing a large number of small and medium enterprises, imposing hard budget constraints, and also improving the legal componenits envisaged by the Project. Under BESAC, the restructuring of some big enterprises was initiated, and a significanit contribution to institution-building must be considered as positive. Overall, the Bank's work in the context of BEfSAC helped Mongolia to formulate and implemenit an importanit reformi agenda in the banking and enterprise sectors. I 1. Sustainability. The achievements in the enterprise sector are expected to be sustainable- but this is less certain for the banking sector. The Mongoliani Governmeit needs to undertake a number of follow-up actions to ensure sustainability of the bankinlg sector reform, in particular: bank restructuring and privatization need to go ahead; further progress on the legal and regulatory front is required; the amount of non-performing loans for the system as a whole and the level of loan interest rates should be reduced; MARA needs stronger support from the Government to continue in its effort of debt recovery; and the fiscal deficit has not been brought down to the target levels. Key Lessons Learned . Government Commitment and Credit Structure. The strong commitment of the Government was critical in achieving the project's objectives. Wheni the Government's attention phased itself out, implementation performance suffered. The lesson here is that conditionality should be used as much as possible to induce the Governmenit to maintain its effort and its commitment to the project's success. * Project Monitoring and Supervision. Monitorinig and supervisioni is important, especially in the early phase of reforms when slippage may occur. However, supervision activity may lose most of its relevance if follow-up action is not possible or not contemplated within the project design. * Focus on Enforcement rather than Approval/ Establishment. Project objectives should give priority to measures relevant to law implementationi and enforcemenlt. BESAC envisaged the submission of a draft insolvency law to Parliamenlt prior to credit effectiveness, but no further action was contemplated to implement the law. Similarly, in the case of the CIB, BESAC focused its emphasis on the creation of a new institution, rather than on its operational functioning and achievements. * Legal Infrastructures, Banking Reforms, and Credit Structure. Reform of the banking sector in transitional economies is a very slow process that requires investment and changes in institutions, legal infrastructures, and human capital. Consequently, more attention could have been paid to the structure of the Credit, in the sense that a two-tranche operation would have viii allowed the Bank to include and monitor certain critical objectives that normally take more time to be achieved. * Fiscal Consequences of Banking Reform. More attention should be paid to the fiscal consequences of banking sector reforms, in order to assess short-term and long-term costs. This requires the construction of credible scenarios regarding the future viability of the newly- established financial institutions. * Institution-Building and Technical Assistance. When institution building is crucial for a project's objectives, as it is in transitional economies, structural adjustment operations that provide a broad agenda for reforms in particular sectors should be accompanied and supported by parallel, well-designed and timely technical assistance projects. BESAC and BELTAC constituted a good attempt at implementinig this simple principle. 1 IMPLEMENTATION COMPLETION REPORT MONGOLIA B3ANKING AND ENTERPRISE SECTOR ADJUSTMENT CREDIT (Credit 2947 MOG) PART I. PROJECT IMPLEMENTATION ASSESSMENT A. Project Objectives and Description 1. Project Background. The Banking and Enterprise Sector Adjustment Credit (BESAC) of Special Drawing Rights 7,200,000 (equivalenit to US$10 million) was a single-traniche adjustment operation designed to support the structural reforms in the banking and enterprise sectors. Mongolia joined the Bank in February 1991, and BESAC was the Bank's first operation focusing on the Mongolian banking and enterprise sectors. 1 2. At the time when preparation for BESAC started, Mongolia's economy was still troubled at the structural level, but showing signs of emerginig from its difficult period of adaptation to the newv market economy. In 1994 and 1995, for the first time after the transformation of the economy. Mongolia achieved positive real growth. Unfortunately, during 1996, as preparation for the BESAC intensified, the Mongolian economy was hit by a succession of external and internal shocks. External developments comprised tertns of trade negative shocks: world copper price declined by 25 percent; and cashmere price by 10 percent.2 The external current account deficit widened to 11 percent of the Gross Domestic Product (GDP). On the internal front, many enterprises were experiencing a deep economic and financial crisis. Tax revenues fell sharply, and spendinig pressures intenisified, especially in the run up to the June 1996 national elections. As a result, the budget deficit rose to 9.5 percent of GDP from 4 percent in 1995. The economic difficulties of the enterprise sector combined with old problems within the banking system caused a s,evere bankinig crisis. Most commercial banks were illiquid, and some of the largest ones insolvent. In 1996. only one bank was able to maintaini adequate reserves with Bank of Mongolia (BOM), while the remaining banks had to rely on BOM funding. Against these developments, it became clear to the Government that a decisive program of reforms was necessary to complete Mongolia's transition to a full market economy. The new government, elected in June 1996, took steps to accelerate the pace of structural reforms and the stabilization of the economy. The approval of the BESAC program was one of those steps. 3. Project Objectives. The BESAC aimed to support the banking and enterprise reform program of the first non-communist elected Mongolian Government, and to assist Mongolia in meeting the financial requirements of the reform program. BESAC built on and complemented the macroeconomic stabilization and structural reforms undertaken by the Government within both the IMF Enhanced Structural Adjustment Facility (ESAF) and ADB Financial Sector I A Financial Sector Technical Assistance Project (FSTA). financed by Japan's Policy and Human Resources Development Fund (PHRD). was approved in 1994 to finance advisory assistance to BOM's Banking Supervision Department, and preparation of a legal diagnostic study of financial and commercial legislation. 2 In 1995, mineral products, mainly copper. accounted for 65.5 percent of total Mongolian exports; textiles, mainly cashmere. for 21.4 percent. 2 Program Loan (FSPL) programs. BESAC's objective was to restore functional efficiency and to support the institutional development of the banking sector, as well as to improve the economic performance of the enterprise sector. The main structural problems of the two sectors were to be tackled using an integrated approach. Banking sector project objectives and enterprise sector project objectives are presented separately below. Specific actions and monitoring indicators related to the banking and enterprise sector program and following credit effectiveness are presented in Box 1. 4. Banking Sector Project Objectives. On the bankinig sector front. BESAC pursued the following key objectives: (i) supporting the implementation of the banlk restructuring strategy; (ii) stepping up the commercial banki loan recovery effort: and (iii) assisting the Government in the adjustment of the banking sector needed to serve a new market-oriented economny. 5. Within the support of the overall bank restructuring strategy. important up front measures were implemented prior to Board presentation. These measures included: the liquidation of two large insolvent banks (People's Bank and Insuranice Bank); the establishment of two new commercial banks (Savings Bank and Reconstructioni Batik), and the creation of the Mongolian Asset Realization Agency (MARA). At the same time, the performing assets of the two insolvent banks were transferred to the two new banks, and all non-performing inherited loans were removed from the banks' balance sheets and replaced by government bonds. Moreover, for the two remaining large financial institutions that were also facing serious financial difficulties (Agriculture Bank and Investment and Technological Innovation Bank), Memoranda of Understanding were signed between the BOM and the two banks in order to guide and monitor the required bank rehabilitation. 6. The second core componenit of the BESAC intervention in the Mongolian banking sector was related to the development of a debt workout capacity and to the intensification of the loan recovery efforts by the government and commercial banks. This was a two-pronged strategy. On the one hanid. the recovery of the stock of noti-performing loans was delegated to MARA and to a special debt wvorkout unit within Trade and Development Bank (TDB). On the other hand, measures to deal with the flow problem of new loans extended to potential defaulting borrowers were adopted as well. In particular, actions were taken to stop directed lending through the commercial banks, and BOM issued regulationis to halt all bank credit to defaulting borrowers. A Credit Informatioii Bureau (CIB) was also established within the BOM to enable banks to determine if any borrower was in default to a third bank. 7. The third component comprised a mix of measures aimed at modernizing and enhancing the role of the banking sector in the new market economy. In this context. BESAC envisaged a review of the implementation and the effectiveness of the central bank and banking laws. BESAC also assisted TDB in a bank twinning arrangement to promote international banking practices. Finally, bank privatization was considered as part of the Government's medium-term reform program. 8. Enterprise Sector Project Objectives. BESAC supported the implementation of enterprise reform that complemented the banking sector strategy. The Project's key objectives were the following: (i) imposing hard budget constraints on public enterprises; (ii) restructuring or liquidating selected enterprises that were not economically viable; and (iii) contributing to private sector development by accelerating enterprise privatization and strengthening the economic legal framework. 9. The imposition of hard budget constraints was a key element to prevent defaulting enterprises, cut off from bank credit, turning to the budget as an alternative source of finance. In 3 so doing, the imposition of hard budget constraints was supposed to complement the banking sector strategy, and to stop the drain on public resources that these enterprises represented. The implementation of harder budget constraints envisaged the reduction of the level of arrears in enterprise loan payments to the budget, and the phasing out of subsidies, transfers and subsidized loans made under the budget to public enterprises. A few exceptions were made for urban transport, electricity, and heating enterprises, and two state-owned enterprises included in the State Property Commission (SPC)-led pilot restructuring exercise. 10. The enterprise restructuring component ained also to restructure or liquidate six selected enterprises chosen on the basis of their relatively large amount of defaults to banks.3 Out of these six, two enterprises were state-owned (Darkhan Minimetal and Bagahangai Meat) and the respective restructuring exercises were carried out by the SPC. The objective was to attain either a viable reorganization or a liquidation of the two entities, based on the results of two preliminary viability assessments. The same objective applied to the remaining four enterprises; in these cases the TDB was in charge of the restructuring plan silce the four enterprises were among the TDB's worst defaulters.4 11. The private sector development component envisaged a widespread and rapid privatization program and a strengthening of the economic legal framework. The privatization program aimed to increase the number of privatized enterprises in order to improve the governance structures of enterprises and to increase the volume of the budget revenues. The progress on the legal front envisaged the preparation of a draft insolvency law. 12. Evaluation of Objectives. The BESAC objectives were consistent with the first Bank's Country Assistance Strategy (CAS), prepared in June 1995, and with the Policy Framework Paper (PFP) for the period 1997-2000. Both CAS and PFP aimed at three main objectives: (i) establishing macroeconomic stability, reducing the size of the state sector and fostering private sector development by strengthening the banking sector; (ii) developing a more transparent and effective legal system; and (iii) promoting foreign investment. BESAC was also consistent with the other concurrent IDA operations. In particular, there were close synergies between BESAC and the Banikinig, Enterprise and Legal Technical Assistance Credit (BELTAC); the latter had an explicit short-tern objective aiming to facilitate the implementation of BESAC through financing for advisory support, traininig and equipment to TDB, SPC and Ministry of Justice (MOJ). The social impact of banking and enterprise reforms were mitigated by a Poverty Alleviation Project (Credit 2760-MOG). 13. The BESAC objectives were important for the development of the Mongolian economy. Without BESAC intervention in the banking and enterprise sectors, the stabilization program and the overall medium-term reform strategy would not have been sustainable and credible. In 1996, the banking sector was on the verge of collapse with most commercial banks facing a liquidity and solvency crisis. In light of the situation of the banking sector at that time, measures taken wilthin the BESAC program were timely and effective in tackling the banking crisis. 14. With some exceptions, BESAC objectives were clearly specified, but too ambitious and too wide in scope. BESAC envisaged different components, including objectives related to the banking sector, the legal system, fiscal adjustment, the enterprise sector, and the establishment of new institutions. The scope of these objectives was too wide, especially for a single-tranche loan with a relatively small leverage on the borrower. The BESAC objectives were also demanding for 3 The combined defaulted loans of the six selected enterprises accounted for about a third of all past due loans, and about 15 percent of total loans outstanding to the banking sector. 4 Arrears to the four private enterprises to TDB alone represented 43 percent of TDB's total loans. 4 the economy as a whole. The realism of the Project has to be evaluated in conjunction with the whole program of intermational assistance that Mongolia received in that period, among which there was a three-year arrangement under the IMF ESAF program, and a $35 million credit from the ADB. These two important programs had with BESAC a commonality of economic goals in terms of macroeconomic stabilization, banking and enterprise sector objectives. However, these operations have probably constituted a heavy workload for the absorptive capacity of a small and troubled country, which at that time was also struggling with a severe banking crisis. 