Economy & business

“Enhancing the contribution of preferential trade agreements to inclusive and equitable trade: The case of Mongolia” – Final Part II

Continued from edition No. 11, 30.11.2017 of TMO

By Namsrai BATNASAN, Professor, Business School, National University of Mongolia

The economy has undergone some very important structural changes during the transition period that have important implications for the sustainability of future growth.
The most important structural change occurred in the country’s ability to generate its own resources for capital accumulation and growth. At the end of socialism or late 1989, gross national capital formation accounted for 44.6 per cent of GDP, 2/3rd of which were financed from foreign sources, primarily the Soviet Union24. As the economy collapsed, gross national capital crashed to just over 17.8 per cent of GDP by 1994, of which one half consisted of domestic savings25. Since, gross national capital formation has recovered quite well, and by 2015 it accounted for 27.4 percent of GDP26. What is important is that in recent years national savings have grown rapidly, amounting to almost two thirds of gross national capital formation, whereas foreign savings has dropped27.  These figures provide evidence to the fact that economic growth is now based on a more secure and more sustainable foundation than it did any time before
Mongolia’s economy has successfully reoriented its external sector, which is another important accomplishment in the economy. At the beginning of transition, Mongolia’s trade policy was more focused on internal economic situation with an emphasis on protecting domestic production. Then trade policy shifted fundamentally in favor of export orientation with the active promotion of FDI. Resultatively, the ratio of export to GDP almost doubled compared to the concluding years of socialism. More importantly, the country achieved this trade expansion by diversifying both the destination of its exports and the sources of its imports far beyond the borders of the former Soviet bloc.
Nonetheless, trade has come to be rooted much more on the fundamental strengths of the economy, such as, market competitiveness, rather than on political favors from the Soviet bloc that existed before the transition. During the transition years, Mongolia’s export rapidly shifted, in terms of its composition, from labor-intensive agricultural and manufacturing sector to a highly competitive and internationalized capital-intensive mining sector. This confirms that the growth of the Mongolian economy has also become much more sustainable. (See Figure 5)

    Since the transition Mongolia has finally learned that in an increasingly globalized world, small countries like Mongolia stand little chance before larger and stronger competitors. However, in such a huge world of production there should be certain commodities with which these small economies could have a comparative edge. The country identified trade and its trade-led growth the base, and has learned that comparative edge is much more important than artificial political favor. It is hoped that the country will continue to rediscover its comparative edge under changing circumstances. (See Figure 6)

    It is clear that as Mongolia pursues a fairly open trade regime, the economy should be rooted in those industries in which the country has a comparative edge. Mongolia’s comparative advantage lies in natural resource-intensive industries, of which there are two major types including livestock-based processing industries such as textiles, leather and dairy, and the mining industry. Those sectors complement each other. Mining is capital intensive and generates large part of income necessary for further economic growth, while agriculture is labor intensive and generates jobs for people.
From the point of view of poverty reduction, the pattern of growth must be such that the poor people are able to benefit from the growth process. Resulting the capital-intensive nature, the mining sector does not generating much work place, hence this sector is less contributing to the poor to benefit from the growth process. However, budgetary revenue and foreign exchange earnings generated in the mining sector, aggregate demand generated by the export of minerals are necessary for poverty reduction. Incomes generated in the mining sector should provide investible resources that could stimulate the development of sectors where there is greater scope for labor absorption on the one hand, and on the other, stimulating demand.
During last two decades, majority of foreign and domestic investment invested in mining sector.  However opposite phenomenon could be observed in agricultural sector. Given the high incidence of rural poverty in Mongolia, it is clear that agriculture must remain an important part of pro-poor strategy.
Despite the leading role played by the mining industry as the engine of growth in recent years, agriculture has not been successful in growth and productivity. A market will come into existence only if the potential gains from market transactions exceed the transaction costs, this is, as we know, basic economics. Because of the small-volume market, caused by low level of income, sparse and scattered population, either markets have not developed at all; businesses in the rural areas have not developed well enough, and rural agricultural sector does not attract either foreign or domestic investors. And so, although Mongolia has made significant gains in economic development during the transition, poverty, unemployment and inequality are very high, especially in the rural areas. Therefore, open regime of trade and FDI alone are not enough for tackling such social problems as poverty, unemployment and inequality. The solution of these problems demand sound and integrated economic policies both at the domestic and international levels.

