ASIAN DEVELOPMENT BANK RRP: MON 35376

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON A

PROPOSED PROGRAM CLUSTER OF

LOANS AND A TECHNICAL ASSISTANCE LOAN

TO MONGOLIA

FOR THE

SECOND PHASE OF THE GOVERNANCE REFORM PROGRAM

September 2003

CURRENCY EQUIVALENTS (as of 15 August 2003)

Currency Unit – togrog (MNT)

$1 = MNT1136 MNT1.00 = $0.00088

ABBREVIATIONS

ADB – Asian Development Bank

AG – Accountant General BOM – Bank of Mongolia CBGR – Capacity Building for Governance Reforms CGA – Customs General Administration CPA – certified public accountant CS – Cabinet Secretariat ECTAC – Economic Capacity-Building Technical Assistance

Credit FFS – fiscal framework statement GDP – gross domestic product GFM – government financial managers GRP – Governance Reform Program GRP-II – Second Phase of the Governance Reform Program GDNT – General Department of National Taxation GGHS – Good Governance for Human Security HIA – head of internal audit IAS – international accounting standards IMF – International Monetary Fund IPSAS – international public sector accounting standards MICPA – Mongolian Institute of Certified Public Accountants MOFE – Ministry of Finance and Economy MOH – Ministry of Health MOSTEC – Ministry of Education, Culture, and Science MPAC – Mongolian Professional Accounting Council MSWL – Ministry of Social Welfare and Labor MTEF – medium-term expenditure framework NCAC – National Council on Anticorruption NSO – National Statistical Office PIP – Public Investment Program PRGF – Poverty Reduction and Growth Facility PRSP – Poverty Reduction Strategy Paper PRSC – poverty reduction strategy credit PSMFL – Public Sector Management and Finance Law SBP – strategic business plan SDR – special drawing rights SITC – Standard International Trade Classification SOE – state-owned enterprise SPC – State Property Committee SPIA – State Professional Inspection Agency SSC – State Service Council TA – technical assistance TOR – terms of reference TSA – treasury single account UNDP – United Nations Development Programme

NOTES

(i) The fiscal year (FY) of the Government ends on 31 December. (ii) In this report, "$" refers to US dollars.

This report was prepared by a team comprising R. Subramaniam, senior corporate and financial governance specialist as team leader, and N. Tas-Anvaripour, financial management specialist, both of the East and Central Asia Department; V. You, senior counsel, Office of the General Counsel; and N. Dorj, senior economics officer, Mongolia Resident Mission.

CONTENTS Page

LOAN AND PROGRAM SUMMARY ii

I. THE PROPOSAL 1

II. INTRODUCTION 1

III. RECENT MACROECONOMIC DEVELOPMENTS 3

IV. THE SECTOR 4 A. Sector Description and Performance 4 B. Lessons Learned 8 C. Issues and Opportunities 9 D. External Assistance to the Sector and Donor Coordination 10

V. THE PROPOSED PROGRAM 11 A. Objectives and Scope 11 B. Important Features 11 C. Policy Framework and Actions 12 D. Financial Implications of the Reform Program 18 E. Financing Plan 19 F. Implementation Arrangements 19

VI. THE PROPOSED TECHNICAL ASSISTANCE LOAN 21 A. Objective and Scope 21 B. Components 21 C. Cost, Financing Plan, and Implementation Arrangements 23

VII. PROGRAM BENEFITS, IMPACTS, AND RISKS 24 A. Benefits 24 B. Impacts 24 C. Potential Risks 25

VIII. ASSURANCES 26

IX. RECOMMENDATION 26 APPENDIXES 1. Support from Funding Agencies for Governance and Public Sector Reforms in Mongolia 28 2. Policy Matrix 30 3. Second Phase of the Governance Reform Program: Subprogram 2 Milestones 37 4. Development Policy Letter 39 5. Program Logical Framework 45 6. New Financial Management Arrangements Proposed under Second Phase of the

Governance Reform Program 50 7. Ineligible Items 51 8. Proposed Technical Assistance Loan for Capacity Building for Governance Reforms: Outline

TOR for Consulting Services 52 9. Summary Poverty Reduction and Social Strategy and Poverty Impact Assessment 58

LOAN AND PROGRAM SUMMARY

Borrower Mongolia The Proposal A program cluster with two subprograms is proposed to support the

Government of Mongolia for the Second Phase of the Governance Reform Program (GRP-II) A technical assistance (TA) loan for capacity building for governance reforms (CBGR) is also proposed to support the implementation of the policy measures under GRP-II.

The Program Rationale Governance is a key pillar of the Asian Development Bank (ADB)

country operational strategy for Mongolia, where ADB has supported public sector governance reforms since 1995. The Governance Reform Program (GRP)1 led to the formulation of a 10-year reform roadmap to be implemented over 1999–2009. GRP also helped implement critical administrative and financial management reforms on a pilot basis in selected budgetary agencies over 1999-2002. A milestone achievement of GRP was the adoption of the Public Sector Management and Finance Law (PSMFL), which provides a sound legal framework to guide budget, output, performance, and financial management reforms. While its processes have been strengthened through GRP, the public sector continues to face significant challenges and constraints. It is large and inefficient, and significantly risks fiscal instability unless concerted reforms as provided by PSMFL are undertaken. The Government’s forward-looking approach, formulated with support from ADB and other funding agencies, aims to (i) improve public expenditure management and enhance the quality of public services to reduce poverty; (ii) implement PSMFL systematically through learning by doing, given the capacity constraints; (iii) infuse sound financial management practices to enhance fiscal responsibility at all government levels; (iv) strengthen the civil service; (v) address medium-term issues of administrative consolidation at the regional, provincial (aimag), and district (soum) levels, to enhance economies of scale and achieve efficiency in delivery of public services; and (vi) mainstream governance reforms in key institutions, including state-owned enterprises and the judiciary, among others. The proposed program cluster forms an integral part of the governance reform roadmap and will help further the reforms through capacity building as well as mainstreaming measures.

Objective and Scope The goal of GRP-II is to enhance accountability and efficiency of the

public sector, to be measured by fiscal sustainability and tangible improvements in delivery of key public services. The purpose of GRP-II, following the measures adopted under GRP on a pilot basis, is to support the gradual implementation of public sector administrative

1 Loan 1713-MON: Governance Reform Program .

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and financial management reforms. GRP-II will adopt a three-pronged approach to the following: (i) Enhance institutional capacity.

(a) Support implementation of PSMFL-related measures

on strategic planning and output-based budgeting, with focus on health, education, and social welfare and labor.

(b) Strengthen the institutional and implementation arrangements for financial governance norms in the public sector.

(ii) Improve fiscal sustainability.

(a) Initiate pension reforms to alleviate fiscal pressures on the budget stemming from the public pension system.

(b) Initiate administrative consolidation to reduce multiple layers of control that impede efficiency and lead to waste of scarce resources.

(iii) Mainstream governance reforms.

(a) Enhance the enforcement capacity of the State Service Council to improve the quality of the civil service.

(b) Enhance confidence in key public institutions. Poverty Classification Other Thematic Classification

Good governance, economic growth

Environmental Assessment

Category C. Environmental implications were reviewed, and no significant adverse environmental impacts identified.

The Program Loan Loan Amount and Terms

GRP-II adopts a cluster approach comprising subprograms 1 and 2. A loan of SDR9.699 million (equivalent to $13.5 million) from ADB’s Special Funds resources will be provided for subprogram 1. The loan will have a term of 24 years, including a grace period of 8 years, and an interest charge of 1.0% per annum during the grace period and 1.5% per year for the remaining period. A loan of $10 million is envisaged for subprogram 2, to be designed and proposed separately for ADB’s consideration upon satisfactory implementation of subprogram 1.

Program Period and Tranching

Subprogram 1 will be implemented from October 2003 to December 2005, while the program framework also includes a number of program measures have been implemented since September 2002, when GRP was completed. Subprogram 2 will be prepared after the midterm review of subprogram 1. The loan for subprogram 2 will be presented for ADB’s consideration, based on progress in

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presented for ADB’s consideration, based on progress in implementing in subprogram 1. The resources of SDR9.699 million under subprogram 1 will be divided into two tranches: the first, for subprogram 1, for SDR3.592 million (equivalent to $5.000 million), will be released upon approval of GRP-II by ADB and loan effectivity. Subject to satisfactory fulfillment of all the second-tranche release conditions in the policy matrix and the other program conditions that can be monitored, the second tranche of SDR6.107 million (equivalent to $8.500 million) is expected to be released by July 2005.

Executing Agency

The Ministry of Finance and Economy (MOFE) will be the executing agency for GRP-II and responsible for implementing all PSMFL-related measures, public sector financial management reforms, and social security reforms. The Cabinet Secretariat (CS) will be the implementing agency for all the local government reform issues, civil service reforms, and the anticorruption component. CS will also ensure Cabinet-level coordination to implement GRP-II efficiently. The Government has established a GRP program implementation unit (PIU) under MOFE. Given the coverage of a number of cross-sectoral issues and the complexity of the reforms, the Government will form a steering committee and an operational working group to advise and support MOFE and CS. The steering committee will be led by the chief of CS and comprise the minister of finance and economy, minister of social welfare and labor, economic advisor to the prime minister, and two representatives from the Parliamentary Working Group on Governance. The operational working group will be led by the deputy minister of finance and economy, and comprise deputy chief of the CS in charge of local government reforms, the heads of fiscal policy and accounting departments of MOFE, and head of administration of the National Audit Office (NAO).

Procurement The loan proceeds will be used to finance the foreign exchange costs

of items produced and procured in ADB member countries (other than items specified in the negative list and imports financed by other bilateral and multilateral agencies). The Government will certify that the value of eligible imports exceeds the amount of ADB's projected disbursements under the loan for the given period. ADB reserves the right to audit the use of the loan proceeds and verify the accuracy of the Government's certification.

Counterpart Funds

The Program includes specific components that bear distinct costs of structural adjustments. The counterpart funds to be generated out of the loan proceeds will be used to finance the cost of such structural adjustments and high-priority development projects.

The Technical Assistance Loan

Loan Description

The proposed TA loan for CBGR will help the Government enhance its overall capacity to implement the key governance-related

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Description its overall capacity to implement the key governance-related

measures under GRP-II, including on-the-job training programs for government accountants and auditors. The scope of CBGR will cover the following:

(i) financial management reforms in public sector accounting, auditing, and asset valuation;

(ii) support for strategic planning in relation to PSMFL implementation; and

(iii) software and limited hardware support to efficiently undertake financial statement and performance audits and output costing.

Loan Amount and Terms

A TA loan of SDR1.437 million ($2 million equivalent) for CBGR is proposed to be provided from ADB’s Special Funds resources, with a term of 32 years, including a grace period of 8 years. The TA loan will carry an interest charge of 1.0% per annum during the grace period and 1.5% per year for the remaining period.

Executing Agency

MOFE will be the executing agency for the TA loan. The PIU established for GRP-II will also coordinate all the activities under CBGR. CS will support interministerial coordination.

Procurement The TA loan for CBGR will involve the use of 53 person-months of

international consulting services, comprising the following: (i) advisor to the accountant general for 18 person-months; (ii) PSMFL strategic planning advisor for 13 person-months; (iii) advisory services to the NAO for 18 person-months through a team of two international auditors, who will work with six NAO auditors to implement the relevant GRP-II conditions; (iv) an asset valuation expert for 2 person-months; (v) a management information systems (MIS) expert to design a software package for audits and provide training for 2 person-months. About 120 person-months of domestic consulting support will also be procured in the above areas, including project management. All international and domestic consultants will be recruited individually in accordance with quality- and cost-based procedures, ADB’s Guidelines on the Use of Consultants, and other arrangements satisfactory to the ADB for engagement of domestic consultants.

Risks and Safeguards Institutional reforms, particularly in the public sector, are subject to

risks. As GRP has set the overall direction of reforms, GRP-II has fewer risks. However, subprograms 1 and 2 are likely to face four specific types of risk, for which the program has sufficient safeguards: (i) PSMFL implementation may falter due to capacity constraints. The Government has thus adopted a gradual, learning-by-doing approach. ADB emphasizes that implementation should allow for mid-course corrections. Ongoing TAs and the proposed TA loan for CBGR will provide significant capacity-building support to alleviate capacity constraints and to assuage the concerns of the civil servants.

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constraints and to assuage the concerns of the civil servants. (ii) Pension reform anywhere is complex as it involves difficult policy choices, including elimination of early retirement privileges, which may affect laborers in certain industries. However, the Government recognizes that the pension system will have serious problems unless its generous provisions are changed. Significant advisory support has been provided to analyze various options, guided by sound actuarial modeling. The Government has drafted guidelines to gradually reduce early retirement privileges. GRP-II will support wide public consultations, education, and consensus building for reforms in this area. (iii) Administrative consolidation measures carry considerable risks. The Government has undertaken preliminary analysis and stakeholder consultations. However, the degree of acceptance or resistance to reform can be gauged only when the Government finalizes its concept paper and engages in well-structured consultations with the local citizens’ representative assemblies. The Government is optimistic that the much-needed reforms can be facilitated if consolidation measures are designed gradually with local inputs. (iv) Some political risks are associated with a program of this nature. In particular, as Mongolia will hold parliamentary elections in mid-2004, serious reforms may not be carried through. Short-term concerns of local governments with regard to difficulties in implementing PSMFL, opposition to pension reforms, and resistance to administrative or structural changes may prevail over the need for reforms. Two factors could cushion reform against the political risk. First, the Government and Parliament have been fully committed to public sector reforms. Despite a major change in the Government in 2000, reforms were implemented smoothly. Given the significant political capital and financial resources invested, it is also in the Government’s and Parliament’s best interest to ensure that PSMFL-related reforms are irreversible. Second, the cluster program modality gives the Government greater flexibility than otherwise possible by providing the overall program framework and a longer implementation period.

I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on (i) a proposed program cluster concept for the Second Phase of the Governance Reform Program in Mongolia (GRP-II), (ii) proposed loan to Mongolia for subprogram 1 of GRP-II, and (iii) proposed technical assistance (TA) loan for capacity building for governance reforms (CBGR) to support the implementation of subprogram 1.

II. INTRODUCTION 2. Unlike other transition economies in East and Central Asia, Mongolia managed its transition well until the mid-1990s. Output decline in the early years of the transition was reversed in only 4 years, and real gross domestic product (GDP) grew at 1% in 1994, and 6% in 1995. Inflation declined significantly and fiscal deficit was brought down from 13% of GDP in 1990 to 7% by 1995. However, the initial gains were not sustained due to various constraints, primarily lack of economic diversification, with heavy reliance on livestock and copper production. Central and local fiscal discipline was also lacking, which led to a build up of on- and off-budget expenditures. Economic performance thus deteriorated in the second half of the 1990s, with GDP growth declining from 4% in 1997 to just over 1% in 2000 and 2001. The fiscal deficit increased to 8% of GDP in 1996 and further to 14% of GDP in 1998. 3. Fiscal profligacy in the mid-1990s was exacerbated by a variety of factors, including (i) weak budget management, reporting, and control frameworks, resulting in inadequate checks and balances; (ii) full devolution of expenditure responsibilities to lower tiers of government without adequate accountability; (iii) weak revenue administration; (iv) inadequate treasury controls; (v) weak political will and bureaucratic commitment to maintaining overall fiscal discipline; and (vi) weak operational and financial practices adopted by budgetary bodies and state-owned enterprises (SOEs). 4. Against this background, in 1998 the Government sought ADB’s support through the Governance Reform Program (GRP)2 to strengthen public sector administration and financial management. As part of GRP, a 10-year governance reform roadmap was formulated to guide governance reforms in 1999-2009, with initial implementation support provided on a pilot basis under the program in 1999-2002. GRP aimed to facilitate the transition to a new structure by establishing systems for sound public sector financial management and accountability and transparent data and for information dissemination. GRP thus focused on (i) improving aggregate fiscal discipline, (ii) strengthening public sector budget formulation and execution, (iii) enhancing operational efficiency within the public sector, (iv) addressing the social impact and financing needs of sector reforms, and (v) preparing the groundwork for continuation of reforms. The enactment of the Public Sector Management Finance Law (PSMFL) in June 2002, after extensive consultations in 1997-2002, was the most important milestone of GRP as a program-end condition. PSMFL3 has placed Mongolia ahead of the other countries that have introduced new public sector management approaches but in the absence of a sound legal framework. 5. GRP introduced reforms in strategic planning, output specification, and performance management, first in five major public service agencies (bunch-1 entities): General Department

2 ADB. 1999. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to

Mongolia for the Governance Reform Program . Manila. 3 Supplementary Appendix 1 outlines PSMFL’s basic features.

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of National Taxation (GDNT), Customs General Administration (CGA), National Audit Office (NAO),4 State Service Council (SSC), and National Statistics Office (NSO). Based on a review of government progress in the bunch-1 agencies, GRP also phased in basic reform measures in 11 ministries and agencies and two provinces5 with ADB TA support.6 As GRP was envisaged as a pilot program, the Government did not aim for any structural changes in central or local public administration in the first phase. 6. While GRP has laid a sound foundation to guide public sector administration and financial management reforms in Mongolia, a formidable reform agenda remains to be fulfilled. In particular, effective implementation of PSMFL is highly critical to ensure that reforms do not fail. The public sector remains large and inefficient, and risks significant fiscal instability. While the constitutional and political structure have conferred significant administrative autonomy to the local governments, most local governments, except for three provinces, have relied heavily on transfers from the central Government for more than 60% of their revenue needs. However, PSMFL gives local governments the flexibility to make expenditure decisions. Effective from 1 January 2003, PSMFL calls for fiscal responsibility, accountability, and transparency at all levels—outcomes that require time and persistent reforms. 7. A 10-year reform roadmap has been adopted in recognition of the complexity of budget, output, and performance management reforms. While the introduction of output and performance management reforms was relatively easier for bunch-1 agencies due to their well-defined functions and outputs, reforms in line ministries and other budgetary agencies have yet to gain momentum. The line ministries have to implement PSMFL in their agreements with local governments to deliver public services. The central Government should link policy priorities with measurable outputs. Line ministries should strengthen their planning, internal control, and monitoring functions so that local authorities’ outputs can be evaluated. Local authorities, in turn, should clearly articulate their local development needs and ensure that they are adequately reflected in national priorities through output agreements. 8. The proposed program cluster builds on GRP reforms and the lessons learned.7 PSMFL-related measures must be mainstreamed gradually at all levels of the public sector in appropriate sequence: (i) PSMFL has clarified the relative functions, roles, and responsibilities of governments at different levels; (ii) capacity constraints need to be addressed; (iii) the implementation process should recognize such constraints and adopt a learning-by-doing approach; (iv) civil service reforms need to be launched; and (v) structural constraints, including multiple levels of public administration, need to be removed gradually. The program cluster aims to support the Government through the second phase of reforms, building on lessons learned from the design and implementation of the initial phase of reforms under GRP.

4 NAO used to be the State Audit and Inspection Committee. 5 These include Ministry of Finance and Economy (MOFE); Ministry of Social Welfare and Labor (MSWL); Ministry of

Justice and Home Affairs; Ministry of Education, Culture, and Science (MOSTEC); Ministry of Health (MOH); Ministry of Environment; State Financial Inspection Department; Environmental Protection Agency; Land Administrative Authority; State Meteorological Agency; and Clinical Hospital No.1. GRP also focused on two pilot provinces , Arhangi and Selenge; and on Nalaikh District Administration, a jurisdiction within Ulaanbaatar City, to pilot-test provincial and subprovincial administrative reforms.

6 Appendix 1 presents information on TA support. Under TA 3316-MON: Initial Phase of Public Administration Reforms, a team of domestic experts was trained by the international consultants in international best practices in public sector resource management. Since then, the team has been implementing reforms.

7 Section IV, subsection B, outlines of lessons learned from GRP. The program completion report for GRP (December 2002) presents additional details.