15. In some cases. BESAC was also demanding for some of the agencies in charge of implementing those actions envisaged by the BESAC agreement. For instance, TDB work load to assess the viability of four large defaulters first, and then to implement restructuring/liquidation plans can be objectively considered as a very demanding task. given the initial conditions, constraints, and potential of TDB. Box 1: Actions and monitoring indlicatorsfollowing credit effectiveness. Specific actions related to the banking sector program and following credit effectiveness included the following: * prepare privatization plans, acceptable to IDA, to privatize all state-owned banks (by July 1, 1998; institutional responsibility: BOM, State Property Committee (SPC)); * complete a review of the implementation of the banking law (by July I, 1998; institutional responsibility: BOM, Ministry of Justice (MOJ)); * move the CIB to an organization independent of the BOM (by December 31, 1998: institutional responsibility: BOM); * complete viability assessments for four selected enterprises (by December 31, 1997: institutional responsibility: TDB and selected enterprises) * complete implementation of restructuring/liquidation plans of selected enterprises (by December 31, 1998; institutional responsibility: TDB and selected enterprises). Specific actions related to the enterprise sector program and following credit effectiveness included the following: * reduce the level of arrears in enterprise loan payments to the budget to 24 percent of loans outstanding in 1997: 10 percent in 1998. and 0 percent in 1999 (institutional responsibility: MOF). * eliminate all government subsidies to public enterprises starting from the 1997 budget, with the exception of urban transport enterprises which will be limited to Tg455 million in 1997, Tg600 million in 1998, and Tg700 million in 1999 (institutional responsibility: MOF). * stop all government loans, except to enterprises in electricity and heating, starting from the 1997 budget. MOF loans to these enterprises will be given at 2 percentage points below the central bank bill rate in 1997: at the central bank bill rate in 1998, and at market rates by the 1999 (institutional responsibility: MOF). * complete viability assessments for Darkhan Minimetal and Bagahangai Meat plants (by December 31, 1997), approve respective restructuring/liquidation plans (by March 31, 1998), and implement and complete restructuring/liquidation plans (by December 3 1, 1998) (institutional responsibility: SPC and MOF). * prepare a privatization program for all state-owned enterprises (by July 1, 1997; institutional responsibility: SPC). * present a draft insolvency law to Parliament, satisfactory to IDA (by September 30, 1997; institutional responsibility: MOJ). 5 B. Achievement of Project Objectives 16. Assessment of BESAC must take account of the initial condition and the peculiar situation of Mongolia. Mongolia was, and is still, different from many other transition economies. It is a small economy and geographically isolated; population is 2.7 million, with one of the lowest population densities in the world, and a large component of nomads. Prior to political reform, Mongolia had almost no connection with market economies. Foreign investment has been very limited so far. Moreover, Mongolia was ruled by a communist regime for 70 years. Consequently, human capital, institutions and legal framework relevant for a market economy were extremely scarce. Any assessment of a program aiming to introduce and strengthen a full market-oriented economy has to consider these Mongolian features which make the achievement of good results relatively more difficult compared with many transition economies. 17. On this premise, and with a few exceptions. the program supported by the BESAC achieved many of its objectives. BESAC has had a positive impact on banking and enterprise sector reform. The Borrower has implemented a number of actions to establish a more appropriate frarnework for a market economy. Despite some delays in the implementation of some covenants, the Project has moved ahead almost as planned. The observed delays were mainly due to factors that were out of the control of the Mongolian implementing agency.5 Good progress has been made in restructuring enterprises, imposing hard budget constraints, and also in improving the legal environment. The underlying macroeconomic framework has contributed to supporting these reforms. However, some areas require on-going action by the Mongolian authorities: the biggest state-owned enterprises need to be privatized; bank restructuring and privatization need to go ahead: MARA needs stronger support from the government to continue to recover debts. Progress under the BESAC Program 18. Legal Covenants. The most important actions within the BESAC program were taken prior to credit effectiveness, when the government dealt directly with two major problem banks. Two nonviable banks were closed (People's Bank and Insurance Bank), and a large amount of non- performing loans was carved out to a special newly-established agency (MARA). The major covenants after effectiveness were instead related to developing debt workout capacity, stopping the flow of bad loans, improving the legal environment, imposing hard budget constraints, and restructuring enterprises. 19. Developing Debt Workout. MARA was established in December 1996, with a very ambitious goal of expected recovery equal to 90 percent of assets transferred during its three year lifetime. Since its creation, Tg3O.8 billion of bad loans have been transferred to MARA from People's Bank, Insurance Bank, and more recently from Central Asia Bank. MARA was quite successful in recovering bad loans in 1997. During that year, MARA recovered TgS.4 billion (18 percent), of which about 50 percent was in cash and the rest in physical assets. However, more recent performance has been less satisfactory. During 1998, the amount of debt recovered has declined to Tgl.4 billion, of which Tg880 million was in cash. MARA has been facing growing legal, administrative, and financial difficulties. However, despite many obstacles, MARA's management is still optimistic about debt recovery potential for 1999. According to MARA, a significant percentage of outstanding bad loans-almost 50 percent-could be recovered during 5 Delays in court decisions and the strong decline in the price of copper in 1998 were two cases in point. 6 1999. However, given the past performance and the growing difficulties MARA is facing, such an estimate seems to be too optimistic. 20. Another special Debt Workout Unit-responsible for the recovery of the four large non- performing loans extended to Ulaanbaatar Carpet Factory, Erdenet Carpet Factory. Herlen Carpet Factory, and Ermeel Textile Company-was established within TDB in mid-1997. The Debt Workout Unit has been functioning with two staff and overseen by a director-level manager.6 The Unit has not met the deadline for the viability assessments and liquidation/restructuring plans established in the BESAC agreement. This was due to some delays caused by the late Parliamentary ratification of BESAC first, and then to the long-lastinig and time-consuming lawsuits with the defaulted borrowers. However, recently all the pending legal disputes between TDB and the four borrowers have been resolved, and TDB is making some progress in recovering debt, but is still short of the 30% recovery target set out in the President Report. In the second part of 1998, TDB effort in debt recovery was boosted thaniks to the technical assistance component of BELTAC. Within that program, NBR. the constiltinlg firm having the twillilig arrangement with TDB, made viability assessments and loan restructuring plans for the four enterprises. 21. Stopping the Flow of Bad Loans. Two measures requested by BESAC were expected to contribute to the solution of the bad loan flow problem: the issue of a BOM regulation requiring all commercial banks to report (on a monthly basis) their ten largest loans, and theestablishment of the CIB within BOM. In a second stage, the CIB was also expected to become an organization independent of BOM. 22. In line with BESAC requirements, BOM issued the required regulation, and the CIB was established in March 1997. One person and one computer have been deployed at the CIB. All in all, information provided by the Bureau has been poor and limited, and access to the system has been cumiibersome. CIB's present status leaves room for improvement, and its usefulness for commercial banks and central bank purposes remains scarce. The CIB was not transformed into an organization inidepenidenit from the BOM by the end of 1998, as stated in the Letter of Development Policy, and at present it is still part of the BOM.7 By and large, CIB's role in assisting commercial banks in managing credit risk is still very limited, and no progress has been made since its establishmenlt. 23. Improving the Legal Environment. BESAC required the presentation of a draft of the insolvency law and a full review of the banking law. A draft insolvency law was prepared and ratified in November 1997, and became effective in January 1998. The new insolvency law regulates the relationships between creditors and debtors under bankruptcy conditions and provides the necessary procedures for the rehabilitation or the liquidation of the insolvent entities. However, the application of the new law still encounters obstacles due to the lack of implementing rules. On this front, useful initiatives are being implemented within BELTAC.8 24. A review of the banking law was initiated by the BOM, and some important amendments were approved by the Parliament; they have been effective since September 14, 1998. The most 6 According to BESAC. the unit was expected to comprise a director-level manager and four full-time TDB staff. 7 BOM has recently developed an ambitious plan to strengthen the CIB in terms of financial and human resources, quality and amount of information gathered, links and procedures. In order to implement such a plan, BOM intends to apply for World Bank financial assistance within the technical assistance component of the Private Sector Development Credit, which was approved by the Board of Directors of IDA on May 25, 1999 8 Within BELTAC, thirty three judges were trained on insolvency issues, and three judges are about to visit South Korea to get experience and to study the Korean case; these three judges will be responsible for preparing the implementing rules of the new insolvency law. 7 significant changes introduced were as follows: The selection criteria for commercial bank executives, chairmen, and members of the Board of Directors have been tightened to prevent people with a doubtful past and insufficient banking skills and experience from being nominated. The BOM has increased its control over commercial banks.9 The minimum amount of the paid- up capital has been raised from Tg400 million to Tgl billion, and dividend distribution has been made conditional to compliance with BOM criteria. Auditing of commercial bank books, and comrmercial bank financial reporting has been made more reliable and transparent. In case of breeLch of the banking law, banks, staff members. and director executives now face higher penalties. Moreover, changes in the banking regulation have been recently introduced. Some important amendments refer to capital adequacy requiremenits, and loan classification. 25. Imposing Hard Budget Constraints. As part of the BESAC program, the Government pursued a strict fiscal policy aimed at hardeninig the budget constraint for state-owned enterprises. In 1998, the Government did not provide subsidies to public enterprises, except to urban transport enterprises which received Tg500 million subsidies during 1 998 (same amount as 1997). During 1997-1998, there was no lending to public enterprises, even including electricity and heating companies. The level of arrears in enterprise loan repayments to the budget was reduced by 11 percent in 1998 (50 percent decrease in 1997) from Tgl O.5 billion to Tg9.4 billion. Moreover, the Government remains committed to lend, in case of need, at market rates in 1999. 26. Enterprise Restructuring and Privatization. Within the Enterprise Restructuring Cornponent, BESAC envisaged an economic analysis of two state-owned enterprises (Darkhan Mhinimetal and Bagahangai Meat plants) to decide about either a viable reorganization or a liquidationi of the two entities. BESAC requested to complete an availability assessment by December 31, 1997, to approve respective restructuring/liquidation plans by March 31, 1998, and to implemenit and complete restructuring/liquidation plans by December 31, 1998. At the end of 1997, right after the ratification of BESAC, the State Property Committee selected BMB, a Dutch conisultitlg firm, to conduct viability assessment and restructuring/liquidation plans for both enterprises. All these reports were recently completed, and restructuring plans of the two enterprises are unlder way. As far as the Enterprise Restructuring Component is concerned, BE:SAC conditionis have been met, although with some delays. However, some concerns can be expressed on the terms and amount of credit extended by the MOF to the two enterprises.10 27. Under the Government privatization strategy, approved in July 1997, all state-owned economic enterprises (about 850) are expected to be privatized by the year 2000. During 1997, privatization revenues amounted to Tgl5 billion (1.9 percent of GDP), and Tgl6 billion revenue are expected for fiscal year 1998. The majority of small firms and properties have already been sold, but the biggest and most sensitive industries have not been privatized yet. 9 For instance. BOM. on its own initiative. may now call for a general shareholder meeting of a commercial bank at any time, and misleading advertising by banks is now strictly prohibited. 10 In June 1998. an agreement was reached about the on-lending arrangement between the MOF and the two enterprises. The terms of the arrangement for the "working capital" ]ending envisage a ten year maturity, four year grace period. and I percent interest rate per year. The two parts also agreed on a disbursement schedule that envisaged full disbursement of Tgl billion by July 1997 for BMP. and about Tg2 billion by the end of 1999 for DMP. However, MOF has disbursed so far only about 77 percent of the committed funds. This delay has negatively affected the performance of the two enterprises. and especially BMP given its seasonal activity. Moreover, the two enterprises complained about the asymmetry of the penalty determination mechanism (penalties are envisaged for delay in repayment by enterprises. but there is no penalty for delay in disbursement by the MOF). 8 28. Overall, judged by the legal covenants envisaged before and after the credit became effective, the project was successful in achieving most of its objectives, and the Project's outcome can be rated as satisfactory. 29. Macroeconomic Policies. Results in the macroeconomic stabilization process were patchy, but all in all they can be considered positive and supportive of the BESAC program. In particular, the creation of a stable environment for economic growth received strong support from the declining inflation rate, and from reallocation of credit towards the private sector. 30. Since the beginning of the reform process, the authorities adopted a fully convertible and floating exchange rate regime. fully liberalized the capital accoulnt, deregulated interest rates, and eliminated directed credits. Over the last two years. remarkable achievemelits on inflationl were combined with less satisfactory results on the fiscal and external accounts, mainly caused by external developments. In 1996 and 1998, Mongolia was hit by tw o severe and similar external shocks which affected negatively the terms of trade. In both years, the economy faced trouble coming from declininig prices of Mongolia's major export commodities that caused a sigilificant reduction in tax revenues and a deterioration of both the fiscal and external accounts. Attempts by the BOM to maintailn a stable nom inal exchange rate to control inflation contributed to an appreciation of the real exchange rate, which in turn further worsened the external trade balance. In both years the deterioration of the budget account forced the IMF ESAF program off track. 3 1. Monetary policy was relatively tight througilout the 1996-98 period, and the inflation rate fell significantly.'1 Inflation rate was equal to 17.5 in 1997 and single-digit inflation rate is expected for 1998. Credit allocation shifted in favor of the private sector,12 and lending to public enterprises and the governmaenit declined. However, the amount of credit extended by commercial bankis to private enterprises has been limited and insufficient for a strong growth of private investmenit. Bank interest rates have been particularly sticky, and have remained extremely high despite the strong reduction of inflationi; the high levels of bank interest rates have constituted the major impedhient against a sound credit demand, and hence against private sector development. Under these conditionis, demand for credit has originated mainly among very short-term-oriented traders, and adversely selected borrowers for whom the probability of default is extremely high. This situation has been adding fuel to a vicious circle which compels banks to channel a small amount of resources to the private sector.]3 In addition to trade finance, banks occasionally have extended very short-term vsorking capital loans, but almost no term finance has been available in Mongolia. 