Trade preferences & Mongolia

Land-locked and remoteness from world seas and key international transport routes, small and sparse population, vast territory, and extreme weather conditions are all factors that contribute to economic underdevelopment and weakening of competitiveness of Mongolia’s export products on the global market.
In spite of technological improvements in transport and logistics, landlocked developing countries continue to face structural challenges to access world markets. On the whole, in terms of overall development and external trade, landlocked countries often lag behind their maritime neighbors. Trade and economic performances of those countries are often dependent on their transit opportunities. Landlocked developing countries face such persistent challenges because of the difficulty of trade, geographical remoteness, and non-access to specialization and associated benefits. The difficulty of transportation over great distances today remains a serious drawback despite huge technological advances.
Landlocked countries are paying high transportation costs in their export and import; and as a result, goods produced in landlocked countries have low competitiveness in the world market. Owing to their limited export earnings, such countries tend to have access only to poor technologies, exhibit low productivity, and are characterized by low income and low living standard. Therefore, an International Conference held under the auspices of the United Nations in Almaty, Kazakhstan in September 2003 adopted a Declaration that recognized landlocked countries as a special group among the poorest of developing countries with limited capacities and dependence on a very limited number of commodities for their export earnings28.  Some studies confirm that the GDP per capita of landlocked countries is lower than by 57 percent compared with maritime countries29.
Similarly, like other landlocked countries, Mongolia’s geographical location is becoming a principal driver of higher cost of production and lower competitiveness, considering the poor development of external and internal logistical infrastructure. High transportation costs in land-locked-countries usually generate cost disadvantage relative to coastal countries when competing in global markets. Thus, Mongolia is paying a relatively high transportation cost for exportation and importation of goods30.
The vast territory, and the small and sparse population are not only rendering businesses and trade in some sector unprofitable. It is also contributing to transport infrastructure inefficiency. Extreme weather conditions generate seasonal characteristics in some businesses and increase the cost of living and production in Mongolia.
To address the challenges and compensate above costs that limit land-locked country’s potential gains from trade and economic cooperation, Mongolia needs to focus on the following priority areas of trade policy31.
First, landlocked developing countries need to place emphasis on developing their external and internal logistical infrastructures. Hence, investments in the development of logistical infrastructure, both of construction and maintenance, are crucial for the reduction of transport costs.
Second, investment in the production sector that produces goods with a lowest transportation costs could be an important way to reduce transportation cost. These include production of goods, such as services, luxury or high-tech products, some products with higher value or less transport cost relative to their value.
Third, trading goods to or from the closest markets with a less transport cost, could increase opportunity to compete in the foreign markets. Thus, regional integration and cooperation strategies are instrumental in reducing transport cost.
Policies focusing on mitigating the effects of land-lockedness needs to address country-specific obstacles to accessing global markets and region-specific challenges to market integration. As for Mongolia, first and second ways are seeming to be difficult in terms of investment financing at this stage of our development.
In the new era of globalization, every country aims at boosting people’s incomes and the quality of life, by improving the terms of trade using demand opportunities in foreign markets, increasing the efficiency of trade participation, and improving trade balance. As for Mongolia, the country desperately needs a sound and strong regional trade strategy that targets well-defined market segments, particularly in specific geographical regions. Now this is becoming important than ever before, when the country has gone a long way towards sustainable growth, as an increase in trade volume has converted Mongolia as a one of the important suppliers of commodities to the world market. Resulting from the country’s specific unique problem of “land-lockedness” Mongolia’s trade policy should be aimed at reducing higher transportation costs, at ensuring producers’ greater competitiveness in the global market, and at guaranteeing its citizens a wealthier standard of living.
However, one of the ultimate goals of trade policy is to integrate Mongolia into regional and world economy. To date, Mongolia has signed only one EPA and that with one of its major trading partners – Japan. With a growing array of cooperation and liberalization agreements, Mongolia is seeking ways to diversify its trading partners, improve terms of trade, and to lower trade tariffs. At present, the country is seeking ways to sign effective FTAs with its major trading partners within the framework of multilateral trade regulation.
According to GATT 94 any member country of WTO can have preferential market access by joining WTO and by signing bilateral or regional Free Trade Agreements. Currently, Mongolia trades with more than 170 countries, the dominant ones being Russia and China. Total annual trade turnover reached USD 8.27 billion in 2015, of which trade with its immediate neighbors accounted for 70.8 per cent. The remaining portion of trade turnover falls to developed countries such as EU, Switzerland, Singapore, Japan, USA and others.
If we look back at Mongolia’s foreign trade practices during the years of transition, the country has benefited from preferential access to its key markets including EU, USA and Japan under the Generalized system of preference of WTO, GSP and GSP+ of European Union and under the Economic Partnership Agreement with Japan.
Compared with other sectors of industry, textile and clothing industries have benefited much greater than other sectors of the economy. Apart from other main commodities (as copper, coal, gold, meat and leather etc.), the clothing and cashmere sectors are specially considered as industries with considerable competitive edge for Mongolia. This sector is one of the major manufacturing and employing sectors that provides approximately 1/3rd of all the industrial work places of the country. This sector includes cashmere and wool processing, garment and clothing factories, which produces approximately one sixth of the total industrial production and its exports accounts for more than 6.1 per cent of total export32.