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III. RECENT MACROECONOMIC DEVELOPMENTS 9. In accordance with the GRP, and in line with the Poverty Reduction and Growth Facility (PRGF) of the International Monetary Fund (IMF), the budgets for 1999 and 2000 aimed to reduce deficit levels. The budget deficit declined from 12.2% of GDP in 1999 to 6.8% in 2000 and 5.3% in 2001, which is impressive given the expenditure overruns due to the dzud (dry summer followed by harsh winter) in those years. Improved collection of tax and non-tax revenues and a 2.0% increase in value-added taxes and import taxes on energy inputs helped raise the revenue-GDP ratio from 27.2% in 1999 to 38.0% in 2001. The recovery in international gold prices also helped compensate for expenditure overruns. 10. Economic prospects improved in 2002 after 2 years of stagnation. Despite the continuing low world prices for copper and cashmere, Mongolia’s key exports, real GDP registered 3.9% growth in 2002. Inflation slowed considerably to 1.6% in 2002, against 8.0% in 2001. However, the Government, in line with the promises made in 2000 to increase civil service wages and pensions, announced a 20% rise in wages and pensions effective 1 October 2002, which pushed current expenditure up by as much as 1% of GDP. The Government and IMF had estimated that this measure would increase the fiscal deficit to 7.0–8.0% significantly above the 6.5% target under PRGF. With World Bank support, the Government then embarked on social sector privatization and civil service reforms. To stay within the established expenditure and revenue targets, an extraordinary session of Parliament revised the budget in August 2002. These efforts, combined with higher-than-expected revenue collection attributable to the sale of the Trade and Development Bank, helped contain the fiscal deficit at 5.6% of GDP. The deficit is forecast at 6.1% for 2003, also below the PRGF target. 11. Since the early 1990s poverty reduction has been the single most complex challenge facing Mongolia. The collapse of the command system led to a general deterioration in access to as well as quality of public services. The latest poverty figures are from the 1998 living standards measurement survey. While income inequality widened over 1995-1998, poverty incidence changed marginally from 36.3% in 1995 to 35.6% in 1998. Urban poverty is more severe, with poverty incidence measured at 39.4% in 1998. Environmental factors, including frequent harsh winters, overgrazing of pastures, and weak natural resource management, have also increased household vulnerability to economic shocks. 12. IMF approved the ongoing 3-year PRGF in September 2001 for SDR29 million. The first annual review, scheduled for 2002, was not conclusive due to fiscal concerns with regard to the increase in civil service wages. Following the budgetary amendments in August 2002, IMF and the Government reached an understanding on the fiscal issues in December 2002. However, slippage in monetary targets coupled with the Bank of Mongolia (BOM) extending two loan guarantees to private sector entities has delayed the PRGF release. IMF has formulated a number of corrective measures that BOM is implementing: (i) a clear policy relinquishing any BOM loan guarantees to the private sector, (ii) completion of a special audit of BOM’s net international reserves at the end of 2002, and (iii) amendments to the Law on the Central Bank to improve governance in BOM. Subject to satisfactory progress on these fronts, IMF is expected to release the pending tranches in the third quarter of 2003.

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IV. THE PUBLIC SECTOR8

A. Sector Description and Performance

1. Overall Public Sector—Public Administration and Key Fiscal Pressures

13. Mongolia is one of the least densely populated countries in the world, with 2.45 million people living across 1.6 million square kilometers. The country is divided into 21 provinces and the Ulaanbaataar capital city administration. The 21 provinces are subdivided into 331 districts; Ulaanbaataar is subdivided into 9 districts. The districts, in turn, are organized as 1,634 villages, which provide services at the lowest tiers of government. At the central level, 11 ministries, 17 regulatory agencies, and 30 implementing agencies formulate policy and administer central functions.9 Five agencies report directly to Parliament: NAO, SSC, NSO, BOM, and Securities and Exchange Commission. There are close to 6,000 budgetary bodies, including schools and hospitals. There are 110 SOEs, with 51% or more of state ownership, which also come under the purview of PSMFL. 14. Measured by expenditure, the government sector is larger than in other comparable transition economies. Consolidated government expenditure as a share of GDP has averaged at around 39% per year in 1993-2000.10 Current expenditures dominate, rising from 57% of total government expenditures in early 1990s to around 70% in 2000. In particular, the public sector wage bill as a share of GDP, at 8.2% in 2000, is among the highest in region,11 amounting to 20% of total expenditures. Tax administration reforms over the last few years have led to a surge in overall government revenue from 25.6% of GDP in 1995 to 38.0% in 2001. However, tax rates are high: corporate and personal income tax rates can go up to 40%. As a result, tax revenue as a share of GDP stands at 29%, much higher than in comparable Asian economies. 15. At the end of 2000 the public sector had 166,700 employees, of whom 135,400 were budgeted positions in the state budgetary bodies, while actual employment was 116,400, indicating a vacancy rate of about 16%. Government service is political (including members of Parliament, heads of governments at different levels, and heads and staff in foreign missions); administrative; special (heads of courts, senior officers of the armed forces, and heads of agencies reporting to Parliament, etc.); and support (education, health, and other government-affiliated organizations). In 2001 political service accounted for 1.9% of all government positions; administrative service, 5.6%; special service, 21.3%; and support service, 71.2%. 16. The public administration system faces a number of challenges. Simply stated, the public sector is unviable. Constraints range from organizational problems resulting in lack of transparency and poor accountability, to the terrain, which imposes unique constraints on public service delivery. The lack of fiscal responsibility and budgetary discipline is mainly due to the large public sector. There is one public sector agency for every 350 people. While the

8 More information on the sector and its key issues and challenges is in ADB. 2003. Governance: Progress and

Challenges in Mongolia. (Draft). 9 Of the 11 ministries, 3 (finance and economy, foreign affairs, and justice and home affairs) perform central

management functions. The rest are line ministries: MOSTEC, MOH, MSWL, environment, defense, infrastructure, trade and industry, and food and agriculture.

10 Uzbekistan has had a higher share over the same period, while Kazakhstan, Bulgaria, Latvia, and Romania, among others, have had lower shares.

11 For instance, Kazakhstan, Kyrgyz Republic, and Tajikistan have had ratios of less than 5%, and the average for a set of comparable transition economies stood at just over 6%.

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Government adopted various decentralization measures in 1995 to improve public service delivery, the public sector’s size has curtailed the benefits of decentralization, given the multiplicity of agencies performing similar tasks. Besides administrative weaknesses, lack of technical skills has been a recurring concern. With regard to the new budget and output-based management reforms, a key weakness is the lack of understanding and ability to define and cost outputs, and to link sector policies with specific measurable outputs and outcomes that can be monitored. This may be a key constraint impeding the formulation of sectoral budgetary appropriations on output basis, which is a requirement under PSMFL. 17. Intergovernmental Fiscal Relations. Fiscal relations between the central and local governments have gone through significant changes over the last decade. In 1990 the share of local expenditures to general government expenditures stood at 49.4%, before declining to 24.4% in 1994. In the mid-1990s the central Government allowed local governments to exercise increasing responsibilities to focus on attaining overall macroeconomic stability. As a result, the share of local in general government expenditures increased to 35.8% in 1995, but later declined to 29.3% in 2001. Over the same period, the share of local government revenue to general government revenue has also declined, from 43.5% in 1990 to 18.4% in 2001. In nominal terms, local public sector wage and salary costs increased 10-fold from MNT6.5 million in 1993 to MNT66.0 million in 2000, while expenditures on goods and services grew 5-fold from MNT13 million to MNT61 million. Overall, local government expenditures have grown from 9.7% of GDP in 1995 to 13.0% in 2000, although they are expected to come down to 10.9% in 2002. 18. Expenditures and revenue collections vary greatly across the provinces: per capita revenue collections ranged from MNT21,000 ($19.00) in Bayanulgii to MNT70,028 ($63.80) in Orkhon in 2002, or a ratio of almost 4 to 1, although it reflects an improvement over 1999 when the ratio was 8 to 1. Per capita expenditures ranged from MNT51,947 ($47.20) in Uvurkhangai to MNT104,626 ($95.10) in Gobisumber, a ratio of 2 to 1. The extent of provinces’ dependence on the center is evident from ratios of local government expenditure to revenue. In 2002 the ratio stood at 1.64 for all provinces, and at 2.20, excluding Ulaanbaataar. Only two provinces (Ulaanbaataar administration and Orkhon province) were net providers of revenue to the center, while all the others relied on net transfers and subsidies for more than 60% of their public expenditures. Education and health have historically been the most decentralized sectors, where local governments have spent 70% and 63%, respectively, of the total expenditure. 19. Until the end of 2002, provincial governors negotiated their budgets directly with Ministry of Finance and Economy (MOFE) to secure the release of funds. District governors dealt with the provincial governors for budgetary transfers. Under PSMFL, the line ministers will enter into output purchase agreements with province governors for all service delivery, including health and education, and the budgetary allocations will be determined on the basis of output costs. However, entity capacity constraints on performance contracting are more prevalent at lower government levels. These constraints need to be placed in the broader context of a number of other structural impediments at the provincial and subprovincial levels, including the following: (i) continuing tension between the center and provinces arising from disparities between expenditure responsibilities and limited decision-making authority devolved to the lower levels, and the resulting conflicts between self-governance and state control from the center; (ii) limited provincial and district revenue-raising capacities; and (iii) multiplicity of administrative layers at provincial, district, and bagh levels, which add to significant public administration costs, increased bureaucracy, as well as weak accountability. 20. Civil Service. Capacity constraints on performance and output-based management are exacerbated by fundamental problems faced by the civil service: (i) capacity constraints within

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SSC to formulate and enforce sound guidelines on recruitment and performance-based management; (ii) lack of transparency in hiring or firing civil servants; (iii) lack of a civil service culture, wherein a permanent, merit-based, career-track civil service system has not been established yet; (iv) frequent staff turnover, particularly at senior levels, caused by past frequent changes in the Government; (v) lack of political neutrality of the civil service; (vi) widespread violations of merit principles in recruitment or career progression; and (vii) lack of sound dispute resolution or administrative grievance settlement processes. Meritocracy is a difficult goal to achieve under the current circumstances. 21. The largeness of the public sector has led to wage compression in the civil service and frequently put significant pressure on the budget despite lower average wages than in the private sector. The monthly per capita wage in the public sector was $52 in 2001, as against the national average of $67. A comprehensive functional review of the core and non-core functions of the public sector needs to be launched to guide future reforms. While the Government has formulated some short-run measures, including the social sector privatization program announced in July 2002, to corporatize and privatize or restructure 56 selected educational institutions and hospital facilities to contain public expenditures, the impact of such measures in isolation of other medium- to long-term qualitative improvements is likely to be small. 22. Fiscal Pressures from the Pension System. The public pension system is a major source of fiscal pressure. Pension expenditure as a share of GDP increased from 0.5% in 1990 to 5.9% in 2001, which is much higher than in the regional average.12 In view of the fiscal sustainability problems faced in all transition economies with pay-as-you-go pension arrangements, Mongolia adopted a legal framework in 1999 based entirely on individual contributions, applying only to those born after 1960, and to become effective from 2010. Given the transition costs involved, notional balances are recorded in individuals’ accounts. The Government’s plan is to convert a portion of the notional accounts into funded privately managed accounts, on the assumption that the pension system will begin to run a surplus by 2005. However, the overall system is in deficit, estimated at 1.6% of GDP. 23. The pension system is fairly generous. A retiree gets 45.0% of the highest 5 years of wages, in addition to a 1.5% additional credit for each year of service over 20 years. The average replacement rate stands at 65% of average wage, which represents almost a 100% replacement rate as pension benefits are not taxed. However, until the mid-1990s, the real value of wages and pensions remained low because of significantly high inflation. There is no good mechanism for indexation. For instance, pensions were not adjusted for inflation in 2000, but were increased by about 10% in 2001. 24. While the retirement age is 60 for men and 55 for women, the actual average retirement ages are 57 and 50, respectively. Only a quarter of the pensioners are 60 when they begin to receive pension benefits. The ratio of pensioners to population above 60 years is close to 2, indicating significant early retirements. Life expectancy at the actual average retirement ages is 20 years for women and 14 years for men. With the generous early retirement provisions, retirees do remain economically active yet receive pensions. An indication of these negative pressures on the pension system is the forecast financial position of the pension fund. Without any transfers from the budget and any reform measures to increase the average retirement age, the pension fund will be in deficit to the tune of about 9.0% of GDP by 2005, rising to 16.4% by 2010, and 34.4% by 2020.

12 For example, the ratio is less than 1.5% of GDP in Kazakhstan and 2.6% in the People’s Republic of China.

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2. Framework for Financial Management and Governance

25. The Law on Accounting, amended in 2002, is based on international accounting standards (IAS) and covers private sector as well as public sector entities, including budgetary bodies. The law provides for an accounting standards committee to set private and public sector accounting standards and monitor their implementation. As per the law, the minister of finance and economy must provide implementation directions to the accounting profession. MOFE is responsible for the final reconciliation and consolidation of all public sector budget accounts, including those of central and local governments. The state property committee consolidates the accounts of SOEs separately, outside the budget. 26. With regard to public sector accounting, the budget classification system is broadly consistent with internationally accepted government finance statistics principles. The budget summarizes the financial position of the Government on a cash basis. With World Bank support, a new chart of accounts has been developed for the Government, based on accounting standards that are conducive to cash and accrual bases. GRP helped five bunch-1 pilot agencies—GDNT, CGA, SSC, NSO, and NAO—convert to accrual accounting. This process needs to be expanded across the public sector. 27. The State Audit Law, amended in 2003, provides the basic legal framework for financial and performance audit of all budgetary bodies. NAO, the supreme audit institution, implements the law. Parliament appoints the chair of NAO, who, in turn, appoints the heads of NAO’s 22 provincial boards. The chair and heads report to and are directly accountable to the local assemblies. As per PSMFL, NAO, which has 275 staff at central and local levels, conducts certification audits of the annual financial statements of all budgetary bodies and majority SOEs. The Law on State Inspection, amended in 2003, guides the activities of the State Professional Inspection Agency (SPIA), which was established under the Prime Minister’s Office in early 2003 by merging all the inspection agencies in various line ministries. In particular, financial inspection of budgetary bodies is the core of SPIA’s activities, a task previously carried out by the State Financial Inspection Agency, which operated under MOFE. SPIA’s finance and control division, which PSMFL entrusts with internal financial inspection of the Government, has 250 inspectors. 28. Three key organizations are involved in private sector accounting and auditing and have overlapping roles and responsibilities: Accounting Policy, Methodology, and Auditing Department of MOFE; Mongolian Institute of Certified Public Accountants (MICPA); and Mongolian Professional Accounting Council (MPAC). MPAC was established by the Law on Accounting to license accounting firms and strengthen and regulate the accounting profession by performing the following functions: (i) recommend standards for accounting and auditing; (ii) review the curricula for the certified public accountant (CPA) examinations, and provide courses for candidates preparing for the exams; (iii) formulate and conduct CPA exams, and grant and record CPA certificates; (iv) process and review auditing licenses and make recommendations to the minister; (v) maintain a database on auditing companies; and (vi) formulate and ensure conformity with codes of professional ethics. 29. Under PSMFL, all budget entities are required to generate accrual-based financial statements that are prepared in line with the international public sector accounting standards by the end of 2003. PSMFL also requires MOFE to consolidate these financial statements to prepare overall financial statements for the Government. Budget entities are responsible for accounting and financial reporting as well as financial management of their budget funds.

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Centralized accounting systems and uniform chart of accounts are absent, and reports prepared by budget entities are in a multi-sheet form submitted to MOFE monthly and quarterly. These reports are not required to reconcile changes between the beginning and ending balances of a specific period. Treasury consolidates these reports to produce government-wide reports, which may not be accurate. 30. PSMFL provides for an independent role for budget entities by promoting entity-based financial management. Under this structure, internal control is important. However, neither MOFE nor the line ministries nor other budgetary bodies have any internal audit function to carry out these responsibilities. The usefulness of internal audit functions is not well understood. While financial inspectors act as internal auditors of central budget governors at budget entities, the scope of work of these inspectors is limited to inspection of certain documents. Central budget governors generally appoint financial inspectors, and each central budget governor has one or two financial inspectors on their payroll. Each line ministry also has its own inspection, monitoring, and evaluation division, which monitors compliance with sector laws and regulations. However, most divisions have no qualified finance specialist or accountant, since their role is primarily to undertake compliance inspections for the ministries. 31. Duplication of functions, weak auditing and accounting procedures, and overall poor capacity in MOFE, line ministries, budgetary bodies, SPIA, and NAO are some of the problems in implementing PSMFL, which requires effective and credible rules along with well-functioning information systems to improve weak financial management. Almost all private and public sector accounting is done on a cash basis. While budgetary bodies present accounting information that is relevant for accrual accounting, including data on inventory, fixed assets, accounts payables and receivables, etc., all such information is lumped together without any analysis by separate asset classes. For fixed assets, data are maintained for information purposes only by recording them at their historical cost. There are no standards for asset revaluation to reflect their present value on the financial statements required by PSMFL. 32. Despite the adoption of the Law on Accounting, which mandates IAS, progress has been severely constrained due to lack of skills and capacity. In most cases, old systems are in place and entries are simply transposed onto the new IAS-compliant financial statements. In particular, asset valuation, expense recognition, and accounting for equity have significant problems. While all enterprises have made some changes from the uniform accounting system, only a few accountants have a reasonable understanding of IAS and how to apply them. Although accounting specialists of MOFE are to oversee the quality of accounting in private enterprises in various provinces and districts , such specialists only verify that financial reports have been filed in the correct format, and do not examine the source material for correct treatment. B. Lessons Learned

33. In formulating the proposed program cluster, specific attention has been paid to incorporating lessons learned from GRP and related TAs as well as ADB’s evaluation on program lending. The GRP-II design is based on the following lessons:

(i) Performance-based management reforms have generally not been

successful. A key lesson from the evaluation of ADB’s support for public sector reforms in the Pacific countries is that performance-based management has not succeeded. While this has been due to the complexity of such reforms, Mongolia

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has the advantage of having PSMFL and a history of acute fiscal problems requiring change. The Government and Parliament have demonstrated strong commitment in designing the overall program. Significant support from funding agencies is envisaged for capacity building and policy reforms.

(ii) Proper sequencing of reforms is critical. GRP-II will adopt a gradual, learning-by-doing approach. The program cluster envisages implementation over 6 years, from 2003 to 2009. GRP-II will (a) focus on PSMFL-related training, (b) help institutionalize financial management reforms, (c) initiate measures to increase fiscal stability, and (d) mainstream reforms in key public institutions. GRP-II will target full integration of PSMFL-related measures in education, health and social welfare, and labor, which together constitute close to 75% of the overall budget.

(iii) Stakeholder participation is vital. The success in adopting PSMFL and implementing the pilot phase has demonstrated the need for close and significant stakeholder involvement. GRP-II will build on this to introduce forward-looking reforms based on stakeholder consultations in social security reforms, administrative consolidation, and anticorruption work.

(iv) Local government autonomy and public sector efficiency should be balanced. The learning-by-doing approach and the cluster modality are intended to suggest mid-course corrections. The implementation of subprogram 1 will guide the level of flexibility between the central and local budgetary bodies.

C. Issues and Opportunities 34. Although GRP was implemented as a pilot phase, the adoption of PSMFL and support by the Government and Parliament for a comprehensive fiscal responsibility system are good indicators of their commitment to long-term reforms. ADB and other aid agencies must coordinate their support for the reform momentum established under GRP to ensure that reforms stay on course and that good governance norms are fully mainstreamed through capacity building and structural reforms. 35. Rationale and Links with the Asian Development Bank’s Country Strategy and Program. Governance reform in general and strengthening of public sector governance in particular are a key pillar of ADB’s country operational strategy. It calls for (i) strengthening of fiscal discipline and strategic planning in the public sector; (ii) introduction of performance-based management at central and local levels; (iii) infusion of transparent and efficient practices to guide intergovernmental fiscal and administrative relations; (iv) support for SOE reforms; and (v) formulation of effective interlinkages between public sector governance reforms and ADB’s other sector-specific interventions, which, in turn, will lead to enhanced accountability and transparency in those sectors. 36. ADB has provided significant TA support over the last 5 years to formulate and implement public sector governance reforms. A comprehensive assessment of the overall governance framework, issues, challenges, and opportunities is being finalized. ADB has been the lead donor for health, education, and social security reforms. Appendix 1 presents a list of ADB TAs and loans for broad public sector reforms. The Government has sought continuing ADB support for GRP-II. The program cluster builds on the reform initiatives launched under GRP to ensure the stability and sustainability of PSMFL-related measures.

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D. External Assistance to the Sector and Donor Coordination 37. While GRP was the first program of support from an international financial institution for governance reforms, IMF, World Bank, United Nations Development Programme (UNDP), and bilateral agencies have supported public sector management reforms (Appendix 1). IMF has focused on overall macroeconomic stability to ensure fiscal sustainability, advising on treasury, budget management, tax, and customs reforms. The treasury single account system has been established with IMF’s support. 38. World Bank’s support for public administration reforms was initiated through the fiscal TA project, approved in 1998 for $5 million, to support debt management, tax administration, and treasury reforms. The project also supported a major public expenditure and financial management review in 2001, which was finalized in July 2002. The review, undertaken concurrently by the Government with the formulation of the Poverty Reduction Strategy Paper (PRSP), identified a number of constraints on, and weaknesses faced by, the public sector. Based on the review, and to support PRSP implementation, the World Bank plans to formulate three poverty reduction strategy credits (PRSCs) in 2003-2007. The PRSCs’ objective is to develop and implement policies and structural reforms consistent with and supportive of the overall economic development strategy in a sequenced and phased manner. PRSC1 is being proposed for $15 million, likely to be approved by October 2003. The sequence of PRSCs will be as follows: (i) PRSC1 will support public sector reforms to achieve macro-fiscal stability; (ii) PRSC2 will focus on private and real sector reform and help create an environment for favorable growth; and (iii) PRSC3 will support social sector reforms and improve access to, and the quality and cost of providing, public services. 39. The World Bank has also designed the Economic Capacity-Building Technical Assistance Credit (ECTAC), for $8 million, to support PRSC implementation. ECTAC will focus on public expenditure management reforms, including budget formulation, execution, and reporting; measures to enhance accountability; and policy evaluation. ECTAC will also help SSC build its capacity in wage management and establish internal controls in the civil service. UNDP has provided advisory support under the Good Governance for Human Security (GGHS) Program and also led coordination of donor support for the Government’s anticorruption measures through the National Council on Anticorruption, headed by the prime minister. The Government of Sweden is advising the Government on local government capacity building to strengthen organizational management. The United States Agency for International Development (USAID) has supported court system reforms. 40. GRP implementation and the consultative process leading to the adoption of PSMFL have proved as useful windows for coordination between ADB and other funding agencies. The division of labor, as it has evolved with the World Bank and IMF, entails ADB coordinating PSMFL implementation. The PRSCs and PRGF will help formulate and adopt MTEF and streamline budget processes. PRSC1 will aim at short-run civil service reform measures, including design of a database of civil servants and adoption of a coherent system of civil service processes. ADB will help ensure that the Government adopts a career-track civil service system at the end of GRP-II. It will help implement PSMFL-related provisions on accounting, and financial and performance auditing reforms, building on earlier ADB TA and World Bank support. ADB will coordinate closely with UNDP to enhance public confidence in the Government.