32. In general, important positive results have been achieved with regard to the macroeconomic situation during the last two years, especially on the inflation side. All in all, the assessment of the progress made on the macroeconomic front can be considered satisfactory. 33. Project's Impact on the Mongolian Banking Sector. BESAC was an ambitious. program. In addition to the explicit covenants envisaged in the loan agreement, BESAC intended to help place the Mongolian banking sector on a sustainable path to full eventual recovery and sound functioning. In this respect, assessment of the achievement of this ambitious objective is more 1I The Government's objective was to reduce and curb inflation significantly in few years; based on the letter of development policy, the Government targeted inflation to 25 percent in 1997, and to single-digit annual inflation by the year 2000. 12 Commercial banks' claims on the private sector were 39.4 percent of total claims in 1997, and 49.5 percent in October 1998 (the latest available figure). 13 Bank intermediation is still very low in Mongolia: as of December 1997, broad money and credit to the private sector amounted to 27.6 percent and 6.3 percent of GDP, respectively. Currency in circulation still represents 34 percent of broad money. 9 complex. First, it is too early to evaluate BESAC's contribution. The creation of a sound and efficient banking sector is a long process that cannot be assessed just after project completion. Second, during the last two years the Mongolian banking sector has achieved mixed results. In 1997, the financial and solvency position of the sector as a whole improved. Unfortunately, the performance of the sector was much less satisfactory during 1998. The banking sector was hurt by the difficulties of the enterprise sector following the strong decline in Mongolian commodity prices. Despite the fact that the loan quality of some banks is still relatively satisfactory, some large banks have recently had very negative performance. Mainly due to the performance of SDme major banks, the level of non-performing loans as a percentage of total banking sector loans increased significantly in 1998. As far as loan quality is concerned, the impact indicator pointed out in BESAC is the repayment record of new loans extended over the period 1997-98. Flowever, it has been difficult to disentangle the contribution of new loans to the high growth of non-performning loans. As of September 1998, the percentage of non-performing loans in the loan portfolio amounted to 45.9 percent (28.1 percent at the end of 1997). At this time, it is difficult to sitate that the banking sector is on a sound trajectory. While the sector is less vulnerable today than it was before BESAC's intervention, and despite banking culture having improved, and there is more longer term thinking and planning, at least in some commercial banks, the system as a whole remains fragile. Compared to 1997, during 1998 the general situation of the sector has deteriorated in terms of loan quality, capital adequacy and profitability. According to the project performance indicators, the restructuring measures for the banking sector should contribute to deepen the financial sector. However, it is too early to measure such an impact, and in any case that indicator is affected by so many factors that is difficult to disentangle the project contribution to its growth. The ratio between M2 and GDP, that was chosen as an impact indicator for the Project, has not increased significantly over the last two years. At the end of 1997, this ratio amounted to 23.1 percent compared to an expected 30 percent for coming years pointed out in the BESAC's President Report. Important opportunities to make the sector stronger, like the "merger" between Golomt Bank and Reconstruction Bank, were not seized. Unfortunately, political considerations to promote political interests have interfered with economic and sector policies. The fall of the Government, in the summer of 1998, was brought about by the Golomt atffair, which if successful, would have privatized a big state-owned bank through the acquisition by a private bank (Golomt Bank). 34. Bank governance has not made significant progress. Bank privatization is proceeding extremely slowly. A chance to privatize a troubled big bank was recently missed. The bulk of the s,ystem is still under state control,14 although at least the best state-owned bank seems to be in the process of privatization. Progress in bank privatization has been hampered by many factors: limited political will, long political stalemates, changes of Government over the two years, limited capacity and availability of local investors, and scarce interest from foreign investors has a'll contributed to the Mongolian's unsatisfactory outcome in this field. A bank restructuring and privatization strategy was recently approved by the Government, and submitted to Parliament for fiurther consideration. The strategy envisages privatization within a relatively short period of time. However, given the recent political stalemate and the financial difficulties of some major banks, the privatization schedule remains too ambitious. 35. Despite the fact that the banking sector as a whole has made some progress-positive results have been achieved on the institutional development front, both in the central bank and in TDB, and improvements have occurred in the financial legal framework-a lot of work remains to be 14 The partial privatization in some banks was a byproduct of privatization of shareholders; however, these changes have not improved bank governance significantly so far. 10 done to build a sound and efficient banking sector. All in all, and with the caveats mentioned at the beginning of thi's section, the achievement of objectives for the banking sector as a whole must be rated as partial. 36. Project Design. The general assessment of the project design is marginally satisfactory. The BESAC design benefited from the integrated approach of addressing both the enterprise and banking sector and the complementary activities under the other Bank-financed operation BELTAC. On the enterprise front, BESAC comprised elements of realism and discrimination. Providing special temporary budget support to two important state-owned enterprises, after approval of a restructuring plan, increased the political viability of the program. However, BESAC discriminated between the two state-owned enterprises, which received budget support, and the four private enterprises under the TDB restructuring program, which instead did not get any financial help. The combined approach for bank and enterprise restructuring was important and took into account previous Bank's experience. It was based on a very sensible idea previously and successfully developed in other Bank operations. Risks and constraints for the project were also adequately identified. 37. The bank restructuring plan implemented prior to credit effectiveness was a quick and appropriate move which tackled a very urgent problem. At the same time, it was a good idea to focus BESAC actions on supporting the only viable bank at that time. For instance, the establishment of a special debt workout unit within TDB and the twinning arrangement constituted sound measures to strengthen the strongest bank in the system.15 Certainly, those experiences have improved banking culture, and strengthened the skills needed for credit allocation and monitoring within TDB. 38. Some questions can be raised on the structure of the operation. Although initially the project was conceived as a two-tranche operation,l6 the final version provided for a single disbursement. Consequently, BESAC envisaged actions to be taken prior to Board presentation and credit effectiveness conditions, but there was no real additional conditionality once the loan was disbursed. Some form of conditionality would probably have improved the borrower performance. Moreover, the single-tranche design probably affected the short lifetime of the project as well. For the achievement of many project objectives, a project lifetime of one year was too short.17 A longer project life would have provided more inputs for a better evaluation of the project as well. Moreover, BESAC design probably overestimated the capacity of the borrower to implement such a wide range of conditions. C. Implementation Record and Major Factors Affecting the Project 39. Factors Generally Beyond Government Control. The President's Report for the BESAC program recognized that a satisfactory macroeconomic framework was one of the main prerequisites to the success of the program. Unfortunately, the macroeconomic conditions were adversely affected by two severe shocks to the terms of trade. Negative changes in world prices of Mongolian major export commodities, mainly copper, gold and cashmere,18 had a substantial negative impact on project results. The strong decline in prices reduced enterprise profitability 15 TDB share of total claims on non banks was 10 percent, in 1996, 18.4 percent in 1997, and 35.6 percent in October 1998. The upward trend is even more strong if just performing loans are considered (from 18 to 48.7 percent over the December 1996-October 1998 period. 16 See the Project Information Document prepared on September 26, 1996. 17 For instance, this is the case for MARA, and many sector objectives. 18 The structure of Mongolian exports is very concentrated with mineral products-essentially copper-accounting for about 60 percent of total exports. 11 drastically. This. in turn, affected negatively both the budget (less tax revenues and less dividends) and the quality of bank assets through the insolvency of some borrowers. Low loan quality contributed to maintain a very higih level of loan interest rates which also hampered the growth of a sound private sector. 40. Moreover, Mongolia has received a very small amount of foreign private investment since its transformation in a market-economy. In particular, no significant foreign bank intervention has occurred in the Mongolian commercial banks so far, and therefore all the benefits associated with foreign participation and presence have not been exploited by the Mongolian banking sector. On the other hand, positive factors affecting project results were related to the strong support that Mongolia received from the international donor community which provided effective assistance in many areas of the BESAC program. 41. Factors Generally Subject to Government and Parliament Control. The implementation of the BESAC program benefited from a good working relationship between the Mongolian Government and IDA, and strong government commitment, especially during project preparation and the first part of project implementation. During the last months of project implementation instead, the program was challenged by political events, which ended up in a long political stalemate during part of 1998. 42. Coordination with the BELTAC program produced positive results, especially on the enterprise restructuring front. BELTAC assistance contributed positively to the achievement of the BESAC objectives, especially in the cases of the two state-owned enterprises involved in the 13ESAC program, and the TDB effort in debt recovery. Good results were also achieved in the rnacroeconomic stabilization program. Despite some external negative developments, the (Government succeeded in controlling price movements. Reduction in inflation was much quicker than expected, and single digit inflation was already achieved in 1998. 43. Parliament's contribution to the Project's success was mixed. The legal covenants regarding the insolvency law and the banking law were met on schedule. A delay occurred in project effectiveness because of the time spent in the ratification of the agreement by the Mongolian Plarliament. An important area where Parliament's actions could have been more supportive of the reform program is privatization (especially implementation of the bank privatization strategy). 44. Factors Generally Subject to Implementing Agency Control. The implementing agency for BESAC was the MOF. During project preparation, the MOF actively participated in designing the project. Despite frequent changes in government and public administrations, and despite the numerous initiatives of international donors that made coordination a difficult task, covenant compliance can be considered satisfactory. Apart from minor delays, Mongolia fulfilled all loan covenants. 45. Less satisfactory results were achieved in the areas of project implementation, project supervision and the operation phase of the project. MOF's commitment waned especially during the last part of the project life. For instance, some weaknesses were encountered in terms of MOF commitment to supporting the MARA effort in debt recovery, and to assisting two state-owned enterprises through extending the needed financial resources announced in their restructuring plans. 46. BOM, SPC, MOJ, and TDB were also involved in the implementation of BESAC. By and large, these entities contributed positively to the achievement of the project. However, better results could be achieved in the areas of privatization, provision of counterparts funds, and in terms of bank supervision by the BOM. For instance, both bank privatization and privatization of 12 the largest enterprises have been proceeding very slowly. Examples of limited counterpart funds allocated for BESAC initiatives regard the small size of CIB, and TDB's effort in deploying staff to serve the debt workout unit. Finally, another negative factor which indirectly damaged project results was the slow improvement of the bank supervision capability of the BOM, partially due to the frequent changes of personnel involved. D. Project Sustainability 47. Due to some important and significant results achieved by the BESAC program, the project is likely to be sustainable. BESAC supported the effort of the Government to accelerate the reform program to transform Mongolia into a full market-oriented economy. In this respect, it seems likely that future actions by authorities will keep moving in the same direction, and hopefully with a faster pace. Institutional strengthening and improvement of the legal framework will have a permanent and positive effect on the economy. Prospects for project sustainability are also affected positively by the high level of economic and technical assistance on which international donors remain committed. Moreover, project sustainability will benefit from other projects which are still in progress, e.g. the ADB Financial Sector Adjustment Credit, or the Private Sector Development Credit (PSDC), which was approved by the Board of Directors of IDA on May 25, 1999. In particular, the latter should produce positive synergies with BESAC both on the banking sector and the enterprise sector side. 48. However, a significant level of uncertainty still exists in some areas, especially in the banking sector. One of the main long-term objectives of BESAC was to place the Mongolian banking sector on a sustainable path to full eventual recovery and soundness. Despite significant progress made by the BESAC program, it is difficult at this time to conclude that the banking sector, as a whole, is on such a sustainable path. Surely the sector is less vulnerable today than it was two years ago, however the banking sector remains fragile. Bank privatization is behind schedule, and important opportunities to strengthen the sector, like the privatization of Reconstruction Bank, were lost. 49. To maintain support for the project objectives and to allow market mechanisms to function, it will be extremely important to continue fostering the legal and regulatory component of the reform program. Another major economic challenge is to introduce competition into the banking sector, reduce the cost of credit, increase its availability, and eventually increase the level of financial intermediation to support a growing level of investment. E. World Bank Performance 50. BESAC was the culmination of a lengthy process that started in 1995. All in all, the quality of identification, preparation, appraisal, and supervision was satisfactory. The skill mix of mission members was appropriate. Project preparation included collaborative work with the IMF, ADB and other international donors. It has to be born in mind that these groups carried out their work during the occurrence of a severe banking crisis, and partially during elections.l9 In addition, previous work done by the Bank in Mongolia paid little attention to the financial, banking, and enterprise sectors.20 The diagnostic analysis of the banking and enterprise sectors carried out during project preparation was satisfactory. A continued dialogue between Bank staff 19 A new Parliament was elected in June 1996. 