Mongolian cashmere has an outstanding position in world market share and its production ranks second in the world, accounting for more than one quarter of world production after China. As with many other raw materials, cashmere prices are volatile, which directly affects country’s export revenue and herders’ income.
In 2015, Mongolia had almost 56 million head of livestock, of which goats and sheep accounted for 42.1 and 44.6 per cent respectively. Goat population has been growing, accordingly, Mongolia produced 8.9 thousand tons of raw cashmere, which constituted close to 30 per cent of the total world supply. Mongolian goats and sheep are adapted to harsh climate and can survive drought, heat, shortage of grazing pasture and water, and pasture range. Sheep wool is an important basic material for making high-quality woolen fabrics and carpets.
The textile industry produces fiber and animal-based products such as cashmere, yak hair, sheep wool, and camel hair. On the other side, this industrial sector is closely linked to livestock breeding sector, which engages about 0.3 million herders or one fourth of the total labor force of the country. The existence of this sector not only affects the living standard of those working in the sector, but also a large number of herders through a backward linkage.
The textile industry consists of five different types of companies, each of them has its own characteristics, markets and opportunities. The first type of companies are early-stage processing plants, which directly procure raw greasy cashmere, wool or animal hair from herders or traders, scour it and produce fine de-haired cashmere or washed wool for domestic or export markets. The second type of companies are garment manufacturers. The third type of companies are vertically integrated cashmere plants, that combine a number of operations from processing of raw materials to spinning, dyeing, garment manufacturing and production of other knit and woven products. Unfortunately, the interests of these three types of companies do not necessarily coincide. The fourth type of companies are carpet manufacturers. There are two major carpet producers – one in Ulaanbaatar and the other one in the northern town of Erdenet. The fifth type of companies are subcontracted Mongolian sewing companies in the garment industry. These companies mainly have Asian-owned foreign investment, operating in the industrial district of Ulaanbaatar. These sub-contracted businesses employ a large number of mainly unskilled, in-house trained workers, and most importantly, using the existing Mongolian trade preferences for the export quota system, that exports mainly to the EU and US markets.
Today there are at least four major types of fibers: cotton, wool, cellulosic fiber and synthetic fiber. Whereas the Mongolian textile industry produce and exports four different types of natural fibers including cashmere, yak hair, sheep wool, and camel hair. Each one of them has a particular characteristic and is discussed separately in its international context.
During the last two decades starting from 1990, global cashmere production almost tripled while international demand for cashmere products remain strong despite the increased selling of low-quality articles. Mongolian cashmere and wool once had good international reputation. However, a major issue of concern for domestic producers of cashmere products continues to be the quality of goat hair, which has been deteriorating.
Mongolian textile and clothing products were first introduced in the western market in the mid-1990s based on preferential market access to EU and USA. During those days, Mongolia promoted FDI and granted 100 percent tax holiday for foreign invested companies in the first two years since inception, and 50 percent waiver in the next 3 years.
In the mid-1990s USA granted Mongolia GSP or Generalized System of Preferences, for the purpose of making the best of trade opportunities, growing the economy and coming out of poverty. GSP is a U.S. trade program designed to promote economic growth in the developing world by providing preferential duty-free entry for up to 4,800 products from 129 designated beneficiary countries and territories. In addition to promoting economic opportunities in developing countries, the GSP program also supports progress of beneficiary countries in affording worker rights to the people, in enforcing intellectual property rights, and in supporting the rule of law.
At the same time, EU has also guaranteed unlimited quota for Mongolia-origin textile products and within the framework of EU’s “Generalized Scheme of Preferences” (GSP) export duties to EU markets were minimized or completely waived off. Later the EU granted additional preferential access to its market within the framework of GSP Plus. GSP Plus is a component of the EU’s Generalized Scheme of Preferences (‘GSP’) for developing countries and offers additional trade incentives to developing countries already benefitting from GSP to implement core international conventions on human and labor rights, sustainable development and good governance.
GSP Plus is a scheme that rewards developing countries that shows a credible commitment to implementing those conventions by granting duty reductions on exports to the EU on some 6,000 tariff lines (66% of the EU common customs tariff). Nine of the GSP Plus countries on the list including Mongolia, are already benefiting from the current scheme, and they continue to benefit from the generous enhanced market access under the GSP Plus starting from 1 January 2014.
Favorable condition in external and internal markets supported the development of textile and clothing industry starting from the mid 1990s, and its share in total export reached 40 per cent in 2000.
The United States, after China’s membership to WTO, also guaranteed preferential market access to that country. This move deprived Mongolia of its advantage in the textile and clothing trade in the US market. Despite the competitive advantage of Mongolian textile and clothing industry in the US market, the country still enjoys from its preferential access in EU markets, and continues to export textile and clothing products at an inevitably high level. Today, EU constitutes the second largest export market for Mongolia and the export of textile and clothes occupy a large chunk of Mongolia’s export to EU.
It is clear that growth concentration in labor-intensive sector creates more jobs, and capital-intensive sectors are generating more income. From the viewpoint of pro-poor policy, income generated in capital intensive sector should support the development of labor intensive sector. In Mongolia’s context, because of poor policy making, mining sector contributed little to the development of non-mining sectors. Instead of mining sector, trade preferences supported the development of labour intensive textile and agricultural sectors of Mongolia.