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V. THE PROPOSED PROGRAM

A. Objectives and Scope 41. GRP-II aims to enhance public sector accountability and efficiency, to be measured by fiscal sustainability and tangible improvements in delivery of key public services. GRP-II’s purpose, following measures adopted under GRP on a pilot basis, is to help implement public sector administrative and financial management reforms. GRP-II will adopt a three-pronged approach:

(i) Enhance institutional capacity.

(a) Support implementation of PSMFL-related measures on strategic planning and output-based budgeting, with focus on health, education, and social welfare and labor portfolios.

(b) Strengthen the institutional and implementation arrangements for financial governance norms in the public sector.

(ii) Improve fiscal sustainability.

(a) Initiate pension reforms to alleviate fiscal pressures on the budget

stemming from the public pension system. (b) Initiate administrative consolidation to reduce multiple layers of control

that impede efficiency and lead to waste of scarce resources.

(iii) Mainstream governance reforms.

(a) Enhance the enforcement capacity of SSC to improve the quality of the civil service.

(b) Enhance confidence in key public institutions. B. Important Features 42. GRP-II will undertake the following to enable reform:

(i) Mainstream governance reforms, centered on output and financial management measures in the public sector, which eventually will trickle down to the entire economy through well-functioning government at all levels.

(ii) Design the cluster program to facilitate learning by doing, by gradually implementing reforms in 2003-2009.13 This approach will (a) allow considerable flexibility and enable ADB to remain engaged in governance reforms, address capacity constraints, and enable stakeholder consultations over a longer period of time than otherwise possible; and (b) mitigate the risks assoc iated with formulating and implementing a complex reform agenda in the run-up to, and immediately after, parliamentary elections.

(iii) Support medium- to long-term administrative consolidation measures, which will help the Government achieve economies of scale in administration and delivery of public services. The cluster design will also enable extensive stakeholder

13 Two TAs are included in the 2004-2005 program to help support broad policy analysis of some of the components

of subprogram 1 and program preparation for subprogram 2.

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consultation and facilitate consensus building on optimal approaches to merge provincial and district administrations or consolidate the delivery of essential public services.

(iv) Target education, health, and social welfare and labor portfolios to complement and leverage reforms supported by ADB through past and ongoing sector-specific interventions.

C. Policy Framework and Actions 43. The policy matrix in Appendix 2 outlines the measures supported under subprogram 1. It will support a number of mainstreaming measures. Subprogram 2, as outlined under the milestones in Appendix 3, will support a series of critical follow-up measures to complete the envisaged reforms, and ensure sufficient stakeholder consultations. Appendix 4 presents the development policy letter. The program logical framework is in Appendix 5. 44. The policy matrix is organized on the basis of the three main components. While GRP implementation was completed in December 2002, GRP-II has adopted a seamless approach of tracking government reforms since enactment of PSMFL in June 2002. The principal aim of the Government since then has been to increase awareness of the law among the public officials to facilitate its implementation. Subprogram 1 has 35 actions across the three components, and 1 action to ensure sufficient budget for a social safety net. As the program is proposed in continuity of GRP, the Government has complied with six important conditions before loan negotiations. Of the remaining 29, 10 are indicated as core second-tranche release conditions, and 19 will be monitored throughout the program.

1. Enhance Institutional Capacity

a. Implement PSMFL-Related Reforms

45. Adopt an Implementation Framework. To continue GRP, the Government has undertaken a number of measures since adoption of PSMFL. As part of GRP-II, the Government approved a PSMFL implementation plan in September 2002. It envisages a 3-year time frame, 2003-2005, consisting of the following: (i) preparatory stage, July 2002-December 2002, to undertake initial work on planning and budgeting, the new accounting and reporting system, performance and expenditure management systems, establishment of ex post audits, and transition to a centralized treasury management system; (ii) second stage, January 2003-December 2005, to introduce an output-based management system; and (iii) third stage, January 2004 onward, to gradually devolve input delegation to lower-level entities. While a 3-year time-bound plan has been adopted, the Government is acutely aware of the complexities of the transition, particularly in light of the capacity constraints. Hence, the implementation plan will be treated as a guide that may be amended as appropriate. 46. Adopt Guidelines and Consequential Amendments to Legislation. The Government, with ADB TA support, has published a detailed explanation guide in Mongolian on public sector finance and management reforms and disseminated over 1,500 copies for use by portfolio ministers, general managers, and key staff of the main agencies. The Government also drafted consequential amendments to 75 laws, necessitated by the adoption of PSMFL, which Parliament enacted in January 2003. Of particular importance are amendments to the laws on budget, civil service, government, and state audit, which clarify and reconcile their provisions with PSMFL. The Government has also issued rules and regulations requiring line ministries

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and budgetary bodies to present their budget estimates in a portfolio appropriation format, in line with the PSMFL requirements, on a trial basis in 2003, leading to full adoption of the new format in 2005-2006. The approved budget for 2003 is presented on a portfolio basis. 47. Launch Capacity-Building Initiatives. To enhance awareness of PSMFL, the Government has formulated a capacity-building program, to be initially funded through counterpart funds generated under GRP. All state secretaries in the line ministries (who are also the ministries’ general managers) and the general managers of all central budgetary bodies have undergone an intensive training program on the basics of PSMFL. A training-of-trainers program was completed, following which three academic-cum-training institutions provided basic training sessions on PSMFL implementation for central and local government officials in May-July 2003. The Government will evaluate the outcomes and design the follow-up training phase. 48. Strengthen Strategic Planning and Output-Based Budgeting. As part of GRP, all the 5 bunch-1 agencies formulated their strategic business plans (SBPs), while the 12 bunch-2 ministries and agencies started to do so. A key difficulty for central ministries has been redefining their roles in the post-PSMFL environment, given the transition from focusing on policy formulation and coordination, to undertaking overall sector management. Although the PSMFL provides for considerable flexibility and autonomy to provincial and district administrations to define their strategic priorities, the law has simultaneously expanded the scope of oversight activities covered by the line ministries. Based on earlier SBPs produced by a limited number of entities, the Government will monitor progress on revisions to the SBPs, which will be done continuously by all ministries and budgetary bodies. ADB TA support has been provided to Ministry of Education, Culture, and Science (MOSTEC), Ministry of Health (MOH), and Ministry of Social Welfare and Labor (MSWL) in preparing for PSMFL implementation. In compliance with a second-tranche condition, these ministries will finalize their SBPs for 2004-2006, to ADB’s satisfaction, by December 2003. By November 2003 MOSTEC, MOH, and MSWL will also finalize the following: (i) output specification in the education and health sectors, and standardized methodology and dissemination of the methods and formats for reporting; and (ii) sector-specific output-costing guidelines and instructions. By March 2004 the ministries will agree on quantitative norms on output costs against which their portfolio outcomes can be benchmarked. Advisory support under CBGR and other sector TAs will focus on strengthening sector medium-term planning, which, in turn, will feed into improving SBPs by evaluating current service delivery performance in the key sectors. 49. The output specification and costing process needs to be strengthened at all levels before the budgetary bodies can comply with PSMFL provisions on finalizing portfolio appropriation estimates on the basis of outputs. In the interim MOFE will liaise with the line ministries to ensure that the transition to output-based estimation is well managed. As part of GRP-II, in May 2003 MOFE submitted to Parliament the fiscal framework statement for 2004-2006 and a draft MTEF. By October 2003 MOFE will also (i) formulate and issue the methodology for medium-term expenditure planning on an accrual basis to all line ministries and budgetary bodies, and (ii) formulate guidelines and issue them to all line ministries and budgetary bodies to enable them to finalize their portfolio appropriation estimates in line with PSMFL provisions. 50. Introduce Measures for Expenditure Discipline. The Government, through MOFE’s coordination with MOH, MOSTEC, and MSWL, will start assessing public sector administrative expenditures incurred to fulfill the above portfolio responsibilities, and, by March 2004, set a ceiling on such expenditures. The Government will control expenditures and encourage coordinating agencies to conserve administrative resources and utilize the savings to provide

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incentives to staff or upgrade infrastructure. The Government will also simultaneously prepare and submit a comprehensive report to ADB annually every October over 2003-2006, focusing on (i) the quasi-fiscal activities and liabilities resulting from noneconomic state sector activities; (ii) contingent liabilities incurred by the Government; and (iii) arrears on taxes and payments to the state budget, categorized by the defaulters’ ownership structure.

b. Strengthen Financial Governance Norms in the Public and Private Sectors

51. Establish Sound Oversight for Public Sector Accounting. Other than the Accounting Policy, Methodology, and Auditing Department of MOFE, which is a policy and standards-setting body, no coordinating department or official oversees actual public sector financial accounting. While all budgetary bodies are required to have an in-house chief accountant, most do not. Those that do, have accountants who lack qualification and skills. To modernize the Government’s financial management system and establish practices leading to sound financial reporting to the Government and Parliament, government accounts must be under centralized leadership and controllership. By January 2004 the Government will establish a new accountant general (AG) position at MOFE, with CPA qualifications, to be responsible for all ex ante financial planning and ex post financial reporting, and overall government accounting responsibilities. Following ADB’s approval of the proposed TA loan for CBGR, the Government will (i) appoint an international senior advisor to the AG with support under CBGR, (ii) ensure that a qualified incumbent staff is nominated as chief accountant in each portfolio ministry and province, and (iii) establish a hierarchical link between the AG and chief accountants of portfolio ministries and provinces. 52. The AG, who will have sound knowledge of accrual accounting and government financial management and reporting, will direct financial management systems as well as ensure accurate financial reporting by doing the following: (i) set accounting procedures, establish financial management policies, and monitor implementation of these regulations; (ii) develop accounting manuals to improve the quality of financial reporting; (iii) implement a uniform and integrated chart of accounts for accounting, budgeting, and reporting for all government entities; (iv) implement international public sector accounting standards (IPSAS); (v) approve the appointment of chief accountants in portfolio ministries and budget entities, and monitor their work plan and performance; (vi) assess the skills of all government accountants and establish benchmarks for quality improvement; and (vii) certify government accountants, based on a well-designed examination and evaluation process. 53. Establish Sound Internal Audit Arrangements. A strong overall internal audit and control environment is needed to promote sound financial management in portfolio ministries and budget entities and enable them to respond appropriately to significant operational, financial, compliance, and other risks, including inappropriate use of assets or their loss from fraud. Liabilities must be identified and managed. Good internal and external reporting requires maintenance of proper records, and processes that generate a flow of timely, relevant, and reliable information from within and outside budget entities, and which can be increased significantly through internal control. Internal audit also expedites compliance with applicable laws and regulations, and also with internal audit policies. Accordingly, by January 2004, the Government will (i) establish internal control functions under the AG’s Office, accountable to the AG, led by the head of internal audit (HIA); (ii) coordinate the nomination of a qualified incumbent staff as an internal auditor in the portfolio ministries, including MOFE and provinces, reporting to the respective state secretaries and provincial governors; (iii) set up a hierarchical

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link between the HIA and internal auditors of portfolio ministries and provinces; (iv) ensure that the AG formally defines the terms of reference of internal audits in line with the operational standards issued by the Institute of the Internal Auditor; (v) ensure that the HIA obtains a government internal audit certificate by meeting all the institute’s requirements; and (vi) establish continued professional education requirements for internal auditors. 54. The following institutional structure for the AG and internal audit arrangements will be established (see Appendix 6 for more detail):

(i) the AG, responsible for consolidating the financial report for the whole Government, will be located within MOFE (but different from the chief accountant in the Treasury or the Accounting Policy and Methodology Department) and report to the state secretary of MOFE;

(ii) heads of the accounting department in all portfolio ministries, including MOFE, and provincial administrations, will be nominated as chief accountant of the respective entities;

(iii) the chief accountant for MOFE will be outside the Treasury or accounting policy and methodology and auditing departments to segregate the Treasury (including cash management) as well as accounting auditing policy-setting functions from financial accounting and reporting, and the MOFE chief accountant will perform the same functions as the chief accountants in other portfolio ministries;

(iv) an internal controller in each portfolio ministry (including MOFE) and provincial administration, will be reporting to the state secretaries or general managers as appropriate; and

(v) the HIA will initially be located within MOFE, and all the internal auditors will report to the HIA, who, in turn, will report to the AG.

55. Enhance Compliance with Internationally Accepted Norms for Public Sector Accounting. The Government is in the process of officially recognizing IPSAS issued by the Public Sector Committee of the International Federation of Accountants. Under GRP-II, by May 2004 MOFE will draft and submit to Parliament amendments to the Law on Accounting to establish a certified government accountant structure for the 3,180 public accountants at the central and local ministries, governors’ offices, and various budgetary bodies. The amendments will also provide for entry and qualification criteria to take effect on a time-bound basis, and for job classifications and categories. By May 2004 MOFE will also have designed an examination structure and review courses to prepare candidates for the exams, and developed continued professional education requirements to certify government accountants. By November 2004 the Government will have conducted the first exam for government accountants. 56. Introduce Sound Asset Valuation Standards. To strengthen the rudimentary norms and practices used for asset valuation, by June 2005, with support from CBGR, the Government will draft and adopt asset valuation standards on movable, immovable, and nonmaterial assets (e.g., trademarks, copyrights, etc.) that are comparable to international standards. 57. Make the Transition to Accrual Accounting. In line with PSMFL, the Government will officially adopt the new chart of accounts (developed under the World Bank’s fiscal TA project) designed to operate on cash and accrual bases. To guide the transition, under subprogram 1 and with support from CBGR, by June 2005 the Government will have implemented a pilot program for education and health to develop (i) an initial set of accrual-based accounts that will recognize the receivables and payables at the end of each fiscal year, and (ii) asset registers for the pilot sectors.

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58. Enhance Transparency through Financial and Performance Auditing. PSMFL entrusts NAO with financial and performance audits of public sector agencies. Under GRP-II, with advisory support under CBGR, by May 2005 NAO will have conducted financial statement audits of (i) MOSTEC, MOH, and MSWL; and (ii) one province14 (to be undertaken through the concerned state audit office) on a pilot basis, to be selected in consultation with ADB. By May 2005 NAO will also have undertaken performance audits of selected functions and outcomes of CGA, GDNT, MOSTEC, MOH, and MSWL, and publish a summary of the audits in major newspapers. 59. Undertake Forward-Looking Measures to Improve Financial Management. The Government will undertake a host of financial management reforms. By May 2005 the Government will have reviewed the functions of SPIA, particularly in financial inspection, and restructure SPIA to ADB’s satisfaction. The review objective will be to ensure that the internal control functions are strengthened in each budgetary agency. By June 2004 the Government will also have undertaken measures to improve the legal, regulatory, and institutional framework for private sector accounting, and (i) separate MICPA from MOFE, (ii) abolish the Mongolian Professional Accounting Council, (iii) translate international accounting and auditing standards into Mongolian and adopt them verbatim, and (iv) draft amendments to the Law on Auditing to streamline the CPA examination and certification process.

2. Improve Fiscal Sustainability

a. Strengthen the Social Security System to Enhance Fiscal

Sustainability 60. The Government, based on advisory support provided under earlier ADB TAs,15 will undertake some critical measures to enhance the fiscal sustainability of the social security system. By July 2004 MSWL will have drafted a white paper on pension system reform, focusing on the need to increase retirement ages (by eliminating early retirement privileges and equalizing retirement ages of men and women), revamp the notional defined contributory system, and properly index pensions. By March 2005 MSWL will have disseminated the white paper for stakeholder consultations and finalized the reform measures to ADB’s satisfaction. Subprogram 2 will pursue implementation of the reforms.

b. Initiate Central and Local Administrative Consolidation to Strengthen Public Sector Resource Management

61. The Government has embarked on a plan to develop five regional centers to redress regional imbalances and evenly distribute the population. While the Government’s objective is to achieve equity in growth across the country, any development of regional clusters may lead to additional layers of public administration. CS and MOFE have, therefore, submitted to Parliament a draft law on the regional management providing that regional development will not create such additional layers or additional expenditure outlays.

14 The Government has requested that the Ulaanbaatar city administration or some of its districts be chosen for this

purpose, as the city accounts for close to 50% of revenues collected and 40% of public expenditures countrywide. As the city administration is focusing on a number of anticorruption measures, financial and performance audits would facilitate the administration’s reform agenda. The advisors under CBGR will assess the needs and advise the Government.

15 ADB. 2000. Technical Assistance for Strengthening Financial Sector Development. Manila; ADB. 1997. Technical Assistance on Social Safety Net. Manila.

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62. The Government and public increasingly recognize that low population density in certain provinces will threaten local fiscal stability. The Government has devoted attention to aggregation of localities, and is formulating a three-pronged approach: (i) explore the potential for interprovincial consolidation, by considering the aggregation of Selenge and Darkhan in the north, Gobi-sumber and Dornogobi in the south, and Orkhon and Bulgaan in the west; (ii) consolidate districts within several provinces; and (iii) establish inter- and subprovincial links to consolidate public service delivery, including health, education, taxation, and other components of public administration. 63. GRP-II will support intra- and interprovincial consolidation. As part of subprogram 1, by March 2004 the Government will have drafted a concept paper on administrative consolidation to improve public expenditure management and achieve economies of scale in service delivery, consisting of a framework to consolidate the following: (i) selected contiguous provinces; (ii) selected districts within the same or other provinces; and (iii) selected public sector administrative units, agencies and institutions, and service delivery functions in the selected provinces and districts Such measures should not disrupt the quality of, or access to, public services. The plan will include safeguards and social safety nets to provide for the short-run transition costs as well as to mitigate adverse impacts of such measures. 64. As part of subprogram 2, the Government will establish consensus through consultations with all the local stakeholders, including the public, local government officials, and provincial citizens’ representative assemblies. The Government will finalize the concept paper based on local inputs, and start to formulate a legal framework, including amendments to relevant legislation, to achieve intra- and interprovincial consolidation. Subprogram 2 will also help the Government achieve such consolidation to enhance fiscal responsibility and achieve economies of scale and efficiency in public sector administration. The Government envisages the following: (i) four districts will be consolidated together to the satisfaction of stakeholders and ADB through consultations, including by merging administrative jurisdictions and jointly providing services across districts ; and (ii) six provincial administrations will be consolidated into three.

3. Mainstream Governance Reforms

a. Enhance Confidence in Public Institutions 65. Enhance Civil Service Culture. GRP-II will support several measures to strengthen SSC, supplementing advisory support from the World Bank, to establish a sound information system on civil servants and their working conditions. As part of GRP-II, SSC, with advisory support from ADB TA,16 will develop the criteria and a code of conduct on ethics for civil servants, which the Government will adopt by May 2004. SSC will (i) by May 2004 have adopted an enforcement mechanism to implement Parliament’s rules on selecting candidates for senior civil servant positions, and a grievance and dispute settlement mechanism for civil servants; and (ii) as part of the regular annual report from SSC to Parliament, submit an assessment of the enforcement outcomes. 66. SSC will also (i) determine if the performance evaluation reports from selected ministries and provincial administrations are in line with SSC’s evaluation requirements, and (ii) submit to Parliament an overall performance evaluation report and make it publicly available. This

16 ADB. 2002. Technical Assistance for Strengthening Public Sector Administration and Financial Management.

September. Manila.

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exercise will be repeated for all ministries and provincial administrations for reporting on outcomes in FY2004. 67. Enhance Transparency and Accountability in Key Public Institutions. The Government has recently taken a number of commendable steps in this direction, including establishment of the National Council on Anticorruption (NCAC), headed by the prime minister, with support from UNDP under the GGHS program. However, public confidence in key institutions, including CGA and GDNT, continues to be low, and public service delivery mechanisms and utilization of budgetary funds in health and education sectors. In March 2003 NCAC adopted the Action Plan on Anticorruption, which focuses on improving confidence in public institutions. 68. Under GRP-II, in line with item 2 of the action plan and with support from UNDP and ADB, CS will (i) coordinate the establishment of an NCAC subgroup to comprehensively assess the role, performance, and efficacy of GDNT, CGA, and service delivery mechanisms in education and health, with participation from civil society, academia, and Parliament, and limited government representation; and (ii) formulate the subgroup’s terms of reference to undertake the performance assessments and design remedial measures. This subcomponent will complement the financial and performance audit measures in para. 66. By June 2004 CS and the NCAC subgroup, with support from UNDP and ADB, will have submitted a comprehensive assessment report and made it publicly available. The Government will start implementing the remedial measures outlined in the report by December 2004. 69. Under GRP, a sample of SOEs finalized SBPs and concluded performance agreements with MOFE. Under subprogram 2 the Government will improve SOE corporate governance and complete privatization after cleaning up any budgetary arrears and debts (Appendix 3).