20 The only available study of the financial sector was a report "Financial Sector Development and Restructuring Plans for Mongolia", dated January 27, 1995, written within the World Bank Financial Sector Technical Assistance Project. At present, the first "Financial Sector Review" for Mongolia is under preparation. 13 and the Mongolian authorities, and a high-quality economic and sector work performed within the Project by Bank staff, provided sound foundations for the design of the project. Important Enalysis on the banking and enterprise sectors, written by Bank staff and consultants, were carried out during the preparation and the life of the Project. 51. BESAC and BELTAC were properly designed to complement each other, and the overall a[ssessment of this combination is satisfactory. Only a minor point can be raised as far as the interaction between the two projects is concerned. Such a point refers to the objectives BESAC defined for TDB on the one side, and to the TA TDB received within BELTAC on the other. While BESAC required TDB to implement very demanding objectives, namely viability assessments and restructuring-liquidation plans for four large defaulters, the TA provided to TDB tlhrough the twinning arrangement component of BELTAC envisaged a much more limited assignment for the consultants. In particular, within the terms of the twinning contract, the consultants were required to provide assistance to TDB Debt Workout Unit in resolving the non- performing loans to the four enterprises for which BESAC required viability and restructuring plans. However, based on consultants terms of reference,21 the consultants had to develop repayment schedules for the non-performing loans. In other words, the assistance was for the restructuring of the loans, and not for the restructuring of the four enterprises, a much more demanding and comprehensive task. 52. The final outcome of the project benefited from the low World Bank staff turnover, especially at the task manager level. There was always the same task manager during the project life cycle.22 Bank staff and the Mongolian authorities have maintained a cordial and frank relationship through the entire period covered by the program, developing an open dialogue not only about the progress of the project objectives, but also about more general issues of the Mongolian economy. 53. Once the project had become effective, Bank staff monitored Mongolia's progress through tvvo official supervision missions.23 Supervision missions reported adequately about project implementation progress and problems. Minor criticisms can be raised about the insufficient coordination with other donors during the supervision phase, and about the assistance provided to the implementing agencies in dealing with possible solutions to the flagged problems. The MARA performance and the CiB status are two cases in point. Since soon after MARA's establishment, it was clear that the target for MARA's debt collection rate was too ambitious. As time passed, it was also clear that MARA was facing growing legal, institutional and economic difficulties, but no assistance was provided during the last period of the project.24 A similar observation applies to the CIB. Despite the fact that the first supervision mission flagged the inadequacy of the CIB, the Bank was not fully able to assist the BOM in improving the operations of the CIB. Fortunately, this issue has been resumed within the Private Sector Development Credit (PSDC) that was approved by the Board of Directors of IDA on May 25, 1999; however, in this area BESAC might have achieved better results with a more rapid response in providing assistance to the borrower. 21 The terms of reference for the foreign twin are attached to the BELTAC President Report (see Annex 5, Debt Workout section). 22 With the only exception of the final supervision mission that was led by a new task manager. 23 The first supervision mission took place in February 1998, and the second one in November 1998 in parallel with the ICR preparation mission. 24 For instance, initially MARA staff had incentives in collecting bad loans because salaries were linked to debt recovery results. During 1998. most of these incentives were cut off. 14 54. Selection of Legal Covenants. The discrepancy between the covenants envisaged in the Development Credit Agreement on the one hand, and the conditions included in the Letter of Development Policy and in the Matrix of Key Policy Actions on the other was significant. The former envisaged only a small subset of the commitments and actions included in the latter. Although there were no major problems with compliance with BESAC legal covenants by the Mongolian side, and despite the fact that, with some minor exceptions, criteria for judging the achievement of objectives were satisfactory,25 some observations can be made on the definition of the most appropriate conditions in order to achieve project final objectives. In this respect, the selection of some conditions included in the Letter of Development Policy and in the Legal Documents was less satisfactory. Those documents envisaged a wide mix of measures and actions involving various Mongolian institutions. Some conditions were not fully translated in operational and quantified targets, e.g. quantitative targets for privatized enterprises were missing; others were not complete, e.g. the request of a draft of the insolvency law by IDA without considering implementing rules. In some minor cases, conditions were also not directly relevant for the Project's final objectives. For instance, what was the economic rationale for requesting CIB to become an independent organization by the end of 1998? Given the Mongolian situation and the shortage of human resources and information within the banking sector, a CIB working as a part of the central bank could have more advantages than disadvantages. F. Borrower Performance 55. The Borrower performed satisfactorily during project preparation. Initially, the Government was highly committed to the Project, and the Mongolian authorities provided extensive and useful cooperation. By and large, and despite the bad macroeconomic conditions and various constraints, including limited human resources, the authorities can take credit for a number of significant and positive actions. The authorities managed to stabilize the macroeconomic situation. The government was also effective in carrying out significant legislative and institutional preparation prior to project effectiveness. The authorities worked actively on the insolvency law, and the banking law. The Government implemented five, out of the six, steps envisaged by the bank restructuring strategy.26 56. Areas where the Borrower's performance could have been more effective include: implementation, adequacy of monitoring, and evaluation of the Project. On the implementation side, privatization and loan recovery constitute two examples where the Borrower's performance was weak. Bank and enterprise privatization has been much slower than planned. The Government was also expected to provide full support to assist the MARA's effort in debt collection. Govemment support stronger than that given could have helped MARA in being more effective. Unfortunately, many legal and administrative obstacles are still hampering MARA's effort in debt collection. Its legal status is weak, its budget has been halved for 1999, incentives for staff has been drastically reduced. Auctioning and price determination mechanisms for physical assets remain cumbersome. No secondary market for non-performing loans has been created so far. 57. Monitoring and evaluation of the Project by the Borrower was deficient. Most of the people involved in the project preparation from the Borrower's side were not involved in project 25 Some minor remarks can be made regarding the definition and timing of project performance indicators; for instance, some outcome indicators referred to conditions which had to be met prtor to credit effectiveness; an impact indicator was specified in terms of M2/GDP ratio increase, but within a too short time framework (end of 1998). 26 The extemal audits of three commercial banks based on international accounting standards was the sixth step envisaged in the BESAC President Report, and was not completed by the end of the Project. 15 iimplementation. The Borrower's commitment waned during the second part of 1998. Even the lparticipation by the Borrower during the two supervision missions was not completely satisfactory, and similar comments apply to the Borrower's responsibility during the first stage of the ICR preparation. Although performance indicators were pointed out in the Presidential Report, no operational plan was prepared either at the negotiations phase or later during the life of the Project. G. Assessment of Outcome 58. Based on the analysis conducted in the field, and on the examination of all relevant documents, BESAC's outcome as a whole can be rated as satisfactory. BESAC achieved most of its major objectives with only a few exceptions. Many of the most important actions were taken prior to loan effectiveness, and compliance with loan covenants is assessed as satisfactory. Good results were achieved in solving the 1996 banking crisis. The cnablinig environment for the private sector made good progress by reducing inflation significantly, privatizing a large number of small and medium enterprises, imposing hard budget constrailnts, and also improving the legal components envisaged by the project. Under BESAC. the restructuring of some big enterprises wvas initiated, and a significant contribution to institution-building must be considered as positive. Overall, the Bank's work in the context of BESAC helped Mongolia to formulate and implement an important reform agenda in the banking and enterprise sectors. 59. Sustainability of the objectives is considered likely, although some significant uncertainties are still pending, especially as far as the situation of the banking sector is concerned. Moreover, some other issues still require actions by the Mongolian authorities: private sector activity is still largely confined to small business, and the biggest enterprises are still in public hands; bank restructuring and privatization need to go ahead; further progress on the legal and regulatory front is required, the amount of non-performing loans for the system as a whole and the level of loan interest rates should be reduced; MARA needs stronger support from the Government to continue in its effort of debt recovery, and the fiscal deficit has not been brought down to the target levels. H. Future Operations 60. To ensure the sustainable attainment of the program's developmental objectives, it is important for the Government to continue to build upon the actions taken and achievements made under the BESAC program. For its part, the World Bank will continue to work closely with the Mongolian Government to strengthen both the banking and enterprise sectors. The recent establishment of the Bank's Resident Mission in Ulaanbaatar, will greatly facilitate this interaction, especially in the form of regular policy dialogue with govemmental officials and donor coordination. 61. In terms of specific projects to build directly upon the foundation created by BESAC (and 13ELTAC), the Private Sector Development Credit (PSDC) was approved by the Board of I)irectors of IDA on May 25, 1999. This US$12 million investment project includes a credit line and technical assistance to support the Borrower's efforts to promote private sector development, and strengthen the institutional capacity of the banking sector. In particular, the PSDC will: (a) promote private sector development by increasing the availability of commercial bank term loans to private enterprises; (b) increase the institutional capacity of participating banks by strengthening their financial intermediation function and resource allocation capabilities; and (c) 16 increase the institutional capacity of the Bank of Mongolia (BOM) by improving its bank supervision function. 62. The planned strategy and other actions for the operational phase of the Project have been discussed with the Borrower (and reflected in their report-see ANNEX B) and include the following key actions: * To prevent a crowding out of the private sector or a resurgence of inflationary pressures, net credit to the Government will be contained to 1 percent of GDP in 1999, and zero in 2000- 2001, subject to the availability of adequate concessional external loans. * Privatization remains the principal means to reduce the size of the state sector and achieve higher sustainable economic growth. Under the Government's strategy, a comprehensive list covering almost all state-owned enterprises and immovable assets was announced for privatization by 2000. Privatization procedures were simplified and sales techniques were broadened. The privatization program is supported by technical assistance from USAID. * The Government is also drafting an Enterprise Restructuring Program supported by UNDP/Netherlands for the 1998-2001 period. The development objective of this project is to help shorten the length and cost of the transition to a market economy by helping to restructure 10 newly privatized large key enterprises, and thereby develop models and methodologies for such restructuring in Mongolia. * The Government and BOM have formulated a medium-term banking and enterprise reform program for the period 1997-2000 in close collaboration with the IMF, the ADB, and the World Bank. A comprehensive strategy for banking reform has been adopted in collaboration with the IMF, the ADB. and the USAID. The strategy addresses two major issues currently confronting the banking system: the insolvency of three major commercial banks, and the deep rooted systemic problems which are hindering effective financial intermediation. The reforms to correct these problems will be guided by four principles: (1) the need for a substantial reduction in the state ownership of commercial banks through privatization; (2) the need to strictly contain the use of public funds for banking sector restructuring; (3) the need to enhance the enforcement of prudential norms by the BOM; and (4) the need to strengthen the legal and supervisory framework to promote good corporate governance and market discipline in the banking system. * To resolve the insolvency of three major commercial banks, the BOM and GOM are implementing a comprehensive, time-bound action plan.27 Implementation of the restructuring plan will be overseen by a High Level Steering Committee, with operational support from a technical Restructuring Working Group. A wide range of actions will be taken in 1999, and beyond, to ensure that the bank restructuring proceeds in a transparent and sound manner and that the systemic banking problems are addressed in line with the general principles mentioned above. Parliamentary approval of a bank privatization strategy will be secured to make the privatization process transparent and irreversible, and the sale of the Trade and Development Bank will be completed by December 1999. * In order to limit financial costs borne by the public sector, Government funds for recapitalization will be provided only in the event of privatization, up to an amount which 27 In the first phase. conservators and full-time bank restructuring advisors will be appointed to halt a further deterioration in the financial position of the three insolvent banks. In the second phase, plans for operational restructuring will be implemented by the advisors. including closures of branches, reductions in overhead and current expenditures, and restriction of the expansion in liabilities and loan portfolios of the banks. In the last phase (by end- 1999), decisions will be taken to deal with the three banks through recapitalization, privatization, and liquidation. 