    There are several reasons to highlight the importance of the role of trade preferences in the country’s economic development as follows:
First, trade preferences have supported the development of labor intensive sectors both directly and indirectly when the economic growth of the country was concentrated in capital-intensive mining sectors; and used more capital-intensive techniques, especially in the growing mining sector; and external and internal conditions were more convenient for capital-intensive mining sector. Thereby, trade preferences helped to keep work places in certain sectors and generated domestic demand for animal husbandry raw materials. Through backward and forward linkages, those preferences also generated many jobs both in urban and rural economy, especially in the service sector.
Second, the trade preferences provided a unique development opportunity to the textile industry. The development of textile industry generated mostly unskilled work place, thus the development of this sector gave opportunity to the poor to be actively integrated into economic processes. From the pro-poor growth aspect, the development of textile industry fully responds to the skills of the poor in a manner that is most consistent with their interests. It also generated jobs in regions where the poor people are basically concentrated and in the sector where poor people had lost their jobs. And the textile industry itself used more labor-intensive techniques.
Third, trade preferences generated more favorable terms of trade for certain sectors of economy and gave opportunity for those sectors to become more efficient. On the one hand, trade preferences gave opportunity to trade at world market prices, and on the other hand, it has improved the productivity in certain sectors.
However, employment is a bridge between economic growth and poverty reduction, and in Mongolia the lack of employment is not a main problem. Most of the poor in Mongolia are ‘working poor’ as the core problem is not in unemployment, but rather in the inefficiency in productivity, and the quality of employment. Thus, employment quality and productivity are believed to be the missing link in order to translate economic growth to poverty reduction in Mongolia. In the Mongolian context, most of the poor people are living in rural areas, because income generated in agricultural sector is often seasonal and productivity of this sector is very low, so their livelihood is vulnerable to a large extent from external shocks, such as diseases and weather conditions. Herders in remote areas have very limited opportunities for participation in markets through the sale of raw materials and the purchase of necessary goods. As a result, many herders in remote areas still engage in barter with small traders, and trade their raw materials even when it is unprofitable to do so.
The preferences, all together generated favorable conditions not only for the textile industry itself, but through backward linkages those preferences helped to improve the living standards of rural herders, which have been sharply declining because of the decline in the price of the livestock raw materials in foreign markets during the transition.
Fourth, trade preferences have softened a strong upward pressure on the exchange rate as well as upward pressure on domestic wage rates and on inflation and production of goods in the sector and to some extent, reduced the living cost, primarily of the poor in the country.
Mongolia’s case is an example which illustrates that trade preferences are powerful instruments of trade policy and industrial development. From the viewpoint of pro-poor policy, trade preferences are aimed at establishing more favorable conditions to labor intensive sectors, which in their turn could make a significant contribution to poverty reduction.

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24 The World Bank “Country meta-data of Mongolia” 2016

25 The World Bank “Country meta-data of Mongolia” 2016

26 The World Bank “Country meta-data of Mongolia” 2016

27 The World Bank “Country meta-data of Mongolia” 2016

28 Edited by Selim Jahan and Batnasan Namsrai “Human development textbook” UNDP 2007 p. 187

29 Edited by Selim Jahan and Batnasan Namsrai “Human development textbook” UNDP 2007 p. 187

30 The World Bank “Doing business 2013” p. 282

31 Edited by Selim Jahan and Batnasan Namsrai “Human development textbook” UNDP 2007 p. 187

32 According to author’s estimation

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