3. Formulate Effective Social Safety Net Measures and Allocate Budgetary Resources

70. The forward-looking thrust of GRP-II will have an overall positive economic and social impact by conserving public financial resources. None of the subprogram 1 measures are likely to have an adverse impact on the poor or vulnerable. However, to address social safety net needs arising from the 2003–2009 overall reform program, the Government will allocate at least $500,000 each year in the annual budgets in 2004-2006. The Government has also agreed that the formulation of specific measures under subprogram 2 will take into account the need for a social safety net arising from their implementation. D. Financial Implications of the Reform Program 71. GRP-II is a time slice of the 10-year governance reform roadmap. Subprogram implementation will cost an estimated $34.1 million equivalent over 6 years (Table 1) to strengthen financial management systems, implement other PSMFL-related provisions, undertake structural reforms for administrative consolidation, pay for the social impact of the reform measures, and pay the net costs of infusing budgetary discipline into SOEs. While some costs such as establishment of public service delivery facilities in regional centers to prepare for consolidation are derived from the Government’s draft MTEF, its full adoption will lead to periodic reevaluation of the financing gaps and costs of reform programs and clarify the impact of structural adjustments.

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72. Public sector modernization has other costs that cannot be quantified yet. In particular, subprogram 1 will support PSMFL implementation on a pilot basis while the Government pursues reform of the entire public sector. To build consensus and support for reform, the Government will also have to enhance social capital, which is not quantified or included here. Hence, the overall cost of the reform process is likely to be considerably higher than the subprogram costs.

Financial Implications of the Governance Reform Program, Phase II (2003-2009)

Reform Elements Cost

($ million equivalent) Subprogram 1 Subprogram 2 Total Strengthening Financial Management Systems 7.0 3.0 10.0 Net Costs of Introducing Other PSMFL Provisions 5.0 2.0 7.0 Restructuring Costs Arising from Functional Review of the Public Sector

3.0 3.0

Ensuring Service Delivery through Inter-provincial and Inter-district Facilities as Part of Administrative Consolidation

5.0 10.0 15.0

Social Safety Net Needs 1.5 4.0 5.5 Net Costs of Infusing Budgetary Discipline through Clearing SOE Arrears before Privatization

10.0 10.0

Savings from Pension Reform Measures (16.4) (16.4) Total 18.5 15.6 34.1 PSMFL = Public Sector Management and Finance Law, SOE = state-owned enterprise. E. Financing Plan

73. A program loan of SDR9,699,000 ($13.5 million equivalent) is proposed to be provided from ADB’s Special Fund resources to support subprogram 1. The program loan will have a term of 24 years, including a grace period of 8 years. The interest charge will be 1.0% per annum during the grace period of 8 years, and 1.5% per year for the remaining period. F. Implementation Arrangements

1. Program Management

74. MOFE will be the executing agency for GRP-II and responsible for implementing all PSMFL-related measures, and reforms relating to public sector financial management and the social security system. CS will be the implementing agency for all the local government reform issues and the civil service reform component. CS will also ensure that all cabinet-level coordination needed to smoothly implement GRP-II is efficient. 75. Given the coverage of a number of cross-sectoral issues and the complexity of the reform measures agreed upon, GRP-II will follow the steering committee model adopted under GRP. A steering committee and an operational working group will assist MOFE and CS. The steering committee will comprise the chief of CS (as head of the committee), minister of finance and economy, minister of social welfare and labor, economic advisor to the prime minister, and two representatives from the parliamentary working group on governance. The operational working group will be led by the deputy minister of MOFE and comprise the deputy chief of CS in charge of local government reforms, head of MOFE’s Fiscal Policy Department, head of

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MOFE’s Accounting Policy Department, head of MSWL’s pension department, head of a relevant department of SSC, and head of administration of NAO. 76. The Government will establish a GRP-II program implementation unit (PIU) in MOFE before loan negotiations with support from domestic and international consultants under ADB TA grants and the TA loan for CBGR. The PIU will comprise at least three counterpart supporting staff, with one nominated from CS and the others from MOFE. The PIU will report to the state secretary of MOFE and shall coordinate with the operational working group monthly to report on progress. The PIU will coordinate quarterly progress reports to ADB on GRP-II and CBGR implementation and submit a program completion report after the Government complies with all the tranche-release conditions that can be monitored. The deputy minister of MOFE and deputy chief of CS will inform the steering committee monthly of all key aspects of GRP-II.

2. Period of Implementation

77. Subprogram 1 will be implemented beginning from board approval to December 2005. Depending subprogram 1’s progress, the subprogram 2 proposal may be presented to the Board for consideration in the first quarter of 2006 and implemented until mid-2009. ADB will prepare an interim program completion report, outlining the progress under subprogram 1, along with a finalized policy matrix to guide subprogram 2 based on milestones. A program completion report for the whole cluster will be prepared within 12-18 months after completion of subprogram 2.

3. Procurement and Disbursement 78. The proceeds of the program loan under subprogram 1 will be withdrawn in accordance with ADB's standard disbursement procedures. Before submitting the first application to ADB for withdrawal from the loan account, the MOFE will open a deposit account at BOM, into which all withdrawals will be deposited. The deposit account will be established, managed, and liquidated in accordance with ADB's Loan Disbursement Handbook (January 2001). ADB reserves the right to audit the use of the loan proceeds and to verify the validity of the certification issued by the governments with each withdrawal application. 79. In accordance with the simplified disbursement and procurement procedure for program loans, the loan proceeds may be utilized to procure goods and services (excluding local duties and taxes) produced in and procured from ADB’s member countries, other than those specified in the list of ineligible items (Appendix 7) and those financed by other multilateral and bilateral official sources, and imports from non-ADB member countries. All procurements under the loan will be done through normal commercial practices for the private sector or the Government’s prescribed procurement procedures acceptable to ADB, with due consideration given to economy and efficiency. No supporting import documentation will be required if, during each year in which the loan proceeds are expected to be disbursed, the value of the Government’s total imports minus imports from nonmember countries, ineligible imports, and imports financed under other official development assistance is equal to or greater than the loan amount expected to be disbursed during such year. The Government will, however, certify with each withdrawal request its compliance with this formula. Otherwise, import documentation under existing procedures will be required. ADB reserves the right to audit the use of loan proceeds and verify the accuracy of the Government’s certification.

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4. Monitoring and Tranching

80. A cluster program modality comprising subprograms 1 and 2 is proposed. Subprogram 1 will have two tranches. Periodic reviews of implementation progress under subprogram 1 will lead in seamlessly to formulating the full reform agenda under subprogram 2, developed on the basis of the milestones in Appendix 3. The first tranche of subprogram 1, of SDR3.592 million ($5.000 million equivalent), will be released upon approval of GRP-II by ADB and loan effectivity. Subject to satisfactory fulfillment of all the second-tranche release conditions appearing in bold in the policy matrix, and other program conditions that can be monitored, the second tranche of SDR6.107 million ($8.500 million equivalent) is expected to be released by July 2005. 81. To finance subprogram 2’s adjustment costs, ADB’s lending program for 2006 has allocated $10 million equivalent based on the forecast indicative planning figures and availability of Special Funds resources. ADB’s support will depend on the final scope of subprogram 2 as well as the availability of Special Funds resources. Subprogram 2 will also be divided into two tranches, and the amounts disbursed will be decided during design of subprogram 2.

5. Program Review 82. Given the reforms’ complexity, ADB will adopt an analytical approach to monitoring program implementation and the reform outcomes. At least three reviews are planned every year during program implementation and progress of policy reforms. The Mongolia Resident Mission will help coordinate the addressing of emerging issues and needs. The governance reform TAs proposed for 2004-2005 will include evaluation of the costs and benefits of policy measures, and assessment of overall PSMFL implementation, integrity of MTEF in key sectors, and stakeholder views on consolidation and other measures. These steps in turn, will help the Government comply with subprogram 1, and feed into the formulation of subprogram 2. The analytical approach will also help the Government formulate mid-course corrections in the overall reform exercise.

VI. THE PROPOSED TECHNICAL ASSISTANCE LOAN A. Objective and Scope 83. The TA loan for CBGR will help the Government enhance its overall capacity to implement the key GRP-II governance-related measures through interim management, on-the-job training programs, and technical support. CBGR will cover the following:

(i) financial management reforms in public sector accounting, auditing, and asset valuation;

(ii) support for strategic planning of PSMFL implementation; and (iii) software and limited hardware support to efficiently undertake output costing, and

financial statement and performance audits.

B. Components

84. CBGR will provide for long-term advisors who will (i) help senior management in MOFE and other selected ministries implement PSMFL; (ii) provide on-the-job guidance and training to the staff of ministries; (iii) identify areas that need improvement; and (iv) undertake system

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design for financial and performance audits, and install hardware and software, based on the technical assessments. In total, the TA will provide international consulting services for 53 person-months and domestic consulting inputs for 120 person-months. Appendix 9 presents the terms of reference for the positions.

85. Establish Sound Oversight for Public Sector Accounting and International Audit Arrangements. To modernize the Government’s financial management system and establish practices leading to sound financial reporting to the Government and Parliament, CBGR will provide 18 person-months of international advisory assistance to the AG, intermittently, over 36 months. The resident advisor will be a CPA with government accounting and financial reporting experience in market economies and preferably with experience in transition economies as well. The resident advisor will help the AG direct financial management systems as well as build up accurate financial reporting for the Government. In line with their terms of reference (Appendix 8), the AG and resident advisor will be jointly implement the policy matrix to establish oversight for public accounting and internal control arrangements. The resident advisor will also review functions of financial inspectors in budget entities and portfolio ministries to see if their job responsibilities can be converted into internal audit functions through training to develop and strengthen their internal audit capacity. This review will serve as a foundation for the proposed central internal audit unit under the AG’s Office, and internal audit units in the portfolio ministries, provinces, and budgetary entities. 86. Undertake financial statement and performance audits. CBGR envisages advisory support for 18 person-months intermittently over 36 months to help NAO conduct financial statement and performance audit. This support will be provided through on-the-job training for NAO staff assigned to financial statement and performance audits. In consultation with NAO’s senior management, the audit advisors will identify special needs of NAO staff and arrange for short-term classroom training programs. A team of two international auditors will be mobilized to work with 18 auditors of NAO to conduct financial statement and performance audits. Financial statement audits will be undertaken for MOSTEC, MSWL, and MOH, and for one province on a pilot basis, to be selected in consultation with ADB. Performance audits will first be undertaken for functions and outcomes, to be selected in consultation with ADB, of MOSTEC, MSWL, MOH, CGA, and GDNT, and a summary of the audits published in major newspapers. 87. Develop Asset Valuation Standards. MOFE will be assisted with 2 person-months of international consulting services in drafting asset valuation standards in line with international standards, and in preparing a user’s manual to apply them. 88. Support Strategic Planning Processes to Implement PSMFL. This component, with 13 person-months of international advisory inputs, will provide overall strategic planning, output specification, and costing support, in line with PSMFL requirements, to MOH, MOSTEC, MSWL, Ministry of Infrastructure, and two other ministries to be selected in consultation with MOFE, depending on the level of preparedness and a needs assessment. This process will entail a comprehensive assessment of the strategic focus, policy orientation, output planning, interministerial and interagency coordination, and progress in PSMFL implementation within the selected portfolios. Based on these assessments, time-bound strategic plans with measurable benchmarks will be formulated to guide process-oriented as well as structural reforms. The advisory component will also help NCAC implement the subcomponent to enhance confidence in public institutions.

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89. Modernize Financial Management. This component will have two modules. The first will help NAO develop a software package for financial statement and performance audits, by using system-based computerized methods. The second module will help modernize the output-costing processes in all portfolios. A needs assessment will evaluate the hardware and software at central and local budgetary bodies. The module will help MOFE procure a modern output-costing program with full licensing rights for use by a large number of budgetary entities. Hardware and basic software support will be provided selectively. The output-costing software and associated training are anticipated to be provided to about 3,000 accountants. To support the software and hardware assessments and design, an international management information systems expert will be recruited for 2 person-months. C. Cost, Financing Plan, and Implementation Arrangements 90. The total cost of the capacity-building activities is estimated at $2.4 million, of which it is proposed that ADB provide $2 million equivalent (SDR1.437 million) from its Special Funds resources. The Government will provide $400,000 equivalent in counterpart facilities. The TA loan will have a term of 32 years, including a grace period of 8 years, and carry an interest charge of 1.0% per annum during the grace period and 1.5% per year for the remaining period. 91. All international and domestic consultants will be recruited on an individual basis by the PIU through competitive selection. All consultants will be recruited in accordance with the ADB’s Guidelines on the Use of Consultants and other arrangements satisfactory to the ADB for the selection and engagement of domestic consultants. CBGR will be implemented over 3 years, from October 2003 to September 2006. MOFE will be the executing agency, with coordination and implementation support provided by CS for strategic planning. The PIU, directly working under and reporting to state secretary of the ministry of finance and economy, will be in charge of day-to-day implementation. The PIU will submit quarterly progress reports to ADB on CBGR implementation until all TA loan activities are successfully completed. 92. Procurement of goods and services from ADB loan funds will be in accordance with ADB’s Guidelines for Procurement. The procurement of hardware and software for the management information systems component will be based on international shopping procedures. The PIU will establish one imprest account in foreign currency at a commercial bank acceptable to ADB, to disburse funds to procure equipment and fund operating costs. The account will receive an initial deposit upon loan effectiveness of $150,000 for the first 6 months of implementation, including for payment to domestic consultants and procurement of equipment and materials. Eligible operating expenditures under CBGR will be reimbursed or drawn from the imprest account advance against satisfactory statements of expenditure subject to a maximum for any single payment of $50,000, in accordance with procedures acceptable to ADB, and in accordance with the Loan Disbursement Handbook. 93. MOFE will maintain records and accounts in accordance with sound accounting principles, with sufficient detail to identify all goods and services financed under CBGR and to indicate the use to which they were put. The accounts (including financial statements, statements of expenditure, and imprest accounts records) will be audited annually by independent external auditors acceptable to ADB. Separate records will be maintained for the imprest account. ADB reserves the right to audit these accounts at any time. Costs for annual audits throughout CBGR implementation have been included in TA loan costs. MOFE will submit certified copies of the audited accounts and the auditor’s report to ADB within six months of completion of each fiscal year. MOFE will also provide ADB with any reasonable additional

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information concerning the TA loan accounts and financing that ADB may request from time to time.

VII. PROGRAM BENEFITS, IMPACTS, AND RISKS

A. Benefits 94. Overall Benefits. GRP-II will have institutional, fiscal, and public service-user benefits. By mainstreaming modern management reforms in line with PSMFL, the program will help increase public sector capacity. Enhanced efficiency will lead to lower administrative expenditures as well as improved service delivery. The program will directly help reduce the pressures on the budget through pension reforms and administrative consolidation. 95. Administrative and Financial Management Reforms. By instituting measures for sound strategic planning on output delivery, GRP-II will help define the role of each public sector agency, and cost the outputs so that entity budgets can be formulated accurately. While provinces have derived most of their revenues through resource transfers from the center, detailed ex ante or ex post financial reports have not been required. PSMFL requires all entities to prioritize and formulate their medium-term financial needs, unlike before when ad hoc demands were placed on the center, and to submit complete financial statements at the end of the budget cycle, presenting all relevant information on revenues and expenditures. GRP-II will provide extensive policy and capacity-building support for PSMFL’s financial management reforms. GRP-II will institutionalize oversight arrangements at the highest level by establishing the AG’s office at MOFE, and at the level of the spending units by setting up internal control units. These and the financial and performance audits will help enhance transparency and accountability, besides cutting expenditures through improved internal controls. As GRP-II will primarily focus on health, education, and social welfare and labor, the reforms will release scarce resources to improve the quality and quantity of public services in these sectors. 96. Enhancing Fiscal Sustainability. GRP-II aims to enhance fiscal sustainability. While PSMFL requires strategic planning, output, performance, and financial management reforms, equally critical are policy reforms in certain key areas such as social security. GRP-II measures will strengthen the pension system by gradually eliminating early retirement privileges and ad hoc increases in pensions, and by equalizing the retirement ages for men and women. These measures will benefit the central budget in the long run and help enhance fiscal sustainability. Local administrative consolidation measures will enhance economies of scale in service delivery. B. Impacts 97. Poverty Impact. Appendix 9 presents the poverty impact assessment. Subprogram 1 is not expected to have any adverse social impact or negative consequences for the poor. By targeting public sector administration and financial management reforms in education, health, and social welfare, GRP-II will ensure that the scare resources are utilized well. Subprogram 2 administrative consolidation measures may have a short-term adverse impact on the poor and other vulnerable groups run, particularly in education, health, or other social service delivery. While the Government aims to consolidate provision of such facilities and not eliminate them, the location of certain segments of the population may reduce their access to essential social services. The Government has agreed to formulate appropriate measures to mitigate any negative impact of such reforms on the poor.

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98. The Government signed a poverty partnership agreement with the ADB in March 2000. Two annual reviews have been undertaken. Over The Government has undertaken several measures to promote the mainstreaming of poverty reduction in all development activities. 99. Other Social Impact. Subprogram 1 will not lead to any other social impact. The administrative consolidation measures under subprogram 2, depending on their nature and scope, may lead to changes in the configuration and provision of public services. If areas targeted by subprogram 2 suffer decreased access to facilities, the Government will institute measures to mitigate such outcome. 100. Environmental Impact. None of the GRP-II measures are likely to have any adverse impact on the environment. C. Potential Risks 101. Institutional reforms, particularly in the public sector, are subject to various risks. In GRP, the adoption of PSMFL was delayed due to several political risk factors. Subprogram 1 entails fewer risks as the policy and legal framework has already been adopted. In particular, since the Government has effectively campaigned on the need for the public sector management reforms, the follow-up measures formulated under GRP-II are sufficiently credible. However, some of the measures in subprograms 1 and 2 are likely to face risks. 102. First, the implementation of PSMFL has to be efficiently managed. The law requires major changes in entity-level management practices. For instance, performance management reforms need detailed contractual agreements between portfolio ministries and local governments, and budgetary bodies. ADB has emphasized gradual implementation, guided by learning by doing, to ensure that capacity constraints within the civil service do not lead to fatigue. Yet, a whole range of performance or output delivery contracts has been drawn up. Central and local civil servants, while recognizing the need for reforms, have expressed reservations that PSMFL has led to considerably more “paper work.” Ongoing TAs as well as the proposed TA loan for CBGR will provide significant capacity-building support to alleviate capacity constraints, and assuage the concerns of civil servants. 103. Second, pension reform anywhere is complex as it involves difficult policy choices, including elimination of early retirement privileges, which may affect laborers in certain industries. However, the Government recognizes that the pension system will face serious financing problems unless its generous provisions are changed. Significant advisory support has been provided to analyze various options, guided by sound actuarial modeling. Based on this, MSWL has drafted guidelines on social security reforms. Subject to cabinet endorsement of these guidelines, the Government will initiate the drafting of necessary legal amendments. 104. Third, measures relating to administrative consolidation do carry considerable risks. The Government has conducted a preliminary analysis of this area. Some stakeholders have been consulted, although their acceptance of or resistance to the reform measures can be gauged only when the Government finalizes its concept paper and holds well-structured consultations with local citizens’ representative assemblies. The Government is confident that the much-needed reforms can be facilitated if consolidation measures are designed gradually with local inputs.

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105. Fourth, political risks are associated with any program of this nature. In particular, Mongolia will go for parliamentary elections in mid-2004. The present Government may not want to undertake any serious reforms just before or after the elections. Short-term concerns of local governments with regard to implementing PSMFL and their resistance to administrative or structural changes may prevail over any long-term need for public sector reforms. Two factors may cushion overall political risks. First, the Government and the Parliament have been fully committed to public sector reforms. Despite a major change in the Government in 2000, reforms were implemented in a fairly smooth manner. It is also in the Government’s and Parliament’s best interest to ensure that the PSMFL-related follow-up measures are implemented well. Second, the cluster program modality gives the Government greater flexibility than otherwise possible. While it defines the broad policy framework, the Government can formulate the specific reform measures over a period, based on the outcomes of subprogram 1 implementation.

VIII. ASSURANCES

106. In addition to the standard assurances, the Government has given the following assurances, which will also be incorporated in the legal documents, that it will do the following:

(i) Fulfill all the conditions specified in the policy matrix to release the tranches of the program loan and will furnish ADB with copies of all documents evidencing compliance with such conditions.

(ii) Ensure that all the policies adopted and actions taken as described in the program framework and the development policy letter continue in effect during and after program implementation.

(iii) Keep ADB informed of, and exchange views with ADB on, the progress, problems, and constraints encountered during GRP-II implementation and on desirable changes to overcome or mitigate such problems and constraints.

(iv) Keep ADB informed of policy discussions with other multilateral and bilateral aid agencies that have implications for GRP-II implementation, provide ADB with the opportunity to comment on any resulting policy proposals, and ensure that ADB’s views are considered before such proposals are finalized.

(v) Establish a steering committee for GRP-II within one month of loan effectiveness. (vi) Implement the TA loan on time and efficiently so that the program loan

requirements will be met as stipulated. (vii) Use the counterpart funds to finance the adjustment costs of implementing

reforms as envisaged under GRP-II, except as ADB may otherwise agree.