17 will bring the bank's net worth to zero. Under conservatorship, new lending by insolvent banks will be terminated; collateralized liquidity support by the BOM will be provided only to contain system risk in the interbank payment system; and the hierarchy of claims in the Banking Law, which gives highest priority to household deposits, will be strictly enforced. * With regard to bank supervision, the BOM will continue to strengthen prudential and regulatory norms, review bank licenses and take action in cases where banks fail to meet the -license and "fit and proper" criteria, and initiate prompt supervisory and legal action against banks violating prudential regulations. I. Key Lessons Learned 63. The experience with the BESAC program confirms some lessons that have been learned in many previous Bank operations, but also suggests some other lessons that have been learned as particularly relevant for transition economies: * Government Commitment and Credit Structure: Government commitment is essential to project success. Initially the strong commitment of the Government was critical in achieving the Project's objectives. However, when the Government's attention phased itself out, implementation performance suffered. The lesson here is that conditionality should be used as much as possible to induce the Government to maintain its effort and its commitment to the Project's success. Single-tranche operations should be kept to the lowest level, especially in transition economies where governments, public administrations and reform programs are in a strong state of flux. * Coordination and Division of Labor Among International Donors: Coordination among donors is crucial when a number of international agencies are involved in the same sector, as it was the case in the Mongolian banking sector. BESAC and the Mongolian experience highlighted the need for the Bank to clarify its role in a crisis situation. In some sense, the small banking crisis-relative to other financial crises in the world-anticipated the need to develop a well-defined division of labor among international organizations when a crisis occurs. However, if discussions occur during a banking crisis, priority should be given to those actions needed to tackle the emergency situation. In other words, discussing the division of labor between donors should not delay the implementation of the emergency action plan. * Project Monitoring and Supervision: Monitoring and supervision is important especially in the early phase of reforms when slippage may occur. However, supervision activity can lose most of its relevance if follow-up actions are not possible or not contemplated within the project design. Institutional capacity for project monitoring by the borrower is also crucial. BESAC might have benefited from a better commitment and institutional capacity to monitor project implementation. Such capacity might also have had the effect of mitigating some implementation problems and, in the end, improving project effectiveness. * New institutions: BESAC program envisaged the establishment of two new institutions: MARA and the CIB. The assessment of their operations was not very satisfactory: MARA's impetus and success in recovering debt waned gradually, and CIB's role in assisting commercial banks in managing credit risk has never been developed significantly. The lesson here is that developing new institutions is a long process, which needs to be evaluated in the right perspective, given the situation and the constraints of the country. 18 * Focus on Implementation and Enforcement rather than Approval of a New Law: Implementation and enforcement of laws are a much more difficult and complex process than approval of a new law, especially in transition economies. Therefore, project objectives should give priority to measures relevant to law implementation and enforcement. Of course, in those cases where the relevant legislation is missing, the passage of legislation might be included among the Board presentation conditions. BESAC envisaged the submission of a draft insolvency law to Parliament prior to credit effectiveness, but no further action was contemplated to implement the law. Similarly. in the case of the CIB, BESAC focused its emphasis on the creation of a new institution rather than on its operational functioning and achievements. * Legal Infrastructures, Banking Reforms, and Credit Structure: Experience with banking sector lending in transition economies has demonstrated that reform of the banking sector is a very slow process that requires investment and-changes in institutions, legal infrastructures, and human capital. Consequently, more attention could have been paid to the structure of the credit, in the sense that a two-tranche operation would have allowed the Bank to include and monitor certain critical objectives that normally take more time to be achieved. In particular, within banking sector reforms in transition economies greater priority should be given to the legal, regulatory and institutional changes needed to facilitate sound credit transactions and debt collection and restructuring. Although BESAC has been a good attempt to work in this direction, especially through its twinning with BELTAC and its focus on institutional development, even more emphasis should be placed on the above-mentioned issues in order to make a successful financial reform more likely. * The experience under BESAC has also shown that the Bank should develop an appropriate strategy for those operations whose final objectives can be fully achieved only years after disbursement is completed. This is not an easy task, but it certainly constitutes a relevant issue especially for operations regarding financial sector reforms in transition economies where the needed time to get results is almost, by definition, a matter of years. A possible answer is to carry out follow-up projects that continue or expand activities covered under the previous project. Moreover, it is essential for the Bank to develop an appropriate strategy for the sector as a whole, and within such a strategy sequential projects should be considered. * Bad and Good Bank's Role in Banking Reforms: As almost everywhere, there are relatively well-managed banks and bad banks in the Mongolian banking sector. BESAC helped close down two bad banks and tried to strengthen the best bank of the sector. The lesson here is that when banking reforms are used in transition economies, the authorities should endeavor to strengthen and broaden the best commercial banks instead of fixing and reorganizing the worst ones. BESAC has shown that when investments and resources were directed toward good institutions that good results emerge. TDB is on track to become a well- managed financial institution and the central pillar of the Mongolian financial sector. At the same time, weaker banks should be restricted in their operations. These limitations should be strictly enforced by the central bank. Unfortunately, this was only partially the case in Mongolia, and the weakest banks have caused further problems during their existence. This aspect gives rise to a question regarding central bank independence in transition economies. Central bank independence should focus not only on independence in deciding monetary policy and governmental finance, but also in applying and enforcing financial regulation towards state-owned commercial banks. * Fiscal Consequences of Banking Reform: To the extent possible, more attention should be paid to the fiscal consequences of the banking sector reforms in order to assess short-term and long-term costs. This requires the construction of credible scenario regarding the future 19 viability of the newly-established financial institutions. The analysis of BESAC's effort in estimating the fiscal cost of the Mongolian bank restructuring shows that some consequences of the bank restructuring process were not fully included in the expected fiscal costs. For instance, the running costs of MARA, and the potential costs of future crises of the two newly-established banks were not included in the calculation. e Bank Privatization: BESAC's experience confirms that bank privatization in transition economies is a very complex and prolonged process. Bank privatization cannot be seen in isolation from the capacity of monetary authorities to supervise commercial banks, and in isolation from the capacity and availability of local and foreign investors to absorb new private banks. The lesson here is that bank privatization must be placed in proper perspective when it is part of credit conditions. * Institution-Building and Technical Assistance: Wheni institution building is crucial for a project's objectives, as it is in transition economies, structuiral adjustinent operations that provide a broad agenda for reforms in particular sectors should be accompanied and supported by parallel, well-desigined and timely technical assistance projects. In preparing a technical assistance project, it is crucial that the borrower be actively involved in determining the technical assistance needs. BESAC and BELTAC constituted a good attempt at implementing this simple principle. 21 PART II. STATISTICAL TABLES Table 1. Summary of Assessments A. Achievement of Objectives Substantial Partial Negligible Not Applicable Macroeconomic policies X Sector Policies X Financial Objectives X Institutional development X Physical objectives X Poverty reduction X Gender issues x Other social objectives x Environmental objectives X Public sector management x Private sector development X B. Project Sustainability Likely Unlikely Uncertain x C. Bank Performance Highly Satisfactory Satisfactory Deficient Identification x Preparation assistance X Appraisal x Supervision X D. Borrower Performance Highly Satisfactory Satisfactory Deficient Preparation X Implementation X Covenant compliance x Operation (if applicable) N/A N/A N/A E. Assessment of Outcome Highly Satisfactory Unsatisfactory Highly Satisfactory Unsatisfactory x 22 Table 2: Related Bank Loans Year of Loan Title Purpose Approval Status Preceding operations 1. BELTAC (CR. 2948) To facilitate implementation of the proposed BESAC 1997 Active Project. in particular. the debt workout and loan recovery elements of the Government's reform program. To finance advisory support, training. and where appropriate, materials and equipment for: (a) Trade and Development Bank. a newly-established Debt Workiout Unit (DWU) in T&D Bank-; (b) the State Property Committee (SPC): (c) participating enterprises: and (d) legal support institutions, including. MOJ, the judiciary and the agency responsible for property registration. The longer- term objective is to promote institutional and skills developmenit. so that thie reforms implemented under BESAC can be sustainied. Following operations 1. Private Sector T-he main objectives of the PSDC are to support the 1999 Active Development Credit Borrower's efforts to promote private sector (PSDC) development and to strengthen the institutional (MN-PE-49789) capacity of the banking sector. PSDC, in part, is a follow-up to IDA's BESAC and BELTAC Projects. Table 3. Project Timetable Steps in Project Cycle Date Planned Date Actual Identification June. 1995 June 26, 1995 Appraisal October, 1996 February 02, 1997 Negotiations November, 1996 February 25. 1997 Board Presentation December. 1996 May 01, 1997 Signing July 31, 1997 July 31. 1997 Effectiveness November 26, 1997 November 26, 1997 Project Completion June 26, 1997 June 26, 1997 Loan Closing December 3 1, 1998 December 31, 1998 Table 4. Loan/Credit Disbursement: Cumulative Estimate and Actual (USS Million) FY98 Appraisal estimate 10.0 Actual 9.7 Actual as % of estimate 97% Date of final disbursement January 31, 1998 23 Table 5a. Key Indicators for Project Implementation - Banking Sector Reform Policy Commitments Institutional Implementation Cornditions of Effectiveness * and Measures to be taken by Responsibility Record other measures taken by credit project completion date effectiveness date PlacePeople's Bank and Insurance BOM Done Bank under receivership Establish and license the new BOM Done Saviings Bank and the new Reconstruction Bank Subrnit 1997 budget to Parliament MOF Done withi Tgl6 bl. Earmarked to finance banic restructuring * Establish MARA with power and MOF Done responsibility acceptable to IDA Prepare privatization plans. BOM. SPC A bank privatization acceptable to IDA. to strategy was privatize all state-owned approved by the banks Government in the second part of 1998. but some doubts remain about the feasibility of the plan. Complete a review of the BOM. MOJ Done banking law Issue a BOM regulation requiring BOM Done banks to report their ten largest loans outstanding * Establish a Credit Information BOM Done Bureau (CIB) Move the CIB to an BOM As of Dec. 1998, CIB organization independent of is still part of BOM. BOM Establish DWU in TDB with its TDB Done (DWU has operations supported by 5 TDB staff been operating with 3 (included a director-level manager) TDB staff) Complete viability TDB Met with some delay assessments for four selected enterprises Complete implementation of -TDB Met with some delay restructuring/liquidation plans of selected enterprises 24 Table 5b. Key Indicators for Project Implementation -Enterprise Sector Reform Policy Commitments Institutional Implementation Measures taken by credit Measures to be taken by Responsibility Record effectiveness date project completion date Eliminate Government Linit Governmtenit subsidies MOF Done subsidies to enterprises starting to urban transport enterprises from the 1997 bidget. withi the exception for urban transport enterprises Stop all government loans Lend to enterprises in MOF Done starting from the 1997 budget. electricity and heating. at except to enterprises in CIB bill interest rate electricity and heating Reduce the level of arrears in Reduce the level of arrears MOF Done enterprises loan payment to the in enterprises loan payment budget to the budget to 10% of loans outstanding in 1998 Present a draft insolvency law MOJ Done to IDA Present draft insolvency law MOJ Done to Parliament Complete viability SPC. MOF Done assessment for Darkhan Minimetal and Bagahangai Meat plants Approve and complete SPC, MOF Met with some implementation and delay restructuring/l iquidation plans for Darkhan Minimetal and Bagahangai Meat plants Prepare privatization SPC On-going program for all state-owned enterprises 25 Table 6-a Key Indicators for Project Operation-Banking Reform' INPUT OUTPUT OUTCOME IMPACT Commercial Bank Two large insolvent Savings Bank; Financial deepening as Restructuring banks closed/liquidated; Reconstruction Bank; measured by increase in Two other large and Mongolia Asset M2/GDP, from 23% in troubled banks put Recovery Agency 1996 to 30% by end under strict restructuring established. 1998. contracts. Stopping Loans to Reporting mechanism Lending to defaulters Improved asset quality Defaulters established for monthly ceases, resulting in of individual banks, monitoring of reduction in total non- measured through commercial bank performing loans as a repayment record of lending. percentage of total loans new loans given since from 51 % in 1996 to 1997 by end 1998. 30% by end 1997. Recovery of Non- Loan Recovery of 30% of Establishment of similar performing Loans. repayment/workout for outstanding loans to workout exercises in E_stablishment of Debt four selected private T&D Bank of the four other commercial banks 'Workout Unit in T&D enterprises. selected enterprises by by end 1999. B3ank. Provision of end 1998. c onsultant Services. (Financing: BELTAC) I The matrix of performance indicators reflects the synergy between BESAC and BELTAC particularly with regard to enterprise reform. Input. process and output indicators for banking reform primarily reflect TA provided by other institutions (ADB. IMF). The output and outcome indicators will be evaluated soon after the program ends, while the impact indicators will be evaluated two to three years thereafter. 