IX. RECOMMENDATION 107. I am satisfied that the proposed program cluster concept, program loan and technical assistance loan would comply with the Articles of Agreement of ADB and recommend that the Board approve

(i) the program cluster concept of $25,500,000 equivalent for the Second Phase of the Governance Reform Program in Mongolia;

(ii) the loan in various currencies equivalent to Special Drawing Rights 9,699,000 to

Mongolia for subprogram 1 of the Second Phase of the Governance Reform Program, from ADB’s Special Funds resources with an interest charge at the rate

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of 1% per annum during the grace period and 1.5% per annum thereafter; a term of 24 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board; and

(iii) the loan in various currencies equivalent to Special Drawing Rights 1,437,000 to

Mongolia for technical assistance for capacity building for governance reforms, from ADB’s Special Funds resources with an interest charge at the rate of 1% per annum during the grace period and 1.5% per annum thereafter; a term of 32 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Technical Assistance Loan Agreement presented to the Board.

Tadao Chino President

8 September 2003

Appendix 1

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SUPPORT FROM FUNDING AGENCIES FOR GOVERNANCE AND PUBLIC SECTOR REFORMS IN MONGOLIA

1. The following matrix shows donor-funded technical assistance (TA) and loan projects in governance and public sector reforms.

Support from Donors Support from Asian Development Bank World Bank

• Fiscal Reform TA loan ($5 million, since 1998). Infrastructure modernization of treasury and government financial management information systems. It also focused on debt management and tax administration reforms.

• Economic Capacity Building TA Credit ($8 million, proposed for approval). Public expenditure management and civil service reform. Specifically, the TA credit will help (i) formulate budgets, and adopt a medium-term expenditure framework; (ii) execute and report on budgets; (iii) strengthen accounting and internal audit capacity at center and agency level by advising the State Professional Inspection Agency; (iv) evaluate policy; (v) strengthen civil service management capacity and support the State Service Council; (vi) establish a human resource management information system; (vii) rationalize the civil service wage bill, incentives, and employment; and (viii) strengthen accountability for performance.

• TA for a state audit and inspection system and strengthening of overall accounting capacity (under which chart of accounts has been formulated)

• TA for national health accounts • Am series of three poverty reduction strategy

credits (PRSC). PRSC1 is being prepared and expected to be approved by October 2003, for $15 million in budgetary support. PRSC2 and PRSC3 will be for $10 million each over 2004–2006.

• Legal and Judicial Reform Project, for $5 million, to (i) establish an administrative court system, (ii) disseminate legal and judicial information, (iii) build a national legal training center; and (iv) enhance legal education.

International Monetary Fund

• Overall support under the Poverty Reduction and Growth Facility (PRGF) umbrella (ongoing PRGF consists of SDR29 million support)

The Asian Development Bank (ADB) has provided significant TA and lending support for broad governance reforms, and targeted sector-specific measures (with policy and investment content) in health, education, and social security sector development.

• Governance Reform Program, for $25 million, over 1999-02

• Past TA for general governance reforms includes about $6.5 million equivalent in advisory and capacity-building services: (i) ADB. 1996. Technical Assistance to Mongolia for Institutional Support for Local Government and Decentralization (Phase I). Manila; (ii) ADB. 1996. Technical Assistance to Mongolia for Restructuring and Staff Rationalization. Manila; (iii) ADB. 1997. Technical Assistance to Mongolia for Institutional Strengthening of the Local Government and Decentralization (Phase II). Manila; (iv) ADB. 1997. Technical Assistance to Mongolia for the Initial Phase of Civil Service Reforms. Manila; (v) ADB. 1996. Technical Assistance to Mongolia for Strengthening of the Taxation System. Manila; (vi) ADB. 1997. Technical Assistance to Mongolia for Program Preparation of Governance Reforms. Manila. ADB. 1999.

• Recently completed and ongoing TAs ($1.8 million) focusing on capacity building for public sector administration and financial management. These were attached to Governance Reform Program, including (i) ADB. 1999. Technical Assistance to Mongolia for the Initial Phase of Public Administration Reform. Manila; (ii) ADB. 1999. Technical Assistance to Mongolia for the Public Expenditure Management. Manila; and (iii) ADB. 1999. Technical Assistance to Mongolia for the Study of Central-Local Government Aspects of Reform Implementation. Manila.

• A current advisory TA ($650,000) to help improve liaison between the Ministry of Finance and Economy and other line ministries in budget formulation and coordination; and to support civil service reform measures, including assessing current qualifications, and formulating a code of ethics and a medium-term civil service

Appendix 1

29

Support from Donors Support from Asian Development Bank • Advice on treasury management and reforms,

with focus on establishing and maintaining the treasury single account

• Advice on tax revenue rationalization and allocation between the center and provinces

United Nations Development Programme

• Support for overall governance reforms since 1996, anchored on human security and development

• Earlier TA support (over 1996-98) for public sector financial management

United States Agency for International Development

• Judicial Reform Project. Overall advisory support to the Ministry of Justice and Home Affairs and the General Council of Courts on court organization, diagnostics assessments, and drafting of judicial code of ethics, among other areas

Government of Sweden

• TA support for local government reforms, to change management and improve organizational behavior

a code of ethics and a medium-term civil service reform strategy (in collaboration with World Bank)

• An advisory TA (Capacity Building for Accounting and Auditing Professionals, for $500,000) to support private sector capacity enhancement

• An advisory TA (Capacity Building for Integrated Regional Development Planning, for $600,000) to help implement the regional development concept

• An advisory TA (Health Sector Reform, for $650,000), approved in June 2003, to help health and social welfare and labor portfolios understand output and performance-based budgeting

• A regional TA (Strengthening Performance Based Budgeting in Selected Sector Agencies, for $250,000, and also covering Cambodia) to help the Ministry of Education in results-based management

• TA to develop Mongolia’s legal framework ($500,000, in 1995). A $1-million TA to retrain legal professionals was provided in 1997 and successfully implemented, including establishment of the Legal Retraining Center (LRC). A follow-up small-scale TA for LRC is under way.

• TA for 2004–2005 to consolidate administration ($400,000) and formulate governance reform ($500,000)

• TA ($9.2 million) to develop education, health, and social security policies, formulate an institutional reform agenda, and build capacity in these sectors

• Ongoing TA for education, health, and social security reforms, including for PSMFL implementation in the health sector

• Education Sector Development Program, $6.5 million, 1996

• Health Sector Development Program, $4 million, 1997

• Social Security Sector Development Program, $8 million, 2001

• Investment projects in the above three portfolios for $43 million, with cofinancing from Japan International Cooperation Agency leveraged for $42 million in the education sector to develop school infrastructure

POLICY MATRIX Second Phase of the Governance Reform Program:

Subprogram 1 Performance Indicators

Goal and Purpose: The goal of the Second Phase of the Governance Reform Program (GRP-II) program cluster is to enhance public sector accountability and efficiency, to be measured by fiscal sustainability and tangible improvements in delivery of key public services. GRP-II’s purpose, following the measures adopted under GRP on a pilot basis, is to support the gradual implementation of public sector administrative and financial management reforms. GRP-II will adopt a three-pronged approach:

(i) Enhance institutional capacity. (a) Support implementation of PSMFL-related measures on strategic planning and output -based budgeting, with focus on health, education,

and social welfare and labor. (b) Strengthen the institutional and implementation arrangements for financial governance norms in the public sector.

(ii) Improve Fiscal Sustainability. (a) Initiate pension reforms to alleviate fiscal pressures on the budget stemming from the public pension system. (b) Initiate administrative consolidation to reduce multiple layers of control that impede efficiency and lead to waste of scarce resources.

(iii) Mainstream Governance Reforms. (a) Enhance the enforcement capacity of the State Service Council (SSC) to improve the quality of the civil service. (b) Enhance confidence in key public institutions.

Sub-objective Actions Planned Actions Completed

before Board Consideration1

Program Actions that can be Monitored, and Second- Tranche

Conditions (Board approval to December 2005)2

Enhance Institutional Capacity to Implement Budget, Output, and Financial Management Reforms Implement the Public Sector Management and Finance Law (PSMFL), adopted by Parliament in June 2002.

1. The Ministry of Finance and Economy (MOFE) and the Cabinet Secretariat (CS), in accordance with Government Decree 119 of 2002, will (i) adopt a time-bound implementation program for PSMFL; (ii) publish and circulate a guide on public sector management and finance reforms, outlining the key reform principles and steps to be adopted by all budget entities; (iii) formulate and initiate a training program on PSMFL for public servants; and (v) initiate transfer of all entities financed from the central and local budgets into the new budget and financial management system under PSMFL.

September 2002

1 Actions under GRP were completed in August 2002 and the second tranche of GRP released in September 2002. 2 Second-tranche release conditions are in bold.

Appendix 2 30

Sub-objective Actions Planned Actions Completed

Prior to Board Consideration3

Program Actions that can be Monitored, and and Second- Tranche

Conditions (Board Approval to December 2005)4

2. Amend 75 relevant laws as required by the adoption of PSMFL, including those on budget, civil service, government service, and state audit.

January 2003

3. CS will coordinate training on PSMFL implementation for (i) state secretaries of all ministries and general managers of all budget entities, and (ii) all budget and key public administration officials of provinces and their district administrations.

June 2003

Strengthen entity-level strategic planning, in line with PSMFL provisions.

4. Strategic business plans for 2004-2006 will be finalized, to ADB’s satisfaction, for the Ministry of Health (MOH); Ministry of Education, Science, Technology, and Culture (MOSTEC); and Ministry of Social Welfare and Labor (MSWL).

December 2003

5. MOFE and the three line ministries listed above will jointly assess their respective public sector administrative expenditures and agree on ceilings on such expenditures, to take effect from 1 January 2005.

March 2004

6. MOFE and the three line ministries listed above will assess the output costs of their respective portfolios and agree on quantitative norms against which their outcomes can be benchmarked.

March 2004

7. MOFE will prepare a report on (i) impact of quasi-fiscal and off-budget activities of the budgetary bodies, (ii) contingent liabilities of the Government and guarantees against state-owned enterprises and other budgetary bodies, and (iii) tax and expenditure arrears in the budget.

October 2003/October 2004/October 2006

Streamline the forward planning processes to improve public expenditure management.

8. MOFE will (i) finalize and submit to Parliament the fiscal framework statement for 2004-2006, (ii) formulate and issue the methodology for medium-term expenditure planning on accrual basis to all line ministries and budgetary bodies, and (iii) formulate and issue guidelines to all line ministries and budgetary bodies to enable the latter to finalize their respective portfolio appropriation estimates in line with PSMFL provisions.

May 2003 [for item (i)]

October 2003 [for (ii) and (iii)]

Mainstream output-based budgeting by setting sound examples in key sectors.

9. MOSTEC, MOH, and MSWL will finalize, to ADB’s satisfaction, (i) the methodology for output specification and costing, and the formats for reporting the outputs and costs, in the education, health, and social sectors; and (ii) sound standards for monitoring the utilization of budgetary allocations against the specified outputs.

November 2003

3 Actions under GRP were completed in August 2002 and the second tranche of GRP was released in September 2002. 4 Second Tranche Release conditions are identified in bold.

Appendix 2 31

Sub-objective Actions Planned Actions Completed

Prior to Board Consideration3

Program Actions that can be Monitored, and and Second- Tranche

Conditions (Board Approval to December 2005)4

10. MOFE will (i) coordinate and convene a working group of the state secretaries of MOFE, MOSTEC, MOH, MSWL, Ministry of Justice and Home Affairs, and Ministry of Infrastructure to assess the implementation of PSMFL; and (ii) submit lessons learned and recommendations to improve PSMFL implementation for the Cabinet’s consideration.

March 2004 March 2005 (ongoing)

11. The Government, through a cabinet decree, will (i) establish the position of accountant general (AG) position at MOFE with certified public accountant (CPA) qualifications, to be responsible for all ex ante financial planning and ex post financial reporting, and overall accounting responsibilities of the Government; (ii) appoint an international senior advisor to the AG with support under the TA loan for Capacity Building for Governance Reforms (CBGR); (iii) ensure that a qualified incumbent staff is nominated as chief accountant in each portfolio ministry and province; and (iv) establish a hierarchical link between the AG and chief accountants of portfolio ministries and provinces.

January 2004

12. Government, through a cabinet decree, will (i) establish internal audit functions under the AG’s Office, accountable to the AG, led by the head of internal audit (HIA); (ii) coordinate the nomination of a qualified incumbent staff as an internal auditor in the portfolio ministries, including MOFE, and provinces, reporting to the respective state secretaries and provincial governors; (iii) set up a hierarchical link between the HIA and internal auditors of portfolio ministries and provinces; (iv) ensure the AG formally defines the terms of references of internal audits in line with the operational standards issued by Institute of Internal Auditor (IIA); (v) ensure that the HIA obtains a government internal audit certificate by meeting all requirements of IIA; and (vi) set up continued professional education requirements for internal auditors.

January 2004

13. MOFE will draft and submit to Parliament amendments to the Law on Accounting to strengthen the entry, qualification criteria, job classifications, and categories for the public accountants at the central and local ministries, governors’ offices, and various budgetary bodies.

May 2004

Establish sound institutional structures for effective public financial management.

14. MOFE will (i) design an examination structure and exam review courses, and develop continued professional education requirements to certify Government accountants; and (ii) conduct the first exam.

May 2004 [for item (i)] November 2004 [for item (ii)]

Appendix 2 32

Sub-objective Actions Planned Actions Completed

Prior to Board Consideration3

Program Actions that can be Monitored, and and Second- Tranche

Conditions (Board Approval to December 2005)4

Support transition to implement accrual accounting on a pilot basis.

15. Government, with CBGR support, will implement a pilot program for education and health portfolios to develop (i) an initial set of accrual-based accounts that will recognize the receivables and payables at the end of each year, and (ii) registers for assets to support valuation for costing.

June 2005

Introduce internationally accepted asset valuation standards.

16. MOFE’s Accounting Policy and Methodology Department will draft and adopt asset valuation standards on movable, immovable, and nonmaterial assets (e.g., trademarks, copyrights, etc.), with the support of an international advisor under the TA loan for CBGR.

June 2005

17. National Audit Office (NAO), as part of its work program under PSMFL, will audit financial statement of (i) MOSTEC, MOH, and MSWL; and (ii) one province on a pilot basis.

May 2005 Strengthen the public sector auditing and financial inspection framework.

18. The Government will review the functions of the State Professional Inspection Agency, particularly in financial inspection, and restructure the agency to ADB’s satisfaction.

May 2005

19. MOFE will (i) translate international accounting standards (IAS) into Mongolian to meet IAS guidelines; and (ii) revise the the Law on Accounting to prevent entities from paying penalties rather than submitting financial statements by enforcing submission of financial statements, in addition to penalties, and removing the requirement for quarterly certification of financial statements.

June 2004

20. Government, through MOFE, will (i) separate the Mongolian Institute of Certified Public Accountants (MICPA) from MOFE and establish the institute as an independent organization from the Government; (ii) prevent government officials from serving as officers and management of MICPA; and (iii) amend the Law on Auditing to enable MICPA to conduct practice monitoring of audit firms and ethics investigation of MICPA members.

June 2004

Strengthen the policy, institutional, legal, and regulatory frameworks for private sector accounting and auditing.

21. MOFE will submit to Parliament amendments to the Law on Auditing: (i) abolish the Mongolian Professional Accounting Council (MPAC); (ii) assign the CPA examination function to MICPA, including awarding CPA certificates; (iii) transfer licensing of CPAs and audit firms to MOFE; and (iv) shift MPAC’s training activities to MICPA.

June 2004 Appendix 2 33

Sub-objective Actions Planned Actions Completed

Prior to Board Consideration3

Program Actions that can be Monitored, and and Second- Tranche

Conditions (Board Approval to December 2005)4

22. MOFE will submit to Parliament amendments to the Law on Auditing to (i) modify the CPA certification process in line with the completion of different stages of the CPA examinations, with a title CPA-I given those who complete the first stage of 2 years; CPA-II for the second stage of 5 years; and CPA-III for completing the third and final stage of examinations; and (ii) issue license to audits only for those who have completed CPA-II, upon ensuring that the candidates are examined, and qualified, on their understanding of IAS and international standards of auditing.

June 2004

23. MOFE will issue internal procedures for audit firms developed under ADB TA.

July 2003

Improve Fiscal Sustainability through Pension Reforms and Administrative Consolidation Reduce the short-term structural deficits in the pension system.

24. Using assessments prepared under ADB TAs to support financial sector development and social security sector reforms, MSWL will draft a white paper on pension system reform, focusing on the need to increase retirement ages (by eliminating early retirement privileges and equalizing the retirement ages of men and women), revamping the current notional defined contributory system, and indexing pensions.

July 2004

25. MSWL will disseminate the white paper for stakeholder consultations and finalize the reform measures to ADB’s satisfaction.

March 2005

Consolidate intra- and interprovincial administration to achieve economies of scale and efficiency.

26. CS and MOFE will draft a concept paper on administrative consolidation within and between provinces to improve public expenditure management and achieve economies of scale in service delivery. A framework will consolidate (i) contiguous provinces on a selective basis, (ii) selected districts within the same or other provinces, and (iii) selected public sector agencies and institutions in the selected provinces and districts.

March 2004

Steer the regional development initiative to attain public sector operational efficiency.

27. CS and MOFE will submit to Parliament a draft law on regional development, providing that its implementation will not lead to any additional layers of public sector administration or overlays.

May 2003

Appendix 2 33

Sub-objective Actions Planned Actions Completed

Prior to Board Consideration3

Program Actions that can be Monitored, and and Second- Tranche

Conditions (Board Approval to December 2005)4

Mainstream Governance Reforms and Enhance Confidence in Public Institutions Institute a sound framework to ensure that the public receive good value in return for utilization public sector resources.

28. NAO, with advisory support from the international advisor to NAO, will undertake performance audits of selected functions and outcomes of Customs General Administration (CGA), General Department of National Taxation (GDNT), MOSTEC, MOH, and MSWL, and publish a summary of the audits in major newspapers.

May 2005

Enhance civil service performance.

29. SSC, with advisory support from ADB TA, will develop the criteria and a code of conduct for civil servants, and the Government will adopt the code.

May 2004

30. SSC will (i) adopt an enforcement mechanism to implement the rules on selection of candidates for senior civil servant positions, as adopted by Parliament, and the grievance/dispute settlement mechanism for settling civil servants’ grievances; and (ii) submit, as part of SSC’s regular annual report to Parliament, an assessment of the enforcement outcomes.

May 2004 [for item (i)] May 2005 [for item (ii)]

31. SSC will assess (i) performance evaluation reports from selected ministries and provincial administrations to see if they are in line with the evaluation requirements established by SSC, and submit and make publicly available an overall performance evaluation report to Parliament; and (ii) performance of all ministries and provincial administrations, and report the findings to Parliament.

May 2004 [for item (i)] May 2005 [for item (ii)]

32. CS, in line with item 2 of the March 2003 action plan of NCAC, and with support from the United Nations Development Programme (UNDP) and ADB, will (i) coordinate the establishment of a subgroup within NCAC’s program, to comprehensively assess the role, performance, and efficacy of GDNT, CGA, and service delivery mechanisms in the education and health sectors, with participation from civil society, academia, and Parliament, and limited representation from the Government; and (ii) formulate the terms of reference for the subgroup, to undertake the performance assessments and design remedial measures.

October 2003 Implement the action plans formulated by the National Council on Anticorruption (NCAC) to enhance transparency and accountability in public institutions.

33. CS and the NCAC subgroup, with support from UNDP and ADB, will submit and make publicly available a comprehensive report on the role, performance and efficacy of the CGA, GDNT as well as service delivery mechanisms in the education and health sectors with proposed remedial measures, based on the subgroup’s assessment.

June 2004 Appendix 2 35

Sub-objective Actions Planned Actions Completed

Prior to Board Consideration3

Program Actions that can be Monitored, and and Second- Tranche

Conditions (Board Approval to December 2005)4

34. CS will start implementing the reform measures formulated by the NCAC subgroup.

December 2004

Ensure Adequate Social Safety-Net Provisions to Support Governance Reforms Government to ensure that there are adequate budgetary provisions to support implementation of governance reform measures.

35. MOFE will allocate a minimum of $500,000 in each annual budget during 2004-2006 for social safety nets to mitigate adverse impacts of GRP-II reform measures.

December 2003 December 2004 July 2005

Appendix 2 36

Appendix 3 37

SECOND PHASE OF THE GOVERNANCE REFORM PROGRAM: SUBPROGRAM 2 MILESTONES1

1. Adopt all budget, output, and financial management reform measures in line with the Public Sector Management and Finance Law (PSMFL):

(i) The Government has formulated and adopted a sound fiscal framework statement and a medium-term budget framework, which are integrated with the medium-term national economic and social development objectives.

(ii) All portfolio ministries and agencies have adopted and fully introduced the output, performance, and financial management norms outlined in PSMFL.

(iii) All provincial administrations have adopted and introduced the output, performance, and financial management norms outlined in PSMFL.

(iv) The Ministry of Finance and Economy (MOFE) has in a place a sound policy framework to limit contingent liabilities accumulated through loan guarantees or other explicit and implicit support to state-owned enterprises (SOEs), over and beyond appropriate provisions in the budget for unanticipated contingencies relating to natural calamities.

(v) The Government has assessed in depth the social impact of the governance reform measures and allocated adequate budgetary resources to mitigate any adverse consequences.

(vi) The Government has reviewed the core versus non-core functions of selected ministries (at least five, including Ministry of Education, Culture, and Science, Ministry of Health, and Ministry of Social Welfare and Labor) and formulated reform measures to rationalize the government role in key sectors.

(vii) Recommendations arising from the financial and performance audits undertaken by NAO in subprogram 1 have been implemented.

(viii) The Government has provided social safety nets through adequate budgetary allocations over 2006–2009 to mitigate any adverse impact of subprogram-2 reform measures.

(ix) Parliament has amended all relevant legislation to improve the government accounting framework as outlined in the policy matrix for subprogram 1.

(x) The Government has converted MOFE’s Accounting Policy, Methodology, and Auditing Department into a separate standards setting board, reporting to the prime minister, to set methodology and policy on accounting and auditing.

(xi) MOFE has provided evidence satisfactory to the Asian Development Bank (ADB) that accountants in all central portfolio ministries and all provincial chief accountants have completed the certified government accountant requirements.

(xii) MOFE has presented evidence satisfactory to ADB that the education, health and social welfare, and labor portfolios have made the transition to full accrual accounting in line with PSMFL.

(xiii) MOFE has demonstrated that the other portfolios and public sector agencies have adopted the public sector chart of accounts, developed an initial set of accrual accounts recognizing accounts receivables and payables, and compiled their asset registries.

(xiv) NAO has regularly completed audits of the consolidated financial statements of at least six portfolio ministries and at least six provinces for at least 2 years.

1 The milestones are based on the combined reform initiatives under subprograms 1 and 2, and reflect the expected

outcomes at the end of the Second Phase of the Governance Reform Program (mid-2009). However, the Government has agreed to borrow only for the measures indicated in the policy matrix. The specific conditions of subprogram 2 and their sequencing will be discussed and agreed upon between the Government and Asian Development Bank during the subprogram -1 reviews.

Appendix 3 38

2. Implement measures to enhance fiscal sustainability:

(i) Parliament has enacted amendments to relevant legislation to enable the Government to (a) increase the minimum retirement age by eliminating early retirement privileges; (b) equalize the retirement ages for men and women; and (c) abolish the practice of ad hoc increases in pensions, and adopt a proper indexation mechanism.

(ii) The Government has implemented the above social security reform measures. (iii) Using the draft concept paper, the Cabinet Secretariat (CS) and MOFE have

undertaken detailed consultations on administrative consolidation with provincial and district citizens’ representative assemblies and other stakeholders.

(iv) With stakeholders’ inputs, CS and MOFE have finalized a draft plan on consolidating public sector administration and service delivery functions, ensuring that the quality of, and access to, public services will not be disrupted in any manner, and adequate safeguards and social safety nets are built into the plan to mitigate the short-run transition costs.

(v) Parliament has amended relevant legislation to consolidate intra- and interprovincial administration to enhance economies of scale in public service delivery.

(vi) On the basis of the above, the Government has demonstrated significant progress, satisfactory to ADB, in consolidating (a) selected districts within at least for provinces, leading to a meaningful merger of administrative jurisdictions with joint provision of selected public services across districts, leading to lower overall public expenditures and (b) at least six provincial administrations into a smaller number of geographic jurisdictions to enhance economies of scale in public service delivery and contain public expenditures.

3. Enhance public confidence in the Government, and mainstream governance reforms:

(i) The Government, through the coordination support provided by the State Service Council, has established a sound policy and legal framework for a career-track civil service system, under which appointments will be based on merit, and civil servants will be shielded from ad hoc hiring and firing practices, as and when the Government changes, unless for lack of performance.

(ii) The State Property Committee, with ADB technical assistance, has reviewed the qualifications and expertise of the members of the board of management and board of directors in all enterprises in which the Government holds 51% or more shares, and of the qualifications and expertise of the executive director in 100% SOEs against current legal requirements, and formulated a program of remedial actions.

(iii) The Government has introduced internationally accepted corporate governance norms in the 10 largest SOEs, with focus on (a) revamping the nomination process for board members, (b) appointing individuals with appropriate qualifications to all board positions, (c) ensuring that the boards have independent members; and (d) adopting realistic strategic business plans consistent with the National Privatization Program.

(iv) In line with the ongoing privatization program approved by Parliament, the Government has brought all eligible SOEs to the point of sale.

(v) NAO has audited financial statements and performance of selected functions in at least six of the largest majority SOEs.

MOHrOJI YJICbIH3AcrH:AH rA3AP

.. .. '"11' ! 1 -~ '1r':Date ~J.). ~ - "-",",,,., Ulaanbaatar -12

N°. . ..":; Phone: 976-1-322408

Fax: 976-1-310011

Mr. TADAO CHINOPresidentAsian Development BankManila, Philippines

Dear Mr. President,

1. Mongolia is a large and geographically diverse country. Its landlocked location, inbetween much larger countries, poses it with a lot of opportunities as well as challenges. Amongthe transition economies, Mongolia achieved impressive performance in the first half of the1990s, immediately following the dismantling of the ,command system. The decline in economicfall was reversed in a span of 4 years (GDP grew by 2.3% and 6.3% in 1994 and 1995respectively). However, the large size of the country has meant that the resource needs incountry' economy have also been significant. The second half of the 1990s saw a building upexpenditures stemming from lack of fiscal discipline at various levels. As a result, we recordedlarge fiscal deficits until 1999, at 12.5% of gross domestic product (GDP) in 1998 and 10.6% ofGDP in 1999.

A. The Governance Reform Program

2. In order to enhance fiscal sustainability, Mongolia has pursued public sector reformsactively since the mid-1990s, with support from multilateral and bilateral donors, including theAsian Development Bank (ADB), World Bank, International Monetary Fund (IMF), UnitedNations Development Program, USAID, and Government of Japan, among others. We began tofocus on governance reforms in 1996, with a series of technical assistance (T A) from thedonors. Our initial attempts were centered on short-term measures on fiscal management In1998, we sought ADB's support in undertaking a comprehensive program of governancereforms. Subsequently, a 10-year Governance Reform Program (GRP) was formulated andstarted to implement by the Government and ADB in 1999 to reform the dysfunctional publicsector in Mongolia, which had contributed to large fiscal deficits, led to misallocation ofbudgetary resources, adversely affected operational efficiency and effectiveness of governmentservices, and undermined public and private sector investments and growth, and efforts toreduce poverty.

3. While the GRP was fonnulated and approved during the previous Government's tenure,much of its main mandate was implemented after the present Government came to power inmid-2000. The implementation of GRP has achieved several significant milestones: the

Appendix 4 39

GOVERNMENTOF MONGOLIA

Appendix 4 40

foremost being the enactment of the Public Sector Management and Finance Law (PSMFL),which places Mongolia ahead of the other countries that have adopted similar public sectorreforn1 measures. The extensive consultative process leading to the enactment of PSMFL isevidence in favor of stakeholder participation, a key indicator in itself of good governance.

4. GRP also supported the introduction of budget, output and financial managementreforms on a pilot basis in 2 sets of agencies. The primary focus was on showcasing the actualprocess through implementation of the reform measures in Custom General Administration(CGA), General Department of National Taxa~5eIf1)~ational Statistical Organization(NSO), State Audit Board (subsequently renamed as Nationa~ Audit Office - NAO) and StateService Council (SSC). This was replicated on a selective basis in a set of "bunch 2" agencies,including Ministry of Finance and Economy (MOFE); Ministry of Social Welfare and Labor;Ministry of Justice and Home Affairs, Ministry of Education, Culture, and Science; Ministry ofHealth; Ministry of Environment; State Financial Inspection Department; EnvironmentalProtection Agency; Land Administrative Authority; State Meteorological Agency; and ClinicalHospital No.1. In addition, GRP also focused on two pilot aimags, Arhangi and Selenge, and theNalaikh District Administration, a jurisdiction within Ulaanbaatar City, to pilot test administrativereforms at the provincial and sub-provincial levels.

5. Mr. President, let me highlight some of the key achievements under GRP, to place thecurrent reform agenda in context. To improve fiscal management and provide coherence inexpenditure planning, the Govemment formulated and adopted a basic fiscal frameworkstatement (FFS) FFS for 2001-2003. The FFS aims to develop sustainable fiscal deficitforecasts over the medium term by ensuring consistency with the strategic growth priorities andprojections, and external and domestic borrowing capacity. The Government also preparedguidelines for incorporating contingent liabilities in annual budgets and estimated accumulationof liabilities at the aggregate level and within the five bunch 1 agencies.

6. To bring about budgetary discipline, the GRP's focus was on process-oriented reformson a pilot basis for a limited number of budgetary bodies. Fuller application of the medium-termexpenditure framework (MTEF), work on which has been launched, and output-based budgetingmeasures will gradually result in integrating strategic priorities with overall expenditure planningat all levels of the Government. Also, recourse to off-budgetary funds and ad hoc transactionsfrom the central to local governments or between budgetary bodies on a barter basis is beingreduced. These and the other measures being adopted by the Government as part of the GRPin line with the financial and personnel management provisions of the PSMFL are likely tofacilitate expenditure discipline as well as revenue enhanceme~t in the medium term.

7. As a part of the GRP, the Government with support of IMF took initiatives to establish anew treasury single account (TSA) system. Under Government Decree 132 of 2001, TSA wasintroduced on a pilot basis in 11 public sector agencies. The TSA system involves transferenceof the government deposits in the banking system into a single account at BOM to centralize alldisbursement and accounting responsibilities at MOFE. The Government has closed all off.budget bank accounts held by the ministries and public sector agencies. A comprehensivesurvey of all extra budgetary funds has been undertaken to facilitate proper accounting. Basedon the successful outcomes in the pilot agencies, effective July 2002 the TSA has beenextended to cover the entire budgetary bodies.

8. To provide a strategic focus to the process of budget formulation and execution, theGovernment developed the Development Vision for 2003-2005 and the Economic and SocialDevelopment Guidelines for 2002. These documents, in combination with the Action Plan of the

Government of Mongolia for 2000-2004, establish the strategic priorities to guide budgetformulation over the medium term. To better implement these priorities, a 3-year rolling PIPframework has been formulated as an integral part of the MTEF. The PIP framework isintegrated with recurrent budgets to ensure adequate maintenance of the capital investmentsundertaken. The PIP is being presented to external assistance agencies and finalized annuallybased on confirmed commitments.

9. Under the GRP, the Government has further adopted the framework for a rolling output-based MTEF, including the development of a system of forward estimates, to impr~~linkages between planning and budgeting. This process first established a system for integratingthe requirements of the line agencies into the MTEF, which was initially piloted in the five bunch1 agencies. The actual process of deciding on the top-down and bottom-up elements of theMTEF has involved a number of steps, including: (i) national articulation of fiscal objectives andstrategies; (ii) macroeconomic forecasting and assessment of resource availability; (iii) issuanceof indicative sector budgetary ceilings approved by COM; (iv) determination of subprograms byministries and agencies; (v) negoti~tions between MOFE and line ministries over the programsand subprograms; (vi) integration of forward estimates and basic formulation of the MTEF; and(vii) submission for Parliamentary approval. These procedures have been consolidated in thePublic Expenditure Management Operational Guidelines, issued for use by MOFE, lineministries, and other budgetary bodies.

10. To complement the TSA, the Government has taken steps to introduce a modem andintegrated treasury financial management information system, which aims to integrate (I)elaboration and control of budget accounting and reporting; (ii) administration of the treasury'sbanking transactions; (iii) execution of core financial management functions, includingmonitoring of accounts payables and receivables, asset management, and inventory control andmanagement reporting. To ensure effective control of risks, procedures and correspondingprotocols are being developed for public borrowings and for investment management functions.

11. Moving to the implementation of entity-level reforms as part of the pilot programsupported under GRP for bunch 1 agencies, we have catalyzed ADB T A support to theseagencies to build capacity through a number of workshops as well as hands-on training in theformulation of their strategic business plans (SBPs); preparation of financial statements;specification of the outputs produced by each agency including description, quantity, quality,and cost; preparation of output-based forward estimates; and formulation of and adherence toperformance contracts.

12. Ex-post financial statements were prepared for all bunch 1 entities for the years endingDecember 1998 and December 1999, and audited by NAO. A key step in this process was theshift in emphasis in financial accounting from a cash basis to accrual basis. With T A support,Audit Victoria (the Auditor General's Office of the State of Victoria, Australia) has helped assessthe statements for all bunch 1 entities and verified their quality as well as that of the underlyingfinancial control systems. All the agencies were trained in improved public sector accountingpolicies, and familiarized with the format and content of revised financial statements and output-

costing methodologies.

13. The entire bunch 1 and some of the key bunch 2 agencies and ministries also preparedforecast financial statements, in accordance with IAS. A typical forecast financial statementincludes a statement of responsibility from the general manager of the agency; a statement ofthe accounting policies adopted and the forecasting assumptions employed; a balance sheetcovering a 3-year planning horizon; a statement of the changes in the net-worth position of the

Appendix 4 41

~

Appendix 4 42

agency over this period; and a statement of cash flows. Formulated in this manner, the medium-term forecasts for assets and liabilities will improve strategic budget planning.

14. saps were also prepared for all bunch 1 agencies (for 2001-2003 and 2002-2004) anda rough format for 11 bunch 2 (for 2002-2004) agencies. A typical sap includes an overallvision statement, the strategic priorities, outputs planned for the period, forward appropriationestimates and forecast financial statements, and a linkage between the functions of the agencyand the overall strategic priorities of the Government. The saps provide strategic planningdirections and priorities to the budgeta~~~an.d fully integrate the output requirem.ents andthe projections for budget appropriation estimates.."1n-terms of implementation, however, a keyconstraint has been the difficulty involved in clearly aefining the output to be produced at theentity level, particularly in agencies responsible for policy formulation and execution, whereoutputs may not be tangible or immediately evident as in the case of public sector entitiesresponsible for production of physical outputs.

Setting the Stage for the Second Phase of ReformsB.

15. Governance reforms are complex, and generally involve a long-drawn process. Havingdescribed the achievements thus far, let me turn to the forward-looking agenda, which is quitechallenging. The Government considers GRP essentially as a pilot program. It has helped toenhance awareness of the need for modernizing public sector administration and financialmanagement. Its implementation has prepared the groundwork for continuation of reforms.

16. The PSMFL is effective from January 1, 2003 and the Government has formulated asound plan to implement the new law in a phased manner in next four years. The PSMFLapplies to all levels of government including SOEs and provides an effective framework toregulate all relations of responsibility and authority between the government organizations andindividuals with regards to the preparation, approval, implementation and reporting of budgets,operational and personnel management in budgetary bodies, and budget control and otherresponsibility systems. The objective is to integrate strategic planning at all levels with budgetmaking and execution, decentralize decision making through sound personnel managementpractices and enhanced budget control, accountability and transparency mechanisms.

17. The adoption of the legal framework gives a sound footing to move forward. Based onthe lessons learnt from the Government's initiatives through GRP and support from otherdonors, let me outline a list of the priority areas for the Government:

Continuous capacity enhancement at all levels ot the Government, to ensure thatthe momentum is maintained to implement PSMFL in a well-sequenced manner.More importantly, it is essential that a "hand-holding" process is necessary atsome levels to ensure that the reform objectives, directives and measures areclearly understood. In this regard, the Government recognizes that we need toadopt a leaming-by-doing approach to reforms, so that lessons learnt along theway can be incorporated into the PSMFL implementation plan, and appropriatemid-course corrections can be allowed.

.

An integral part of such capacity building is support for financial managementreforms. Based on the emphasis on improving fiscal and financial transparency inPSMFL, it is of critical importance that financial management systems areupgraded within the Government and the larger public sector. A key componentin this regard is to establish good internal control and audit systems within the

.

line ministries and budgetary agencies. Equally significant is the need forensuring that the financial and performance audit requirements outlined inPSMFL are effectively implemented.

Fiscal sustainability is of paramount importance. This is the guiding concernbehind: (i) the whole govemance reform agenda; (ii) the Government's initiativesfor national economic development; (iii) its formulation of the Poverty ReductionStrategy Paper (PRSP), which has been effectively coordinated with all donors,and (iv) the Government's efforts aimed at reforms in sever"IMy=idtfediensunder the Poverty Reduction and Growth Facility (PRGF) being implementedwith support from the International Monetary Fund (IMF). !

.

Specific attention is needed in some areas to help pave the way for medium- andlong-term fiscal sustainability. We have identified 3 critical areas on which thisGovernment would like to initiate reforms: (i) alleviating the fiscal pressures onthe budget stemming from the pension system; (ii) the need for reducing themultiple layers of administrative controls at the lower tiers of governments, at theaimag and soum levels; and (iii) strengthening of the civil service.

.

The present Government has launched significant reforms in the above 3 areasaimed at enhancing fiscal sustainability. With ADS TA support, the Governmenthas drafted Social Security Reform Guidelines, which incorporate the much-needed reforms to increase retirement ages on a gradual basis.

.

The PSMFL is our launch-pad to initiate and accelerate civil service refonT1s, andthe Government has been working closely with IMF I World Bank and ADB in thisarea. Our goal is to eventually have in place: (i) sound wage and employmentpolicies, with transparency, equity and efficiency considerations - a key

ingredient for this is a sound human resource management infonT1ation system;and (ii) a career-track, perfonT1ance-oriented civil service system that utilizes taxpayers' contributions in an efficient manner to deliver public services at low costs.

.

Administrative consolidation measures are sensitive and complex. Efforts havebeen underway for sometime to explore various avenues for consolidating aimagand soum jurisdictions, given the geographic spread of Mongolia and the highcosts of delivering services. However, this Government wants to go through thisprocess with a lot of care and caution. While we recognize that somefundamental reforms may be needed, at the same time, we want to haveextensive stakeholder consultations and undertake in-depth assessments on theeconomic, social and political viability of such consolidation measures.

.

Governance reforms need to be mainsueamed in certain other key areas,particularly in the state-owned enterprise (SOE) sector and in order to enhancepublic confidence in some of the key public institutions. On SOE reforms, thisGovernment has made significant advances. For example, our efforts have led tosome of the largest privatizations in Mongolian history, with the sale of the Tradeand Development Bank and Agriculture Bank of Mongolia. Yet, it is essential thatgovernance measures are well integrated in SOEs, to ensure that their viabilitycan be enhanced and value increased.

.

Appendix 4 43

44Appendix 4The Government has undertaken significant efforts with the support of UNDPthrough the Good Governance for Human Security Program. A key initiative hasbeen the establishment of the National Council on Anti-Corruption, which I amprivileged to chair. The Government wishes to use this vehicle to launch furtherdeeper reforms in this area, aimed at enhancing the confidence of the generalpublic in institutions.

.

18. The Policy Matrix that the Government has agreed to for the proposed GRP-II outlinesadequately these priority areas for public sector governance reforms. EJections are an integralpart of a well-functioning deMeGratJe SQCjety. While this Government wants to initiate andexpedite reforms in certain critical areas that we believe in, we also wish to bear in mind thepolitical sensitivities of some of the reform measures. As I have outlined earlier, a cautiousapproach needs to be taken to address stakeholder concerns on consolidation and otherforward-looking measures. Hence, this Government wants to adopt a flexible approach inimplementing GRP-II. The proposed Program Cluster Modality offers us with such anopportunity to be specific about the course of reforms, yet remaining flexible with regard to exactmeasures in certain areas. The milestones attached to the Policy Matrix provide an outline ofthe intended outcomes at the end of GRP-II, in 2009.

19. Mr. President, finally let me assure you of my Governmenfs fullest commitment inmoving forward to implement the second phase of the governance reform roadmap thatMongolia and ADB have agreed upon. Specifically t I assure you of our commitment to fulfill allthe requirements and responsibilities that are within the jurisdiction of the Executive Branch ofthe State with regard to: (i) the policy measures outlined in Subprogram 1; (ii) measures neededto achieve the milestones outlined for Subprogram 2; (iii) the proposed technical assistance loanfor capacity building for governance reforms; and (iv) overall GRP-II implementation.

20. Let me thank you and the Asian Development Bank, on behalf of the Govemment ofMongolia, for your commitment and support for over a decade to develop Mongolia into a morevibrant and stronger economy. With your support, we can achieve our common objective ofpoverty reduction.

Yours sinc

~ f.~ ~ I

" {

N.ENKHBAYARPrime Minister of Mongolia

Appendix 5 45 PROGRAM LOGICAL FRAMEWORK

Design Summary Performance

Indicators/Targets Monitoring

Mechanisms Major Assumptions/

Risks Goal The goal of Second Phase of the Governance Reform Program (GRP-II) is to enhance accountability and efficiency of the public sector in Mongolia, to be measured by fiscal sustainability and tangible improvements in delivery of key public services.