26 Table 6-b Key Indicators for Project Operation-Enterprise Reform' INPUT OUTPUT OUTCOME IMPACT Public Enterprise Financial restructuring Implementation Darkhan Minimetal and Restructuring and Debt or liquidation and debt schedule for Bagahangai Meat Plants Recovery service plans prepared restructuring/liquidation restructured/liquidated Establishment of SPC- for two selected public developed for the two by end 1998. led public enterprise enterprises. selected enterprises by restructuring exercise. end 1997. SPC-led Provision of consultant restructuring/insolvency services (financing Formal insolvency model extended to other BELTAC). procedures established. public enterprises. Hardening Public Elimination of all Transparency of public Reduction of budget Enterprise Budget subsidies to public expenditures and more deficit/GDP ratio from Constraints. enterprises and entities, effective targeting of 9% in 1996 to 7.3% in Passage of 1997 Budget. except urban transport. budgetary expenditures. 1999. Stop all Government Electricity and heating Electricity and heating loans except to public enterprises receive loans enterprises receive loans enterprises in electricity ait 2 points below central at central bank bills rate and heating. bank bills rate in 1997. in 1998. and at market rates in 1999. I The matrix of performance indicators reflects the synergy between 131SAC and 13FIV1'AC particularly with regard to enterprise reform. Input. process and output indicators for banking reform primarily reflect 'I'A provided by other institutions (ADB. IMF). 'I'he output and outcome indicators will he evaluated soon after the program ends, while the impact indicators s ill be evaluated two to three years thereaf'ter. 27 Table 7. Studies Included in Project Study Purpose as defined at Status Impact of Study ___________________ appraisal/redefined I. Viability Restructure or liquidate plants Complete Restructuring of two assessments for based on viability assessments plants in progress; Darkhan contingent liability of Minimetal and government resolved. Bagahangai Meat Plants 2. Legal diagnostic Review of Mongolian legal Complete Strengthened court Study system to identifying areas that and judicial systems require strengthening through ongoing training of judges and lawyers. Legislation changed 3. Financial Sector Review of overall banking Complete Bank training for Review system, specific focus on commercial banks developing credit collection in launched. New debt select commercial banks workout unit and credit committee _____________________ ________________________________ established. 4. Mongolia Asset Disposal of non performing Complete Bank training for Recovery Agency assets commercial banks (MARA) launched, debt workout unit and credit committee established. 28 Table 8a. Project Costs (USS million) Appraisal estimate Actual/latest estimate Item Local Foreign Total Local Foreign Total IDA 0 10.0 10.0 0 9.7 9.7 Total 0 10.0 10.0 0 9.7 9.7 Table 8b. Project Financing (US$ million) Appraisal estimate Actual/latest estimate Item Local Foreign Total Local Foreign Total IDA 0 10.0 10.0 0 9.7 9.7 Total 0 10.0 10.0 0 9.7 9.7 Table 9. Economic Costs and Benefits (Not Applicable) 29 Table 10. Status of Legal Covenants Agreement Section Covenant Original Status Description of Type Fulfillment Date Covenant 2947 MOG Article III 9 Periodic Complied Particular covenants with related to progress, monitoring, review, reporting, and accounting 2947 MOG Article V 12 Credit effectiveness Done BOM shall have date (November established a credit 1997) information bureau 2947 MOG Article V 12 Credit effectiveness Done The borrower shall have date (November established an agency 1997) with powers and responsibilities acceptable to IDA for the recovery of non- performing loans 2947 MOG Article V 12 Credit effectiveness Done The borrower shall have date (November presented to IDA for 1997) review revised legislation governing insolvency 2947 MOG Article V 12 Periodic Complied IDA shall be satisfied with with the Borrower's maintenance of a sound macroeconomic framework Table 11. Compliance with Operational Manual Statements There was no significant lack of compliance with an applicable Bank Operational Manual Statement (OD or OP/BP) 30 Table 12. Bank Resources: Staff Inputs (in staff weeks) Stage of Project 1995 1996 1997 1998 1999 Total Cycle Preparation to 0.9 43.3 26.5 70.7 Appraisal Appraisal 0.6 0.6 Negotiation 3.4 3.4 Supervision 0.5 0.5 11.5 a/ 12.5 Completion 6.0 a/ 6.0 Total 0.9 43.3 31.0 0.5 17.5 a/ 93.2 a/ Estimated Table 13. Bank Resources: Missions Stage of Month/ Number Days Specialized Performance ratings Types of Project Year of in staff skills Problems Persons Field representeda Implemen- Development tation Objectives Status Pre- 02/95 2 7 EC, FN Identification Identification 08/95 4 12 EC. FN Preparation 02/96 5 14 EC. FN Preparation 05/96 12 19 EC. FN Pre-Appraisal 09/96 8 11 EC. FN Supervision 02/98 2 14 FN S S Delays in Credit Effectiveness, Legal Settlements a/ EC = Economist, FN Financial Specialist b/ HS = Highly Satisfactory: S = Satisfactory, U = Unsatisfactory, HU = Highly unsatisfactory, NR. = Not Rated/Not Applicable 31 ANNEX A ANNEX A: AIDE MEMOIRE-SUPERVISION AND ICR PREPARATION MISSION November 25, 1998 Ulaanbaatar, Mongolia 1. An International Development Association (IDA) mission, comprising Mr. Luca Papi (Consultant), and Mr. Gambosuren Gansuhk (Consultant), visited Ulaanbaatar from November 16 to November 25 to review the status of the Banking and Enterprise Sector Adjustment Credit (BESAC). The mission held discussions with officials of the Ministry of Finance (MOF), Ministry of Justice (MOJ). Mongolian Asset Realization Agency (MARA), State Property Committee (SPC), Bank of Mongolia (BOM), Trade and Development Bank (TDB), and the representatives of the International Monetary Fund (IMF), Darkhan Minimetal Plant (DMP), Bagahangai Meat Plant (BMP), and Norwegian Banking Resources (NBR). 2. The mission would like to express its appreciation for the cooperation extended by the 13ESAC counterpart working group. as well as representatives from the other institutions involved in the project, for fruitful discussions on the status of BESAC. Based on the visits made and discussions held, this Aide Memoire summarizes the main findings and conclusions reached by the mission. The contents of this Aide Memoire is subject to change, pending review by the rnanagement of the World Bank. 3'. The BESAC project and its objectives 3. The Bank and Enterprise Sector Adjustment Credit (BESAC) of US$10 million was a single- tranche adjustment operation. The credit was approved by the- Bank Board on May 1, 1997, signed on July 31, 1997, but became effective on November 26, 1997, due to delays in the ratification in the Mongolian Parliament. BESAC aimed to restore the functional efficiency and to support the institutional development of the banking sector, and to improve the economic performance of the enterprise sector. 4. Banking sector project objectives. On the banking sector front, BESAC pursued the following key objectives: (i) supporting the implementation of the bank restructuring strategy; (ii) stepping up commercial bank loan recovery effort; and (iii) assisting the Government in the adjustment process of the banking sector needed to serve a new market-oriented economy. 5., Within the support of the overall bank restructuring strategy up-front measures were implemented prior to Board presentation. These measures included the liquidation of two large insolvent banks (People's Bank and Insurance Bank), the establishment of two new commercial banks (Savings Bank and Reconstruction Bank), and the creation of the Mongolian Asset Realization Agency. The second core component of the BESAC intervention in the Mongolian banking sector was related to the development of a debt workout capacity, and to the intensification of the loan recovery effort by the government and commercial banks. This was a two-pronged strategy. On the one hand, the recovery of the stock of non-performing loans was cdelegated to MARA and to a special debt workout unit within TDB; on the other hand, measures to deal with the flow problem of new loans extended to potential defaulting borrowers were adopted as well. The third component comprised a mix of measures that were aimed to rnodernize and make more effective the role of the banking sector in the new market economy. In 32 ANNEX A this context, BESAC envisaged a review of the banking law. Besides, bank privatization was considered as part of the Government's medium-term reform program of the banking sector. 6. Enterprise sector project objectives. BESAC supported the implementation of enterprise reform that complemented the banking sector strategy. The Project's key objectives for the enterprise sector were the following: (i) imposing hard budget constraints on public enterprises; (ii) restructuring or liquidating some selected enterprises that were not economically viable; and (iii) contributing to the private sector development by accelerating enterprise privatization and strengthening the economic legal framework. 7. The imposition of hard budget constraints was a key element to avoid that defaulting enterprises, cut off from bank credit, could ttir to the budget as an alternative source of finance. In doing so the imposition of hard budget constraints was expected to complement the banking sector strategy, and to stop the drain on public resources that these enterprises represented. The enterprise restructuring coiiponent aimed also to restructure or liquidate six selected enterprises chosen on the basis of their relatively large amount of non-performing loans. The objective was to attain either a viable reorganization or a liquidation of the six entities, based on the results of preliminary viability assessments. The private sector development component envisaged a widespread and rapid privatization program and a strengthening of the economic legal framework. The progress on the legal front envisaged the preparation of a draft insolvency law. For specific actions and monitoring indicators related to the banking and enterprise sector programs see Annex 1. Project Implementation Status 1I. Recent macroeconomic developments 8. In 1997, the macroeconomic program undertaken by the Mongolian government achieved good results. IMF ESAF program was on track, and the overall assessment of the macroeconomic situation provided by the previous BESAC supervision mission (February 1998) was highly satisfactory. 9. Conditions changed significantly during the first ten months of 1998. Mongolia's economy has been facing troubles coming from a decline of prices of Mongolia's major export commodities, and from an unstable political situation, that caused a significant deterioration of the fiscal and external accounts. Such a deterioration forced the IMF ESAF program out of track during the first semester of 1998; consequently, the IMF decided to cancel the midterm review in June 1998. Since June, the situation has continued to deteriorate. The budget deficit is expected to amount to 11.4 percent of GDP28 (8.6 percent in 1997). In October 1998, the trade deficit amounted to its record level of US$128.4 (about 12 percent of GDP). 10. Monetary policy has been relatively tight throughout 1998,29 and the inflation rate has continued to decline. In October, inflation achieved the remarkable annual changes of 5.3 percent3O (2.7 from the beginning of 1998); however, bank interest rates on loans still remain extremely high. The tugrik depreciated respect to the US$ by 7.1 percent in the last 12 months 28 The Government is projecting a budget deficit/GDP ratio equal to 10 percent for 1999. In order to achieve transparency in public expenditure and more effective targeting of budgetary expenditures, MOF has prepared a draft law "Public Administration Management and Finance" and submitted it to the Parliament in September 1998. 29 M2 declined by 4.4 percent since the beginning of the year. 30 Inflation rate was 17.5 percent in 1997. 33 ANNEX A ('5.7 from the beginning of the year). GDP growth is expected to be 3.5 percent in 1998 (4 percent in 1997). III. Banking Reform 11. Commercial Bank Restructuring BESAC was intended to place the Mongolian banking sector on a sustainable path to full eventual recovery and sound-functioniing. As already stated above, important bank restructuring measures were implemented prior to Board presentation. The year 1997 was a positive year for the banking sector, and the financial and solvency position of the sector as a whole improved. 12. Unfortutiately, the performance of the sector has been much less satisfactory during 1998. The health of the banking sector as a whole has been hurt by the difficulties of the enterprise sector following the strong decline in Mongolian comimiodity prices. At this time, it is difficult to state that the bankling sector is on a sound trajectory. While the sector is probably less vulnerable today thanl it was before BESAC intervenitioni, the system remains fragile. Important opportunity to make the sector stronger, like the merger between Golomt Bank and Reconstruction Bank, have riot been seized. Unfortunately, political considerations to promote political interests have interfered with economic and sector policies. Some major banks are facing very worrying situations and have been put under strict BOM control. Compared to the last year, the general situation of the sector has significanltly deteriorated in terms of loan quality, capital adequacy and profitability.31 13. A bank restructuring and privatization strategy was recently approved by the Government, and submitted to the Parliament for further consideration. The strategy envisages privatization witilin a relatively short period of time. A working group will be set up to supervise the restructuring and privatization process carried out by the State Property Department. However, the missioni believes that, given the political stalemate and recent financial difficulties of some major baniks, the schedule of the bank privatization strategy might be too ambitious. 14. Debt workLiout MARA. MARA was established in December 1996. Since then Tg3O.8 billion of badl loans have been transferred to MARA from People's Bank, Insurance Bank, and more recently from Central Asia Bantk. MARA has a staff of 108 people. MARA completed the classif'ication of all non-performing loans in its portfolio. The stated goal of its recovery effort was very high, and equal to 90 percent of the assets transferred during its three year lifetime. 15. MARA was quite successful in recovery of bad loans in 1997. During that year, MARA recovered Tg5.4 billion, of which about 50 percent in cash and the rest in physical assets. However, the performance in recent months has been less satisfactory. During 1998 the amount of debt recovered has declined to Tgl.4 billion, of which Tg880 million in cash. 16. MARA is facing growing legal, administrative, and financial difficulties. However, despite many obstacles, MARA management is still optimistic about MARA debt recovery capacity for 1999. According to MARA, a significant percentage of outstanding bad loans - almost 50 percent -could be recovered during 1999. The mission believes that given the past performance and the growing difficulties MARA is facing, such an estimate seems to be too optimistic. 31 According to the project performance indicators the restructuring measures for the banking sector should contribute to deepen the financial sector. However, it is too early to measure such an impact, and in any case, that indicator is affected by so many factors that is difficult to disentangle the project contribution to its growth. The ratio between M2 and GDP. that was chosen as an impact indicator for the project, has not increased significantly over the last two years. At the end of 1997. this ratio amounted to 23.1 percent compared to an expected 30 percent for coming years pointed out in the BESAC President Report. 