• Adherence to overall macroeconomic and fiscal targets under the Poverty Reduction and Growth Facility (PRGF) of the International Monetary Fund (IMF)

• Adoption of an internationally comparable fiscal framework statement (FFS) and medium -term expenditure framework (MTEF) over 2003–2008

• Adoption of sound output specification and costing guidelines by key portfolio ministries

• Demonstrated reduction in government administrative expenditures over 2003-08

• Parliamentary endorsement of the overall financial statement of the Government, as certified by the National Audit Office (NAO)

• Compliance with the output benchmarks agreed upon under the program

• Published MTEF and FFS reports, reviewed against the Government’s medium -term social and economic development guidelines

• Macroeconomic and fiscal framework assessment reports

• Asian Development Bank (ADB) review missions

• Macroeconomic stability and absence of weather shocks

• Political stability • Full cooperation from the

civil service in implementing the Public Sector Management and Finance Law (PSMFL)

• Demonstrated improvements in service delivery through post-evaluation assessments (built into the strategic planning processes) of health, education and social welfare, and labor portfolios

Purpose Its purpose, following the measures adopted under GRP on a pilot basis, is to help gradually implement public sector administrative and financial management reforms .

• Adoption of all budget, output, performance, and financial management provisions of PSMFL in education, health, social welfare, and labor portfolios over 2003-05

• Adoption of the above provisions in other portfolios over 2006-08

• All portfolios and aimags submit timely inputs for MTEF in line with PSMFL provisions

• All aimags to have entered into well-formulated output delivery contracts with the portfolio ministries

• Reports submitted from portfolio ministries to Ministry of Finance and Economy (MOFE) and Parliament

• Final submission of MTEF documents

• Finalized output delivery contracts

• Quarterly reports from MOFE on program implementation

• ADB review missions

• Adequate capacity at all levels

• Continuity of reforms without any major change in the policy framework

Appendix 5 46 Design Summary Performance

Indicators/Targets Monitoring

Mechanisms Major Assumptions/

Risks (i) Formulate a sound

implementation framework to guide public sector governance reforms

• All capacity-building measures implemented, as envisaged in the policy matrix

• Strategic business plans (SBP) for 2004-06, and 2006-08, finalized for education, health and social welfare, and labor portfolios

• Adoption of a realistic ceiling on administrative expenditures and satisfactory benchmarks for measuring portfolio outcomes in health, education, social welfare, and labor portfolios

• FFS, formulated in a manner satisfactory to ADB

• Submission of SBPs • Joint agreement between

the ministries on the administrative expenditures

• Sound coordination between MOFE and all portfolio ministries

• No sensitivities with regard to centralized control of MOFE or the central Government (in relation to local government affairs)

(ii) Strengthen financial governance reforms in line with PSMFL

• Appointment of an accountant general

• Establishment of internal audit units in MOFE and all portfolio ministries and aimags over 2003-06

• Establishment of the certified government accountant structure

• Gradual progress in adopting accrual accounting

• Establishment of a unit on asset valuation and adoption of modern norms on valuation

• Submission of NAO’s audited financial statements for education, health, social welfare, and labor portfolios

• Mongolian Institute of Certified Public Accountants separated from MOFE

• End-of-year reports from the accountant general and the advisor (appointed under the technical assistance (TA) loan for Capacity Building for Governance Reforms [CBGR])

• NAO’s reports to Parliament

• Adoption of all necessary procedures on time

• Availability of sufficient number of qualified accountants to staff the internal control units

(iii) Strengthen the social security system to enhance fis cal sustainability

• Ministry of Social Welfare and Labor to finalize social security reform guidelines, outlining the need to end early retirement privileges and equalize retirement ages of men and women, and formulate a white paper on social security reforms

• Cabinet endorsement of the white paper

• Submission of the white paper for public consultations and formulation of specific reform measures

• Finalized social security reform guidelines and the white paper

• Significant political risks associated with introducing sensitive social security reform measures around the time of parliamentary elections, planned for mid-2004

Appendix 5 47 Design Summary Performance

Indicators/Targets Monitoring

Mechanisms Major Assumptions/

Risks (iv) Start administrative

consolidation • Government to draft a

concept paper on administrative consolidation to achieve economies of scale in service delivery

• Reports from the Cabinet Secretariat on functional reviews

• Endorsement by the Cabinet of the concept paper on consolidation

• Potential for resistance to thorough functional reviews as well as the administrative consolidation measures

(v) Enhance confidence in public institutions

• Completion of performance audits of Customs General Administration and General Department of National Taxation by NAO

• State Service Council (SSC) to assess performance evaluation reports from all ministries and provinces

• Full compliance with SSC’s rules on civil service recruitments

• Government to constitute a subgroup within the National Council on Anticorruption (NCAC)

• Performance audit reports • Civil service reform strategy

from SSC • Report from the

Government on the outputs of NCAC

• ADB reviews

• Acceptance among politicians of the need for a career-track civil service system

• White paper on rule of law reforms taken seriously by the Government and Parliament to address the negative public perception of the judiciary and other key central budgetary bodies

(vi) Ensure adequate social safety nets to support governance reforms

• Evidence that the budgets over 2004-06 include at least $1.5 million counterpart funds generated from GRP-II

• Finalized budgets for the relevant areas

• No adverse impact on the poor or vulnerable beyond what the budgetary allocations can remedy

Outputs (i) Adopt a sound

implementation framework to guide public sector governance reforms:

(a) Institutional

capacity of the portfolio ministries enhanced

(b) Entity-level strategic planning improved in line with PSMFL requirements

(c) Public expenditure management improved

(d) Output-based budgeting mainstreamed

• Consequential

amendments to about 75 laws adopted following PSMFL enactment

• Training modules on output and financial management finalized, and training-of-trainers provided

• SBPs for key portfolios (education, health, social welfare, and labor) finalized

• Clear benchmarks developed to monitor outputs of the above 3 key portfolios

• MOFE finalized an assessment of the quasi-fiscal and contingent liabilities of the Government

• Reports from MOFE • Training provided under

ADB TA • Review missions

• Adequate training for budgetary bodies and local level governments to successfully implement PSMFL

Appendix 5 48 Design Summary Performance

Indicators/Targets Monitoring

Mechanisms Major Assumptions/

Risks (ii) Strengthen financial

governance norms

(a) Sound institutional structures adopted within the Government

(b) Certified government accountant structure established

(c) Internationally recognized public sector accounting norms adopted

(d) Internal control units established in all budgetary bodies

(e) Internationally comparable asset valuation standards adopted

(f) All legal amendments to enable financial governance reforms adopted as per PSMFL

• Internal audit units fully functional in at least 5 portfolio ministries by end-2004, and in another 5 by end-2006

• First set of examinations conducted for accountants nominated under the certified government accountant structure

• Completion of internal control reports in education, health and social welfare, and labor portfolios

• Government established asset registers for all government assets

• Reports from MOFE and the 3 key portfolios on their internal controls

• NAO reports • Review outcomes • Reports from TA loan for

CBGR

• Absorption of the capacity-building measures

• Civil servants and government accountants to learn and understand modern financial management methods

(g) The certified public accountant evaluation system streamlined

• Financial statement audits completed for education, health, and social welfare and labor portfolios

(iii) Strengthen the social security system to enhance fiscal sustainability

• Draft guidelines stipulating gradual increase in retirement ages and elimination of early retirement privileges

• Submission of white paper on social security reform

• Government reports • Resistance from interest groups and stakeholders

(iv) Launch measures for administrative consolidation and other reforms (a) CS and MOFE

have drafted the concept paper on administrative consolidation

• Submission of law on regional development, ensuring that the regional management framework will not lead to any additional layers of public administration

• Concept paper to show clear avenues for achieving scale economies in service delivery and reduction in public expenditures

• Government reports • Review missions

• Lack of broad-based political acceptance of the reform measures in an election year

Appendix 5 49 Design Summary Performance

Indicators/Targets Monitoring

Mechanisms Major Assumptions/

Risks (v) Enhance confidence in

public institutions

(a) A sound framework to institute sound ex post verification on budget execution

(b) Improvements to civil service culture by promoting merit-based entry

(c) Adoption of reforms to enhance trust in public institutions

• NAO to publish the performance audit reports in major newspaper

• Continuous compliance with SSC’s rules on recruitment and performance evaluation

• NCAC has finalized its report on efficacy of taxation, customs, and public service delivery functions in health and education sectors

• Periodic reports from NAO and other bodies

• Government takes these measures seriously and allocates sufficient resources to help achieve the program goals in this area

Inputs • Program cluster concept

to enable implementation of the complex reforms over 2003-09

• Program loan of $7 million equivalent to the Government support GRP-II

• TA loan of $2 million aimed at CBGR

• Cluster concept approved by ADB

• Subprogram 1 approved • TA loan approved and

procurement finalized by October 2003

• The management information system component finalized and procurement underway for costing software by October 2003

• ADB review missions (at least 2 per year)

• TA reports and review

• Continuous monitoring and concerted policy dialogue with the Government and the judiciary

• Close coordination with other funding agencies to ensure TA support is well coordinated and benefits maximized

NEW FINANCIAL MANAGEMENT ARRANGEMENTS PROPOSED UNDER SECOND PHASE OF THE GOVERNANCE REFORM PROGRAM

AccountantGeneral

HeadInternal Auditor

Acc. Policy,Methodology& Auditing

Fiscal PolicyDepartment

TreasuryDepartment

OtherDepartments

ChiefAccountant

InternalAuditor

State Secretary

Deputy Minister

Ministry of Finance and EconomyMinister

Other Departments ChiefAccountant

Internal Auditor

State Secretary

Deputy Minister

PortfolioMinisters New Positions

Reporting Relationship

Appendix 6 50

Appendix 7 51

INELIGIBLE ITEMS

1. No withdrawals will be made from the loan accounts in respect of the following:

(i) expenditure for goods included in the following groups or subgroups of the United Nations Standard International Trade Classification (SITC), Revision 3, or any successor groups or subgroups under future revisions of the SITC as will be designated by Asian Development Bank (ADB) by notice to the Borrower;

Group Subgroup Description of Items 112 - Alcoholic beverages 121 - Tobacco, unprocessed tobacco refuse 122 - Tobacco, manufactured (whether or not containing tobacco

substitutes) 525 - Radioactive and associated materials 667 - Pearls; precious and semiprecious stones, unworked or

worked 718 718.7 Nuclear reactors and parts thereof, fuel elements (cartridges),

nonirradiated for nuclear reactors 897 897.3 Jewelry of gold, silver, or platinum group metals (except

watches and watch cases); goldsmiths’ or silversmiths’ wares (including set gems)

971 - Gold, nonmonetary (excluding gold ores and concentrates)

(ii) expenditure for goods intended for military or paramilitary purpose or for luxury consumption;

(iii) expenditures for pesticides categorized as extremely hazardous or highly hazardous in

Class 1a or 1b of the World Health Organization’s Classification of Pesticides by Hazard and Guidelines to Classification;

(iv) expenditures for goods supplied or to be supplied under any contract that a national or

international financing institution or any other financial agency has financed or agreed to finance, including any contract financed or to be financed under any loan from ADB; and

(v) expenditures incurred more than 180 days before the date of loan effectiveness.

Appendix 8 52

PROPOSED TECHNICAL ASSISTANCE LOAN FOR CAPACITY BUILDING FOR GOVERNANCE REFORMS:

OUTLINE TERMS OF REFERENCE FOR CONSULTING SERVICES A. Introduction 1. Section IV of the Report and Recommendation of the President presents the details on the proposed technical assistance (TA) loan for Capacity Building for Governance Reforms (CBGR). It will primarily advise on public sector financial management reforms, principally to ensure that the Government can implement the policy conditions agreed upon in the policy matrix (Appendix 2) efficiently and on time. CBGR will also help design a software component to support financial management reforms, and adopt a system-based framework for output costing in all portfolio ministries and budgetary bodies. B. Consulting Services 2. CBGR will use 53 person-months of international consulting services, comprising the following: (i) advisor to the accountant general (AG) for 18 person-months, intermittently over 36 months; (ii) advisory services to the National Audit Office (NAO) for 18 person-months, intermittently over 36 months, to work with 18 NAO auditors to implement the policy matrix conditions; (iii) Public Sector Management and Finance Law (PSMFL) strategic planning advisor for 13 person-months to review internal functions in selected budgetary entities; (iv) an asset valuation expert for 2 person-months to help the Ministry of Finance and Economy (MOFE) draft asset valuation standards; (v) systems and management information system (MIS) expert to develop a software program for NAO to conduct computer-based financial statement and performance audits and help modernize the output costing in all portfolios for 2 person-months. About 120 person-months of domestic consulting support will also be procured in the above areas, including project management. All international and domestic consultants will be recruited on an individual basis, in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements satisfactory to ADB for the engagement of domestic consultants. 3. The following outlines the advisors’ terms of reference (TORs). As government advisors, the long-term consultants must be flexible to be able to meet a range of demands. The international advisors will also be responsible for selecting qualified domestic experts, in coordination with the program implementation unit (PIU) in MOFE, formulating their TORs and overseeing their work. The PIU will manage CBGR. The international or domestic consultants, except those appointed as project managers, will not be burdened with administrative tasks of project management.

1. International Advisors/Consultants

a. Accounting Advisor (18 person-months) 4. The consultant will (i) be a certified public accountant (CPA), or equivalent, with extensive theoretical and practical knowledge of financial management in market and transitional economies; (ii) be a member of an internationally recognized professional accounting body, and possess sound knowledge of government and private sector accounting and auditing systems, particularly introduction and implementation of the international public sector accounting standards (IPSAS) promulgated by the International Federation of Accountants; and (iii) have experience in accrual accounting.

Appendix 8 53

5. The terms of reference of the international advisor will include helping the AG direct financial management systems as well as build up accurate financial reporting for the Government by carrying out the following responsibilities:

(i) Implement the newly established accounting and financial management procedures, and monitor the implementation of these regulations throughout the contract term.

(ii) Improve the accounting manuals to improve the quality of financial reporting. (iii) Help adopt the uniform and integrated chart of accounts for accounting,

budgeting, and reporting for all government entities. (iv) Establish a link between the budget and accounting in budgetary entities. (v) Produce government financial reports that reflect IPSAS requirements. (vi) Facilitate the appointment of chief accountants in the portfolio ministries and

budget entities. Monitor their work plan and performance to identify gaps and weaknesses.

(vii) Design and implement a sustainable training program for 15–20 chief accountants in the portfolio ministries and budgetary entities. The program will focus on financial management, financial reporting, supervision, and other weak areas.

(viii) Develop skills assessment for all government accountants and establish benchmarks for quality improvement.

(ix) Design an examination structure and review course to prepare government financial managers (GFM) for the certification program.

(x) Conduct the GFM examination for the first 3 years. (xi) Establish mandatory continuous professional education requirements for GFMs. (xii) Define the TORs for controllers and prepare operational guidelines. (xiii) Review and recommend improvements to convert the functions of inspectors of

budget entities and portfolio ministries into controllers, to establish the proposed internal control unit under the office of the accountant general.

(xiv) Develop training programs to strengthen the capacity of the controllers for improved internal controls.

(xv) Develop mandatory continuous professional education programs for controllers.

b. Financial Statement and Performance Audit Experts (18 person-months)

6. Two international consultants with at least seven years experience as a leader in auditing financial statements and government agency performance in market and transitional economies will be engaged. The consultants will have (i) internationally recognized CPA or equivalent qualifications and (ii) substantive knowledge of international standards on auditing and their implementation.

i. Financial Statement Audit 7. The audit managers will undertake these tasks:

(i) Review the roles, responsibilities, and capacity of NAO, emphasizing financial statement audits of the different government agencies.

(ii) Develop manuals and procedures on the financial audits. (iii) Help disseminate financial audit manuals through workshops, classroom training

courses, and on-the-job training.

Appendix 8 54

(iv) Design and conduct training for the senior staff of NAO on supervision and review technique and on quality control procedures.

(v) Help NAO audit selected government agencies: (a) year 1—Ministry of Science, Technology, Education, and Culture (MOSTEC); Ministry of Health (MOH); and Ministry of Social Welfare and Labor (MSWL); and (b) one province on a pilot basis (through the concerned state audit office).1 The financial audit will cover development of the objectives, identification of audit scope and planning, audit, and follow up.

ii. Performance Audit

8. The audit managers will undertake these tasks:

(i) Review the capacity of NAO in conducting performance audits and identify areas that it should focus on and strengthen. Recommend ways to address the gaps and weaknesses.

(ii) Develop manuals and procedures on the performance audit. (iii) Help disseminate performance audit manuals through workshops, classroom

training courses, and on-the-job training. (iv) Design and conduct training for NAO senior staff on supervision and review

technique and on quality control. (v) Help NAO identify specific areas in the operation of selected agencies that will be

subject to performance audits. (vi) Audit the performance of selected government agencies: (i) year 1—MOSTEC,

MOH, and MSWL; and (ii) year 2—Customs General Administration and General Department of National Taxation.

c. Asset Valuation Expert (2 person-months)

9. The consultant should be a qualified international asset valuation expert with relevant experience in market and transitional economies. The consultant will have the following responsibilities:

(i) Analyze international trends in asset valuation standards. (ii) Examine the feasibility of and options for developing an asset valuation system

using information technology. (iii) Develop a draft asset valuation standard for MOFE, reflecting international

standards and taking in to account the local situation. (iv) Circulate the draft standards to MOFE and other related agencies for comments

and feedback. (v) Conduct a workshop to review the recommendations to the draft asset valuation

standards and associated feedback. (vi) Finalize the draft asset valuation standards to reflect the recommendations

based on the result of the workshop. (vii) Develop a user’s manual to provide guidance on the applications of these

standards.

1 The Government has suggested that the Ulaanbaatar City Administration or some of its districts be chosen for this

purpose. The advisors will undertake an assessment and advise the Government on the selection.

Appendix 8 55

d. Strategic Planning Expert (13 person-months) 10. The strategic planning expert will have extensive experience in strategic planning, output specification and costing, and have the following responsibilities: i. Review core and non-core functions.

(a) Based on any earlier assessments of the core versus non-core functions of ministries and budgetary agencies, critically review the functions of the central portfolio ministries to segregate the core from non-core functions. The functional review will include all the agencies that come under the structure of the ministries included.

(b) Formulate recommendations based on the above review, to streamline the core functions of the ministries concerned. Derive lessons for the Government from this assessment.

ii. Strengthen strategic planning, output specification, and

costing in selected ministries, and provide advisory support to the National Council on Anticorruption (NCAC).

(a) Based on previous assessments of the strategic business plans (SBPs) of

MOSTEC, MOH, and MSWL, review the revised SBPs and certify that they are in line with comparable SBPs of public sector agencies in other countries. In particular, evaluate current linkages between SBPs and medium-term sector-specific budget planning. Recommend ways to integrate lessons from assessments of past sector performance against benchmarks.

(b) Assess the level of preparedness for output specification and costing at the central and local levels, at the headquarters of ministries and provincial administrations.

(c) Advise MOFE and other line ministries on output specification and costing.

(d) Assess the output specification and costing outcomes in MOSTEC, MOH, and MSWL, and recommend measures to strengthen them.

(e) Identify three other portfolio ministries, in consultation with MOFE and at least three provinces, and provide in-depth advisory support to strengthen their output specification and costing. Within these portfolios, select facilities to get a good representation of the chosen sectors, and undertake a full costing exercise.

(f) Design and conduct training programs for central and local government officials (including public sector agencies) on planning, output specification, and costing.

(g) Coordinate and provide advisory support to the work of the NCAC subgroup established as part of Second Phase of the Governance Reform Program (GRP-II) to evaluate the performance of customs and tax agencies, and public service delivery functions in education and health portfolios.

(h) Prepare a comprehensive report outlining the overall current status of strategic planning, output specification, and costing activities in the public sector. Recommend forward-looking reforms in these areas to ensure full compliance with PSMFL.

Appendix 8 56

e. Management Information Technology Expert (2 person-months) 11. The MIS expert will be a qualified systems expert with experience in setting up government MIS platforms, with focus on budgetary, accounting systems, and computer-based auditing. The expert will focus on the following tasks:

(i) Assess the hardware needs of NAO to conduct its activities effectively. (ii) Assess the software needs of NAO with respect to financial statement auditing,

then help either procure or develop an audit software package for NAO reflecting international best practices and taking in to account the domestic situation.

(iii) Install the software developed and pilot-test it to implement changes if necessary. (iv) Help identify and procure an appropriate output costing software package, and

coordinate the training and installation in the identified budgetary agencies. 2. Domestic Consultants

12. About 120 person-months of domestic consulting services will be needed to implement CBGR and help implement GRP-II subprogram 1 policy conditions. Of the total domestic consulting inputs, the following is anticipated: (i) accounting and audit advisory components will require 35 person-months each; (ii) valuation component, 8 person-months; (iii) MIS component, 12 person-months; and (iv) project management, 30 person-months. The allocation of total person-months will be decided by the PIU in consultation with the international advisors and ADB. International experts will formulate the qualification requirements and TORs of domestic consultants, who must be fluent in written and spoken English and be able to communicate and write well.

3. Reporting Requirements

13. The long-term advisors will provide their services intermittently. All experts will submit monthly progress reports to the PIU and ADB, and an interim report midway through TA loan implementation, and a final report just before the end of the assignment. The Government will work closely with the advisors/experts. C. Management Information Systems and Output-Costing Components 14. This component will have two modules. The first will help NAO develop a software package to audit financial statement and performance. The second will help modernize the output-costing processes in all portfolios. A needs assessment will be undertaken to evaluate the hardware and software available at central and local budgetary bodies. This component will help MOFE procure a modern output-costing program with full licensing rights for use by a large number of budgetary entities. Hardware and basic software support will be provided selectively. The output-costing software and associated training will be provided to about 3,000 accountants. D. Cost Estimates 15. Table A8.11 presents the cost estimates. The total cost of the TA loan is estimated at $2.4 million. It is proposed that the TA loan of SDR1.473 ($2.000 million equivalent) for CBGR be provided from ADB’s Special Funds resources, with a term of 32 years, including a grace period of 8 years. The TA loan will carry an interest charge of 1.0% per annum during the grace period and 1.5% per year for the remaining period. The Government will provide the equivalent of $400,000 in counterpart support.