34 ANNEX A 17. Based on the BESAC project, the government was supposed to provide full support to assist the MARA effort in debt collection. A Government support stronger than the present one could help MARA in being more effective in its actions. Unfortunately. many legal and administrative obstacles are still hampering MARA effort in debt collection. Its legal status is weak, its budget has been halved for 1999, incentives for staff has been drastically reduced. Auctioning and price determination mechanism for physical assets remain cumbersome. No secondary market for non- performing loans has been created so far. 18. Debt workout Unit at the Trade Development BankL A special Debt Workout Unit, responsible for the recovery of the four large non-performing loans extended to Ulaanbaatar Carpet Factory. Erdenet Carpet Factory, Herlen Carpet Factory. and Ermieel Textile Company, was established in mid 1997. The Debt Workout Unit is functioning with two staff and overseen by a Director-level manager.32 19. The Unit has not met the deadline for the viability assessments and liquidationi/restructuring plans established in the BESAC agreement. This was due to some delays caused by the late Parliamentary ratification of BESAC first, and theni to the long-lasting and time-consuming lawsuits with the defaulted borrowers. However, recently all the pending legal disputes between TDB and the four borrowers have been solved, and TDB is making some progress in debt recovering.33 20. After almost two years. the court made a final decision declaring the three carpet factories as defaulters and determining the total amount the enterprises owe to TDB. The court has obliged Erdenet carpet factory and Ulaanbaatar carpet factory to pay Tg2.7 billion and Tgl.7 billion to TDB, respectively. TDB has also reached an agreemenit with "iEermel" that envisages the payment of Tg350 million from Eermel to TDB.34 21. TDB effort in debt recovery was recently boosted thanks to the technical assistance component of BELTAC. Within that program, NBR, the consulting firm having the twinning arrangement with TDB, made a viability assessment of Kherlen carpet factory (Choibalsan) in July 1998, and suggested to liquidate the firm. The NBR consultants have also agreed to undertake a liquidation plan of Kherlen carpet factory in the coming two months. Besides, NBR is currently conductinig a comprehensive diagnostic review of Ulaanbaatar carpet factory, including a viability assessment and a loan restructuring plan. Viability assessments and restructuring/liquidation plans for Erdenet carpet factory and "Eermel" plant have not been done by the NBR experts since such tasks, as the experts stated, were not covered by their TOR and they are primarily responsible for loan restructuring. 22. Stopping the Flow of Bad Loans. Two measures requested by BESAC were expected to contribute to the solution of the bad loan flow problem: the issue of a BOM regulation requiring all commercial banks to report on a monthly basis their ten largest loans, and the establishment of a Credit Information Bureau (CIB) within BOM. In a second stage, the CIB was expected to become an organization independent of BOM. 23. In line with BESAC requirements, BOM issued the required regulation, and the CIB was established in March 1997.35 In this respect, BOM has practically met the BESAC conditions 32 According to BESAC. the unit was expected to comprise a director-level manager and four full-time TDB staff 33 So far. TDB has recovered loans worth AusSh. 1.5 million through disposal of some inventories of the Erdenet carpet factory (approx.US$1OO.000) in collaboration with the Bailiff's Office in 1997, and Ulaanbaatar carpet factory (approx. US$537.000) during 1997-1998. 34 Eermel agreed to repay Tg30 million by the end of 1998, and the rest by the end of 1999. 35 At present, the CIB is still part of the BOM. 35 ANNEX A satisfactorily. However, the mission believes that the solution of the loan quality within the Mongolian banking sector is still distant. Despite the fact that the loan quality of some banks have been improved, some other large banks have recently had very negative performance. All in all, and mainly due to the performance of three major banks, the level of non performing loans as a percentage of total banking sector loans has increased significanitly over recent months. As of September 1998, the percentage of non-performing loans in the loan portfolio amounted to 45.9 percent (28.1 percent at the end of 1997).36 24. Credit Information Bureau (CIB). At present. only one person and one computer continue to be deployed at the CIB. The flow of information collected by the CIB comprises general information on borrowers, and amount of outstandinig loans classified according to BOM standards. The informiation refers to the situation at the end of each montil. No informationl is provided on loan commitments, collateral, average monthly balance, and group affiliated borrowers. All in all, itformation provided by thie Bureau remains poor and limited, and access to the system is culilbersomle. CIB present status leaves room for improvement, and its current usefulness for commercial banks and central bank purposes remains scarce. 25. However, BOM hlas recently developed an ambitious plan to strengthen the CIB in terms of financial and human resources, quality and amount of information gathered, links and proceclures. In order to implement such a plan. BOM intends to -apply for World Bank financial assistance within the technical assistance component of the Private Sector Development Credit, which was approved by the Board of Directors of IDA on May 25, 1999. At present, it seems unlikely the CIB will become an organizationi independent from the BOM by the end of 1998, as stated in the Letter of Development Policy. 26. Review of the Banking Law and Regulation. BESAC required a full review of the banking law by July 1, 1998. A review of the banking law was initiated by the BOM, and some important amenecinilelts were approved by the Parliament; they have been effective since September 14, 1998. 27. The most significanit chanlges are the following. The selection criteria for commercial bank executives, chairmen, and members of the Board of Directors have been tightened to prevent people withi doubtful past. and insufficienit banking skills and experience from being nominated. The BOM has increased its control on commercial banks. For instance, BOM, on its own initiative. may now call for a general shareholder meeting of a commercial bank at any time; misleading advertising by banks is now strictly prohibited, and BOM can order those commercial banks in violation to stop doing so. The minimum amount of the paid-up capital has been raised from Tg400 million to Tgl billion, and dividend distribution have been made conditional to comp[iance with BOM criteria. Auditing of commercial bank books, and commercial bank financial reporting have been made more reliable and transparent. In case of breach of the banking law, banks, staff members, and director executives face now higher penalties. 28. The mission has also been informed that changes in the banking regulation have been recently introduced, and other are about to become effective. Some changes will refer to capital adequacy requirements, and loan classification. The mission considers these changes to the banking law and regulation to be positive and satisfactory for the BESAC program. 36 As far as loan quality is concerned, the impact indicator pointed out in BESAC is the repayment record of new loans extended over the period 1997-98. However, the mission was not able to disentangle the contribution of new loans to the high growth of non-performing loans. 36 ANNEX A IV. Enterprise reform 29. Imposition of hard budget constraints. As part of the BESAC program, the Government has been pursuing a strict fiscal policy aiming at hardening the budget constraint for state-owned enterprises. In 1998, the Government has not provided subsidies to public enterprises, except to urban transport enterprises which have received Tg500 million subsidies during 1998 (same amount of 1997). During 1997-1998, there was no lending to public enterprises, even including electricity and heating companies. The level of arrears in enterprise loan repayments to the budget has been reduced by 1] percent in 1998 (50 percent decrease in 1997) from Tgl0.5 billion to Tg9.4 billion. Moreover, the Government remains committed to lend. in case of need, at the central bank bill rates in 1998. and at market rates in 1999. 30. Enterprise restructuring. Within the enterprise restructuring component BESAC envisaged an economic analysis of Darkhan Minimetal and Bagahanigai Meat plants to decide about either a viable reorganization or a liquidation of the two entities. BESAC requested to complete an availability assessment by December 3 1, 1997, to approve respective restructuring/liquidation plans by March 31, 1998, and to implement and complete restructuring-liquidation plans by December 3 1. 1998. At the end of 1997, right after the ratification of BESAC, the State Property Committee selected BMB, a Dutch consulting firm, to conduct viability assessment and restructuring-liquidation plans for both enterprises. 31. Bagahangai Meat Plant (BMP). The viability assessment of BMP was completed on March 13,1998. The conclusion of the preliminary analysis was that, despite BMP theoretical potential for viability, the liquidation of BMP represented a safer route for the Government compared to the risk of further failure. However, on April 20, the SPC in conjunction with the Government, decided to go ahead with the restructuring, confirmed to provide the necessary financial support, and requested BMB to proceed with the development of the restructuring plan. 32. On August 1. 1998 BMB presented the final implementation report. Besides, BMP management, withi the guidance and assistance of BMB, produced a detailed business plan for the current and next four years. The business plan contains very ambitious production targets-so far BMP has kept operations at an extremely low level-and forecasts pre-tax profits of Tg2.1 billion during the 1998-2002 period. However, these figures are based on many debatable assumptions, and according to the BMB consultants the level of profits indicated by BMP may prove to be optimistic.37 33. Darkhan Minimetal Plant (DMP). The preliminary viability assessment of DMP, undertook by BMB on behalf of the SPC, was completed in March 1998. The assessment concluded that the liquidation of DMP would produce only modest realization proceeds (about Tg800 million). Conversely, a successful restructuring of DMP could be achieved, given the important steps toward restructuring already taken in 1996 and 1997. Assuming achievement of production/sales targets, considered realistic by the BMB consultants, DMP could generate cash flow estimated at Tg7.9 billion over the next five years. However, the viability of the restructuring requires additional financial support by the MOF estimated at Tg2.1 billion. 37 For instance, profits are stated prior to consideration of interest charges on existing bank borrowings and on new working capital loans from the MOF; the level of first grade meat which BMP is forecasted to achieve is equal to 85 percent of total meat production, against 50 percent which seems to be the industry average; the meat yield from live weights of animals has been estimated by BMP management as equal to 48 percent, and even a slippage to 47 percent would reduce the cash flow shown in the business plan to break-even; no provision is included for future refurbishing and replacing of BMP's plants and equipment; last but not least, very little consideration has been given to the demand side of the market. 37 ANNEX A 34. In April 1998, the SPC confirmed the necessary financial support and instructed BMB to start developing the restructuring program. DMP restructuring started in June 1998. DMP management, with the assistance of BMB consultants, produced a detailed business plan for 1998 and the next five years. Based on some prudent assumptions. the projections show BMP should start generating profits in the year 2000. Again the figures are stated prior to consideration of interest charges on existing bank borrowings and new working capital loans from the MOF. 35. In June 1998, an agreement was reached about the on-lending arrangement between MOF and the two enterprises. The terms of the arrangement for the "working capital" lending envisage a ten year maturity, four year grace period, and I percent interest rate per year. The two parts also agreed on a disbursement schedule that envisaged full disbursement of Tgl billion by July 1997 for BMP, and about Tg2 billion by the end of 1999 for DMP. However, MOF has disbursed so far only about 77 percent of the committed funds. This delay has negatively affected the performance of the two enterprises. and especially BMP given its seasonal activity. Moreover, concerns have been raised by the DMP and BMP management about the conditions of the on- lending agreement. In particular, the two enterprises complained about the foreign exchange risk they have to bear, and about the asymmetry of the penalty determination mechanism (penalties are envisaged for delay in repayment by enterprises, but there is no penalty for delay in disbursement by the MOF). 36. As far as the enterprise restructurinig componlenit is concerned, the mission considers that BESAC' conditions have been met, althoughi with some delays. However, the mission expresses some concerns on the terms and amount of credit extended by the MOF to the two enterprises. Besides, in the light of the results of the BMB studies and the restructuring actions in progress, consideration should be given for an earlier privatization of both enterprises. 37. Status of Enterprise Privatization. Under the Mongolian Government privatization strategy, approved in July 1997, all state-owned economic enterprises (about 850) are expected to be privatized by the year 2000. During 1997, privatization revenues amounted to Tgl5 billion (1.9 percent of GDP), and Tgl6 billion revenue are expected for fiscal year 1998. The majority of small firms and properties have already been sold, but the biggest and most sensitive industries have not been privatized yet. 38. Insolvency Law. A new insolvency law has been effective since January 1998. However, the application of the new law still encounters obstacles due to the lack of implementing rules. On this front, useful initiatives are being implemented within BELTAC, the BESAC twin program. Thirty three judges have been trained on insolvency issues, and three judges are about to visit South Korea to get experience and to study the Korean case; these three judges will be responsible for preparing the implementing rules of the new insolvency law. Concllusions 39. Thie general assessment of the implementation status of the BESAC project is satisfactory. Despite some delays in the implementation of some covenants, the project is moving ahead almost as planned. The observed delays are mainly due to factors that are out of the control of the Mongolian implementing agencies. Delays in court decisions and the strong decline in the price of copper are two cases in point. In the second part of 1998, good progress has been made in restructuring enterprises, imposing hard budget constraints, and also in reviewing the banking law. However, some other issues still require actions by the Mongolian authorities: the biggest state-owned enterprises need to be privatized; bank restructuring and privatization need to go ahead; MARA needs stronger support from the government to continue in its effort of debt 38 ANNEX A recovery; plans for reorganizing the CIB has to be implemented. For the rating of each project development objective see Form 590. 39 ANNEX A Annex 1. BESAC actions and monitoring indicators Specific actions and monitoring indicators related to the banking sector program and following credit effectiveness included the following: e Prepare privatization plans, acceptable to IDA, to privatize all state-owned banks (by July 1, 1998; institutional responsibility: BOM, SPC); * Complete a review of the implementation of the banking law (by July 1, 1998; institutional resiponsibility: BOM, MOJ ); * Move the Credit Information Bureau to an organization independent of BOM (by December 31, 1998; institutional responsibility: BOM): * Co-mplete viability assessments for all four selected enterprises (by December 31, 1997; institutional responsibility: TD Bank and selected enterprises): * Coimplete implementation of restructurinig/liquidation plans of selected enterprises (by December 31, 1998; institutionial responsibility: TD Bank and selected enterprises). Specific actions and monitoring indicators related to the enterprise sector program and following credit effectiveness included the following: * Reduce the level of arrears in enterprise loan payments to the budget to 24 percent of loan outstanding in 1997: 10 percent in 1998. and 0 percent in 1999 (institutional responsibility: MOF); * Ellnimiate all government subsidies to public enterprises starting from the 1997 budget, with the exception of urban transport enterprises which will be limited to Tg455 million in 1997, Tgl500 million in 1998, and Tg700 million in 1999 (institutional responsibility: MOF); * Stop all governiment loans, except to enterprises in electricity and heating, starting from the 1997 budget. MOF loans to these enterprises will be given at 2 percentage points below the cenitral bank bill rate in 1997; at the central bank bill rate in 1998, and at market rates by the 1999 (institutional responsibility: MOF); * Complete viability assessments for Darkhan Minimetal and Bagahangai Meat plants (by December 3 1, 1997), approve respective restructuring/liquidation plans (by March 3 1, 1998), and implemenit and complete restructuring/liquidation plans (by December 31, 1998) (institutional responsibility: SPC and MOF): * Prepare a privatization program for all state-owned enterprises (by July 1, 1997; institutional responsibility: SPC): * Present a draft insolvency law to Parliament, satisfactory to IDA (by September 30, 1997; institutional responsibility: MOJ). 40 ANNEX B ANNEX B: BORROWER'S CONTRIBUTION TO THE ICR April 1. 1999 Mr. Hoon Mok Chung Sector Manager Private Sector Development Unit East Asia and Pacific Region Washington, D.C 20433 U.S.A FAX: (202) 522 34 54 Your Excellency, Re: Evaluation Report on implementation of BESAC project by the Ministry of Finance 1. The Governmenlt's Medium-Term Economic Strategy supported by a IMF ESAF and the BESAC got off to an impressive start in 1997. Inflation fell from 45 percent in 1996 to 20 percent, well below the program target. and growth recovered from 2.6 percent in 1996 to 4 percent. The external current account (excluding official transfers) shifted from a sizable deficit (10 percent of GDP) in 1996 to a small surplus (1.3 percent of GDP), reflecting strong export price and volume growth. (i) Assessment of the project objectives, design, implementation and operation experience. 2. The Banking and Enterprise Sector Adjustment Credit (BESAC) was signed on July 3 1, 1997. BESAC is the project to support the Govermenit's effort to recover the outstanding loans from those enterprises that most adversely influenlce the banking system. Implementation of both the banking and enterprises restructurinig componenits of the project are considered satisfactory, as is the overall implemenitationi of the project. 3. On the bankinig sector front, BESAC pursued the following key objectives: (i) supporting the implementation of the bank restructurinig strategy: (ii) stepping up the commercial bank loan recovery effort; and (iii) assisting the Government in the adjustment process of the banking sector needed to serve a new market-oriented economy. 4. Within the support of the overall bank restructuring strategy, up-front measures were implemented prior to Board presentation. These measures included the liquidation of two large insolvent banks (People's Bank and Insurance Bank), the establishment of two new commercial banks (Savings Bank and Reconstruction Bank), and the creation of the Mongolian Asset Realization Agency (MARA). 5. The Mongolian banking sector restructuring strategy was related to the development of a debt workout capacity, and to the intensification of the loan recovery effort by the government and commercial banks. This was a two-pronged strategy. On the one hand, the recovery of the stock of non-performing loans was delegated to MARA and to a special debt workout unit within Trade and Development Bank (TDB). Over last 2 years 7.3 billion Togrogs of bad loans were recovered by MARA; on the other hand, measures to deal with the flow problem of new loans extended to potential defaulting borrowers were adopted as well. Registered Borrowers in MARA have been provided with certifications on clearance of bad loans. 41 ANNEX B 6. A special Debt Workout Unit, responsible for the recovery of the four large non-performing loans extended to Ulaanbaatar Carpet Factory, Erdenet Carpet Factory, Herlen Carpet Factory, and Eermel Textile Company was established in mid-1997. The Debt Workout Unit has taken related policy measures, and 150.7 million Togrogs of bad loans was recovered from four enterprises. Delays in court decisions also resulted in weak recovery of bad loans. 7. The Bank of Mongolia established the Credit Information Bureau (CIB). The flow of information collected by the CIB comprises general information on borrowers, and the amount of outstanding loans classified according to Bank of Mongolia standards. The information refers to the outstanding loans at the end of each month, and is disseminated to other commercial banks. 8. Despite delays in the implementation of some covenants, the program supported by the Project is moving ahead almost as planned. The observed delays are mainly due to factors that are beyond the control of the Mongolian implementing agencies. Delays in court decisions and the strong decline in the price of copper are two cases in point. In the second part of 1998, good progress was in restructuring enterprises, imposing hard budoet constraints and also in revising the banking law. 9. However, some other issues still require actions by the Mongolian authorities: the biggest state-owned enterprises need to be privatized; bank restructuring and privatization need to go ahead; MARA needs stronger support from the government to continue in its effort of debt recovery; and plans for reorganizing the CIB need to be implemented. 10. The imposition of hard budget constraints was a key element to prevent defaulting enterprises, cut off from bank credit, from turning to the budget as an alternative source of finance. This program eliminated all Governiment subsidies to enterprises. I 1. The enterprise restructuring component aimed also to restructure or liquidate six selected enterprises, chosen on the basis of their relatively large amount of non-performing loans. The objective was to attain either a viable reorganization or a liquidation of the six entities, based on the results of preliminary viability assessments. 12. According to this objective the following policy measures have been taken: By end-1997, right after the ratification of BESAC by Parliament, the State Property Committee (SPC) selected BMB, a consulting firm, from the Netherlands, to conduct viability assessments and restructuring-liquidation schedules for Darkhan Minimetal (DMP) and Bagakhangai Meat processing (BMP) plants. 13. Implementation of the restructurinig schedule for DMP began on June 1, 1998, and that for BMP on July 1, 1998. In addition to the restructuring schedules, BMB developed 5-year business plans for the two enterprises. Implementationi of the business plans is underway. (ii) Performance of the Borrower and implementing Agencies and Lessons learned. 14. The project implementation plaii was prepared and approved by the SPC. MARA was established in the beginling of 1997, and is monitoring the following private light enterprises: Erdenet Carpet Company; Dornod Carpet Company; UB Carpet Company; and Eermel Textile Company. 15. The Debt Workout Unit has not met the deadline for the viability assessments and liquidation-restructuring plans established in the BESAC agreement. This was due to some delays caused first by the late Parliamentary ratification of BESAC and subsequently to the drawn-out and time-consuming lawsuits with the defaulting borrowers. Recently, however, all the pending legal disputes between TDB and the four Borrowers have been solved, and TDB is 42 ANNEX B making some progress in debt recovery. After almost two years, the court made a final decision declaring the three carpet factories and the Eermel Textile Plant as defaulters, and determining the total amount the enterprises owe to TDB. 16. Trade and Development Bank ' s (TDB) efforts in debt recovery have been boosted thanks to the technical assistance component of BELTAC. Within that program, NBR, the consulting firm having the twinning arrangement with TDB, made a viability assessment of Kherlen Carpet Factory (Dornod) in July 1998, and suggested it to be liquidated. The NBR consultants have also agreed to prepare a liquidation plan for Kherlen Carpet Factory in the coming two months. In addition, Norwegian Banking Resources (NBR) is currently conducting a comprehensive diagnostic review of Ulaanbaatar Carpet Factory, including a viability assessment and a loan restructuring plan. Viability assessments and restructiring-liquidationi plans for Erdenet Carpet Factory and Eermel Plant have not been done by the NBR experts since such tasks, as the experts stated, were not covered by their Terms of Reference (TOR) and they are primarily responsible for loan restructuring. (iii) World Bank Performance. 17. The World Bank played a strong role in this project. The policy-based Banlking and Enterprise Adjustment Credit (US$10 million), and an associated Bankinig. Enterprise and Legal Technical Assistance Credit (US$2 million). became effective in November 1997. These operations are assisting the government in implemenitilig its structural reform programs in the financial and enterprise sector, and developing the legal framework for commercial and financial transactions. Extensive technical assistance has been provided to Mongolia by the World Bank, which has played an important role in implementing key structural measures and developing an institutional and legal framework essential for a market economy. 18. World Bank performance was satisfactory for this project. We learned a lot during the implementation of the Project. For instanice, viability analysis and business plan will be used for other enterprises. However, the Borrower and World Bankl did not designate officials to be in charge of coordination of project components and compiling the progress reports. In lieu of this, the project has satisfactorily coordinated throLigil supervision missions and the cooperation among the officials responsible for the separate componienlts. 2. The Operational Plan for the Future 19. With little prospect for siginificanit improvemilenit in the terms of trade in the short-to-medium term, the government will need to undertake a strong adjustment effort to promote sustained output growth of 3 1/2 - 4 1:/ percenit and mainitaini a single-digit inflation performance, while raising gross reserve cover to a more adequate level of 13 weeks of imports. To achieve these objectives a strong fiscal consolidationi effort will be required, with a progressive reduction in the overall deficit to around 6 1/4 percent of GDP by 2001. To prevent a crowding out of the private sector or a resurgence of inflationiary pressures, net credit to government will be contained to 1 percent of GDP in 1999, and zero in 2000-2001, subject to the availability of adequate concessional external loans. 20. The state-owned enterprise sector continiues to face serious financial problems stemming from poor management and low efficiency. Privatization remains the principal means to reduce the size of the state sector and achieve higher sustainable economic growth. 21. Under the government's strategy, a comprehensive list covering almost all state-owned enterprises and immovable assets was announced for privatization by 2000. Privatization 43 ANNEX B procedures were simplified and sales techniques were broadened. The privatization program is supported by technical assistance from USAID. 22. Privatization has proceeded rapidly, and total receipts during 1997-98 (Tg28.5 billion) were considerably higher than originally expected. The Government is also drafting an Enterprise Restructuring Program. This program is being supported by a UNDP/Netherlands US$2.8 million, Enterprise Restructuring Project covering the 1998-2001 period. The executing agency is the State Property Committee. The implementing agency is the Enterprise Management and Restructuring Center (EMRC). The project target is to restructure 10 newly-privatized large businesses (selected by competition using 23 criteria). 23. The development objective of this project is to hielp shortenl the length and cost of the transition to a market economy by helping to restructure I0 key enterprises, and thereby develop models and methodologies for such restructurinig in Mongolia and enhance the capacities of Mongolian institutions to undertake restructurinig of viable enterprises. This should help build a more dynamic private sector, leading to increased productioni and avoid tihe unnecessary loss of productive assets and gainful employment opportunities. 24. The Government of Mongolia (GOM) is seeking additional financial support and technical assistance for banking and enterprise restructuring. The Government and Bank of Mongolia have formulated a medium-term banking and enterprise reform program for the period 1997-2000 in close collaboration with the IMF, ADB, and the Word Bank. 25. The government recognizes that its strategy for private sector-led growth must be built on the foundation of a solvent and viable banking system. Decisive measures are therefore needed to arrest the recent sharp deterioration in the financial conditions of commercial banks. To this end, a comprehensive strategy for banking reform has been adopted in collaboration with the IMF, the ADB, arid the USAID. The strategy addresses two major issues currently confronting the banking system: the insolvency of three major commercial banks and the deep rooted systemic problems which are hindering effective financial intermediation. The reforms to correct these problems will be guided by four principles: (1) the need for a substantial reduction in the state ownership of commercial banks through privatization; (2) the need to strictly contain the use of public funds for banking sector restructuring; (3) the need to enhance the enforcement of prudential norms by the BOM; and (4) the need to strengthen the legal and supervisory framework to promote good corporate governance and market discipline in the banking system. 26. To resolve the insolvency of three major commercial banks, the BOM and GOM is implementing a comprehensive, time-bound action plan. In thefirst phase, conservators and full- time bank restructuring advisors will be appointed to halt a further deterioration in the financial position of the three insolvent banks. In the second phase, plans for operational restructuring will be implemented by the advisors, including closures of branches, reductions in overhead and current expenditures, and restriction of the expansion in liabilities and loan portfolios of the banks. In the last phase (by end-1999), decisions will be taken to deal with the three banks through recapitalization, privatization, and liquidation. Implementation of the restructuring plan will be overseen by a High Level Steering Committee, with operational support from a technical Restructuring Working Group. 27. A wide range of actions will be taken in 1999, and beyond, to ensure that the bank restructuring proceeds in a transparent and sound manner and that the systemic banking problems are addressed in line with the general principles mentioned above. Parliamentary approval of a bank privatization strategy will be secured to make the privatization process transparent and 44 ANNEX B irreversible, and the sale of the Trade and Development Bank will be completed by December 1999. 28. In order to limit financial costs borne by the public sector, government funds for recapitalization will be provided only in the event of privatization, up to an amount which will bring the bank's net worth to zero. Under conservatorship, new lending by insolvent banks will be terminated; collateralized liquidity support by the BOM will be provided only to contain system risk in the interbank payment system, and the hierarchy of claims in the Banking Law, which gives highest priority to household deposits, will be strictly enforced. 29. With regard to bank supervision, the BOM will continue to strengthen prudential and regulatory norms, review bank licenses and take action in cases where banks fail to meet the license and "fit and proper" criteria, and initiate prompt supervisory and legal action against banks violating prudential regulations. Sincerely. Goncihig Oyungerel Director Restructurinig Policy Department Ulaanibaatar. Mongolia