Appendix 8 57

Scope of Capacity Building for Governance Reforms and Cost Estimates

($‘000)

Foreign Local Total Item Exchange Currency Cost A. ADB Loan Financing

1. Consultancy Services for Capacity Building a. International Consultants (53 person-

months)

i. Remuneration 954 0 954

ii. Per Diem 106 0 106 iii. International and Domestic Travel 106 0 106 b. Domestic Consultants (120 person-

months) 0 100 100

c. Domestic Travel 0 9 9 2. Output-Costing Component a. System-Based Audit Support to NAO 50 20 70

b. Output-Costing Software for 3,000 Budgetary Bodies @$80

240 0 240

c. Hardware Support—Computers and Network Equipment (up to 100 stand-alone computers and networking facilities on a selective basis)

140 0 140

3. Training Activities—Accounting, Auditing,

Output-Costing Workshops (2,500 participants @$50)

25 100 125

4. Support Services—Project Implementation

Unit Logistics and Management 20 10 30

5. Contingency 100 20 120

Subtotal (A) 1,741 259 2,000

B. Counterpart Support 1. Office Accommodation and

Venue, Facilities for Training, Seminar 0

180 180

2. Local Counterpart Staff 0 100 100 3. Hardware and Software for Financial

Management 0

120 120

Subtotal (B) 0 400 400

Total 1,741 659 2,400 ADB = Asian Development Bank, NAO = National Audit Office.

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58

SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY AND POVERTY IMPACT ASSESSMENT

A. Summary Poverty Reduction and Social Strategy

A. Linkages to the Country Poverty Analysis Sector identified as a national priority in country poverty analysis? Yes

Sector identified as a national priority in country poverty partnership agreement? Yes

Contribution of the sector/subsector to reduce poverty in Mongolia: Lack of fiscal responsibility has been a primary factor in large public expenditures and low public sector efficiency. The proposed program cluster aims to introduce a number of measures to improve public expenditure management; increase fiscal and financial transparency; and enhance the quality of service delivery in health, education, and social welfare sectors. B. Poverty Analysis Proposed Classification: Good governance; growth Analysis: 1. Good governance is an integral part of the Asian Development Bank (ADB) strategy to reduce poverty and is essential for efficient management of a developing country's scarce public resources. The Second Phase of the Governance Reform Program (GRP-II) seeks to advance the reform initiatives for public sector management, i.e., bring in strategic focus, efficiency and effectiveness, transparency and predictability, accountability, and participation, which GRP began. GRP-II aims to enhance the capacity of public sector institutions to enable them to generate revenues for public services, and provide a sound regulatory environment to promote public interest, competition, and overall governance. The program will directly benefit the poor by improving delivery of social and other services. Indirectly in the longer term, the program will help achieve macro stability, improve governance, supplement private sector development, and, hence, help boost economic growth and control inflation. GRP-II thus has strong linkages to poverty reduction. 2. The Government remains committed, and is designing a strategy, to reduce poverty on the basis of evaluation of current economic and social conditions. Since 2000 Mongolia has been implementing the national program on good governance for human security (GGHS). Consensus among policymakers and stakeholders is now essential. GGHS facilitates policy focus, coherence, and sustainability for poverty reduction programs by enlisting support from all stakeholders, state administration, related organizations, media and press, private sector, and civil society. 3. The Poverty Reduction Strategy Paper (PRSP) states that the Government is committed to formulating macroeconomic policies in the context of a medium -term framework to support rapid, private sector-led growth and poverty reduction. The Poverty Reduction and Growth Facility, being implemented with support of the International Monetary Fund (IMF), aims to create a stable macroeconomic environment conducive to high private investment and gradually raising gross domestic product (GDP) growth to 4–6% per annum with a single-digit inflation rate. The Government's structural reform program will be guided by the need to strengthen the institutions of macroeconomic management. In the fiscal area, the highest priority has been given to reforms to improve transparency, accountability, and enforcement mechanisms in budget implementation and to ensure more efficient allocations of public expenditure. Banking sector reforms will aim to consolidate the shift to a market-oriented system of indirect monetary management, strengthen bank supervision, and accelerate privatization of state-owned banks. Efforts will be stepped up to restructure and privatize nonfinancial public enterprises, establish a sound legal and regulatory framework, and maintain an open trade and investment regime. These measures are expected to enhance opportunities and incentives for private participation, including by foreign investors. 4. Thus, in line with the PRSP, the Government considers the next 10 years as the phase to improve its strategic focus, make delivery of public services more effective and efficient, and the social security system more viable; and to establish better accountability and transparency mechanisms. More effective and accountable institutions will make sound economic policies and raise public confidence, promote investment and economic development, and increase living standards. The Government successfully implemented GRP over 1999–2002 with ADB’s support, and has requested for a follow-up second phase to further the reforms to develop nascent institutions

Appendix 9 59

ADB’s support, and has requested for a follow-up second phase to further the reforms to develop nascent institutions and strengthen public sector management to improve efficiency and accountability. GRP-II supports the Government’s poverty reduction strategy and is in line with ADB’s poverty reduction strategy. The Government is also formulating a series of poverty reduction strategy credits (PRSCs) with World Bank support to help implement the PRSP. 5. GRP-II is likely to benefit the poor and socially vulnerable through direct as well as indirect channels. Benefits will be enhanced transparency and less public expenditure, which will improve service delivery and access and reduce prices. While some measures may have short-term adverse effects, these are likely to be more than compensated for by the significant medium - and long-term overall benefits. C. Participation Process 6. Stakeholder analysis? Yes. The proposed program cluster forms a part of the 10-year governance reform road map developed under GRP. As part of GRP, Parliament adopted the Public Sector Management and Finance Law (PSMFL) following 5 years of extensive stakeholder consultations. The proposal allows for continued significant stakeholder involvement. Participation strategy? Yes. The program allows for a participatory approach to formulating the specific measures with regard to pension reforms and administrative consolidation. D. Gender and Development 7. Strategy to maximize impacts on women: As part of its PRSCs, the World Bank is formulating a gender development strategy in Mongolia. Given that the PRSCs’ focus is on improving public expenditure management, it is proposed that the strategy paper be reviewed by ADB, gender-linkages to the overall thrust of PSMFL identified, and measures formulated as part of subprogram 2 if needed. 8. Gender plan prepared? No. The proposed measures under the program cluster will not have any differential effects between men and women. E. Social Safeguards and other Social Risks

Significant/

Nonsignificant/ None

Strategy to Address Issues

Plan

Required

Resettlement

None No negative impacts to be mitigated No

Indigenous Peoples

None No negative impacts to be mitigated No

Labor

Nonsignificant The poverty impact assessment below discusses the channels through which labor may be affected.

No

Affordability

Nonsignificant Subprogram 1 is not likely to have any immediate impact on access or affordability of public services. The consolidation measures included in subprogram 2 may have an effect on the access to public services in areas that would be consolidated. ADB will formulate remedial measures based on the final conceptual framework the Government will adopt as part of subprogram 2.

No

Other Risks/ Vulnerabilities

None No negative impacts to be mitigated No

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60

B. Poverty Impact Assessment 1. Social and Economic Situation 1. Poverty is widespread in Mongolia, although trends have been mixed. Poverty increased during the last decade of transition as a result of sudden withdrawal from the socialist system in the face of weak alternative public institutions and policies to mitigate the impact of the transition. As economic growth declined, public access to basic education, health services, and social conditions deteriorated, particularly in early part of the transition. The Government thus launched reforms such as trade and price liberalization, a floating exchange rate, privatization of public sector assets, and tight monetary and fiscal policies. Growth in gross domestic product (GDP) recovered to 2.3% in 1994 and has remained positive since then. Hyperinflation declined to 66.3% in 1994, averaged 27 percent in 1995–1999 and further declined to 8.1 percent by 2000. Unemployment has also gradually decreased since 1996. 2. The 1998 living standards measurement survey showed that about 36 percent of the Mongolian population was poor. While poverty appeared to have stabilized over 1995-2000, the depth and severity of poverty increased and inequality worsened. Various surveys indicated concentration of poverty in four population categories: single-parent households with many children; households with less than 100 heads of livestock; the uneducated; and vulnerable groups (elderly, disabled, street children, and orphans). The survey confirms a direct correlation between poverty and unemployment, and indicates that cost for education and health services is a heavy burden on the poor. Migration to urban areas has been substantial since 1996, concentrating poverty in urban areas. 3. The economy has slowed down in recent years due to several reasons. Several external factors adversely affected the economy: harsh weather (dzuds, severe winters followed by dry summers); onslaught of the foot-and-mouth disease;1 and sharp fall in prices of main export earners (copper, cashmere, and gold). Acute shortage of management skills has inhibited private sector development. Privatization caused a large number of plant closures, job losses, and disruptions in production and supply, resulting in revenue shortfalls, which, combined with inefficient and rising public expenditures, led to large reinforcing deficits and deteriorating public service delivery. The recent economic slowdown in 2000-01 appears to have exacerbated poverty. 4. In summary, while Mongolia has made substantial progress in the transition to a market economy over the last 10 years, serious challenges remain to be overcome to raise living standards and reduce poverty. The economy has recorded a positive growth for seven consecutive years, and inflation has been brought down to single digits. The economy is now more open, citizens have the right and opportunity to set and pursue their economic goals, and a regulatory base for a free and competitive environment for private enterprise has been created. Yet, the country’s economic base is narrow and highly vulnerable to external shocks. Financial intermediation remains fragile. Given the relatively small market, the Government and state-owned enterprises wield a lot of influence. These factors weaken private sector confidence, especially of foreign investors. The public sector is not well managed, which, combined with excessive government controls, has led to deteriorating access and quality of basic services, such as education, health, etc. Reforms in governance and public sector management are thus the key to development and poverty reduction.

1 Animal husbandry is the leading industry, and the disease killed a large number of cattle in the last couple of years.

Appendix 9 61

2. Policy Actions and their Impact on Poverty and Other Social Dimensions 5. The first component of the Second Phase of the Governance Reform Program (GRP-II)—to formulate a sound implementation framework to guide public sector governance reforms—seeks to widen and deepen the reforms initiated as part of the Public Sector Management and Finance Law (PSMFL) to the whole Government. These reforms relate to revamping planning, budget, and expenditures; introducing a performance management system; adopting accounting and auditing systems in line with international standards; and bringing in more transparent reporting systems. The framework proposes to adopt PSMFL-related guidelines and legislation, launch process-related capacity-building initiatives, institute expenditure control measures, and set up accountable institutional structures. These reforms have obvious links to good governance and poverty reduction and will directly benefit the poor by giving them improved access to quality public services. Indirect long-term benefits are also significant. Transparent use of public funds and effective delivery of key services will improve public participation, boost private sector development, accelerate economic growth, and increase jobs. Good growth and employment prospects will have a favorable impact on public sector finances and help reinforce growth, control inflation, and reduce poverty (Table 1). 6. Other than the impacts identified below, GRP-II is not likely to have any other social impact, including on indigenous people or any other vulnerable groups.

Table A9.1: Poverty Impact of Public Sector Governance Reforms Type of Effect Channel Direct Effect Indirect Effect Macro Effect Effect on the

Nonpoor Labor In general,

improvements in administrative processes will make public sector human resources more efficient. Rationalization of employment is likely in some entities following a close scrutiny of expenditures under the newly developed strategic business plans, output contracts, and performance management agreements. However, based on the outcomes in the recent government-initiated organizational restructuring, rationalized labor has been redeployed through contracting-

If public sector efficiency translates into wage increases, it may encourage migration to cities and raise private sector wages, thereby adding to urban unemployment and social security budgets in the short term.

Transparent use of public funds to deliver key services will improve public participation, boost private sector development, and lead to better economic growth and more jobs.

Efficiency will be improved.

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62

out-type reforms. Hence, the net effect is not likely to be negative, even in the short term.

Prices Positive. By enhancing efficiency in service delivery, the proposed activities will reduce overall expenditures and eventually lower prices.

Private sector development and better growth will help stabilize government finances and, hence, prices.

Prices will be stable.

Access for the Poor

Access to public services will improve because of adequate funding and effective service delivery.

PSMFL, with a stable macroeconomic environment, will enhance growth prospects and improve economic opportunities and access for the poor.

Access will improve.

Transfers No change Crucial Assumptions

Reform is successful and not subjected to institutional capture, and expenditure increases in program implementation are matched by savings in administrative expenditure.

Total Net Effect

Positive

Narrative The implementation framework attempts to widen and deepen PSMFL-related reforms to the whole Government. These include revamping planning, budgeting, and expenditure management; introducing a performance management system; adopting accounting and auditing systems in line with international standards; and bringing in transparent reporting systems. The framework proposes to adopt PSMFL-related guidelines and legislation, launch process-related capacity-building initiatives, institute certain expenditure control measures, and set up more accountable institutional structures. These reforms have obvious direct links to good governance and poverty reduction.

7. PSMFL financial governance norms propose to establish institutional structures for financial management; adopt accrual-based accounting, asset valuation, and auditing according to internationally accepted standards; and strengthen public sector auditing and inspection systems and the private sector accounting and auditing regulatory framework. These norms propose to create certain key missing roles; staff them with qualified people; reinforce certain inter-institutional relations; prescribe standards for accounting, valuation, audits, and inspections; and incorporate necessary changes in related laws. A better financial framework will help improve monitoring, control, and accountability of budgetary entities; make them more effective; and have direct links to growth, inflation, employment, and poverty reduction.

Appendix 9 63

Table A9.2: Poverty Impact of the Public Sector Management and Finance Law Type of Effect Channel Direct Effect Indirect Effect Macro Effect Effect on the

Nonpoor Labor Existing labor will have

significant opportunities for professional development through retraining.

Demand and, hence, wages may increase for the accounting profession.

A better financial framework will help improve monitoring and control of revenues and expenditures, is the key ingredient of good governance, and has direct links to growth and employment.

Growth will be higher and job prospects better.

Prices Positive. While expenditures may increase due to the initiation of new structures, enhanced transparency and improved internal controls are likely to lower expenditures and, hence, prices.

None Macro stability and better growth prospects would be reinforced and stabilize government finances and prices.

Prices will be stable.

Access for the Poor

The quality of public services in education, health, and social welfare will improve because of better internal controls, and higher expenditure savings, which can be diverted to poverty reduction initiatives.

Macro effects will reinforce and improve access to public services.

Access will improve.

Transfers No change Crucial Assumptions

Implementation is effective, needed skills become available, retraining is successful, and expenditure increases are matched by savings elsewhere.

Total Net Effect

Positive

Narrative The financial governance norms propose to establish sound institutional structures for effective financial management, adopt accrual-based accounting, asset valuation, and auditing according to internationally accepted standards, strengthen public sector auditing and inspection systems, and strengthen the regulatory framework for private sector accounting and auditing. These norms propose to create certain key missing roles; staff them with qualified people; reinforce certain inter-institutional relations; prescribe standards for accounting, valuation, audits, and inspections; and amend related laws as needed.

8. The second component to improve fiscal sustainability has two aims. The first is to make the social security system more sustainable. Overall social security payments, particularly pensions, have been rising fast because of early retirements and generous benefits. This, together with ad hoc, improperly indexed increases in pensions, threatens the system’s medium-term fiscal stability. Hence, GRP-II proposes a gradual increase in retirement ages,

Appendix 9

64

elimination of early retirement privileges, and indexation of pensions. These provisions may have a short-run negative impact on some of the poor but will benefit most by making social security more sustainable. Credible social security institutions will serve the poor well and have beneficial macro effects on saving, growth, inflation, and poverty reduction.

Table A9.3: Poverty Impact of Strengthening the Social Security System Type of Effect Channel Direct Effect Indirect Effect Macro Effect Effect on the

Nonpoor Labor There may be some

short-term effect on the currently unemployed. However, the employed will significantly benefit from ensured income support during retirement.

The reform will improve real wages by reducing risks of the social security system.

Sustainable and well-funded social security systems will ensure effective participation of the vulnerable, generate resources for investment, and improve growth and employment prospects.

Social security and jobs will improve.

Prices Proper indexation of wages and pensions will moderate the impact on consumer prices, unlike the current system of ad hoc increases.

Consumption will be smoothed, enabling prices to rise gradually.

Higher growth will help stabilize public finances and prices.

Prices will be stable.

Access for the Poor

For the unemployed, there may be a short-term negative impact until better macroeconomic prospects help create more jobs. However, indirect job creation is much more sustainable than the present system.

Social security benefits for the needy will be improved by reducing the risk of default.

Stable funding of social security and other public services will improve the access for poor.

Improved access

Transfers Effects will be negative in the short term but significantly positive in the future through better growth opportunities.

The pension system will become more secure.

Effect will be positive.

Crucial Assumptions

Phasing in of reform is based on careful assessment of flows.

Total Net Effect

Positive

Narrative The social security bill, particularly pensions, has been rising fast because of early retirements and lavish benefits despite incomplete and ad hoc indexation of pensions, which threatens the whole system. Hence, gradual increases in retirement age, a more systematic indexation, and partial funding of pensions, along with some key capacity-building steps for this transition, are proposed to make the system more sustainable.

Appendix 9 65

9. GRP-II aims to consolidate central and local administration to streamline public sector administration and strengthen resource management. Public expenditures have risen rapidly due to administrative proliferation at different government levels. The proposed consolidation measures under GRP-II aim to achieve economies of scale and strengthen public sector resource management. The purpose is to conserve public resources and use them in priority areas. Consolidation measures thus naturally tie in with the effectiveness of government institutions and reinforce macro linkages for growth and poverty reduction, as in the first component. While there may be some negative outcomes in the short term, these are likely to be compensated for by beneficial outcomes in the medium and long term. Significant follow-up measures will be undertaken in subprogram 2 of GRP-II.

Table A9.4: Poverty Impact of Central and Local Administrative Consolidation

Type of Effect Channel Direct Effect Indirect Effect Macro Effect Effect on the

Nonpoor Labor As non-core services

are likely to be contracted out, which might have a short-term negative effect on labor, there will be significant opportunities for redeployment. The outcomes in subprogram 1 will be monitored and remedial measures instituted in subprogram 2.

Intra- and interprovincial consolidation measures will provide greater economic opportunities in local areas and reduce out-migration to cities.

Consolidation will help save public resources, which will enable more effective service delivery, promote macro stability, and reinforce growth and employment.

Employment opportunities will improve.

Prices Lower prices, on average, due to scale economies stemming from consolidation of service delivery

While prices will be lower on average, in the short-run accessibility to public services may be reduced for some segments of the population. In the long run, however, prices will be lower and quality of services higher.

Lower prices on average.

Lower prices on average.

Access for the Poor

A fundamental element of the conceptual framework for administrative consolidation is to preserve access of the poor to essential public services.

Consolidation measures will improve service quality and access.

Impact will be positive.

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66

Transfers Scarce resources will be redirected to benefit the poor.

Crucial Assumptions

The concept paper, consultations, and plans can foresee all pros and cons, and make adequate provisions to deal with them.

Total Net Effect

Overall positive effect

Narrative The proposed consolidation measures aim to achieve economies of scale and strengthen public sector resource management. This component will be carried out on a pilot basis, and will provide for functional reviews, formulation of conceptual frameworks to guide consolidation based on extensive stakeholder consultations, and design of adequate social safety nets to preserve the access of the poor to essential public services.

10. The third component of GRP-II aims to enhance public confidence in the Government and its key institutions, focusing on enhancing performance audit capacity of the National Audit Office, paving the way for a career-track civil service and strengthening the rule of law. By making public institutions transparent and reliable, all these measures will promote growth and reduce poverty.

Table A9.5: Poverty Impact of Enhancing Confidence in Public Institutions

Type of Effect Channel Direct Effect Indirect Effect Macro Effect Effect on the

Nonpoor Labor Certainty in career

advance will make the civil service attractive.

Performance audits may lead to conservation of resources, which, in turn, may be used for new investments.

The rule of law will promote good governance and effective delivery, and have a salutary impact on growth and employment prospects.

Employment opportunities will improve.

Prices Overall, increased transparency will lower prices by reducing expenditures.

Better growth prospects will help stabilize government finances and, hence, prices.

Prices will be stable.

Access for the Poor

Access to public services is likely to improve because of better law enforcement.

Public services will be more responsive and less corrupt.

Macro effects will give the poor more access to public services.

Access to public services will improve.

Transfers No change Crucial Assumptions

Reform is well thought out, and implementation is closely supervised from the highest level of Government.

Total Net Effect

Positive

Appendix 9 67

Narrative The measures include establishing a performance audit team in the National Audit Office and undertaking performance audits in selected tax departments, ministries, agencies, and provinces; enforcing strict merit-based entry system in Government, with a career plan for senior civil servants and an effective grievance resolution system; enforcing the rule of law by scrapping all inconsistent ministerial orders; and establishing an advisory council to promote the rule of law and plan legal reforms, including the role of some key public institutions.