PROGRAM PERFORMANCE AUDIT REPORT
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PROGRAM PERFORMANCE AUDIT REPORT

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ASIAN DEVELOPMENT BANK PPA: MON 25359 PROGRAM PERFORMANCE AUDIT REPORT ON THE INDUSTRIAL SECTOR PROGRAM (Loan 1244-MON[SF]) IN MONGOLIA December 2000 CURRENCY EQUIVALENTS Currency Unit – Tugrik (Tug) At Appraisal At Program Completion At Operations Evaluation (June 1993) (November 1998) (August 2000) Tug1.00 =$0.002500 $0.001230 $0.000929 $1.Tug398.00 Tug813.16 Tug1,076.90 ABBREVIATIONS ADB – Asian Development Bank CBC – case-by-case method GDP – gross domestic product MSE – Mongolian Stock Exchange MSEC – Mongolian Securities and Exchange Commission MTI – Ministry of Trade and Industry OEM – Operations Evaluation Mission PC – Privatization Commission PCR program completion report PPAR – program performance audit report SDR – special drawing rights SME – small and medium enterprise SOE – state-owned enterprise SPC – State Property Committee TA – technical assistance USSR Union of Soviet Socialist Republics NOTE In this report, “$” refers to US dollars. Operations Evaluation Office, PE-563 CONTENTS Page BASIC PROGRAM DATA ii EXECUTIVE SUMMARY iii I. BACKGROUND 1 A. Rationale 1 B.Formulation C. Objectives and Scope at Appraisal 1 D. Financing Arrangements 1 E.Program Completion and Self-Evaluation 2 F. Operations Evaluation 2 II. PROGRAM IMPLEMENTATION AND RESULTS 2 A. Effectiveness of Design 2 B.Implementation of ...

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ASIAN DEVELOPMENT BANK MON 25359 PPA:       
       
PROGRAM PERFORMANCE AUDIT REPORT  ON THE  INDUSTRIAL SECTOR PROGRAM (Loan 1244-MON[SF]) IN MONGOLIA
December 2000
 CURRENCY EQUIVALENTS Currency Unit – Tugrik (Tug)    At Appraisal At Program Completion  (June 1993) (November 1998)     Tug1.00 = $0.002500 $0.001230 $1.00 = Tug398.00 Tug813.16   
    
ADB CBC GDP MSE MSEC MTI OEM PC PCR PPAR SDR SME SOE SPC TA USSR
At Operations Evaluation (August 2000)  $0.000929 Tug1,076.90 
 ABBREVIATIONS  – Asian Development Bank – case-by-case method – gross domestic product – Mongolian Stock Exchange – Mongolian Securities and Exchange Commission – Ministry of Trade and Industry – Operations Evaluation Mission – Privatization Commission – program completion report – program performance audit report – special drawing rights – small and medium enterprise – state-owned enterprise – State Property Committee – technical assistance – Union of Soviet Socialist Republics
NOTE In this report, “$” refers to US dollars.
Operations Evaluation Office, PE-563
CONTENTS  
   BASIC PROGRAM DATA  EXECUTIVE SUMMARY  I. BACKGROUND   A. Rationale  B. Formulation  C. Objectives and Scope at Appraisal  D. Financing Arrangements  E. Program Completion and Self-Evaluation  F. Operations Evaluation  II. PROGRAM IMPLEMENTATION AND RESULTS   A. Effectiveness of Design  B. Implementation of Policy Reforms  C. Management of Program  D. Assessment of Program Results  III. PROGRAM IMPACT   A. Economy-Wide Impact  B. Social Impact  C. Environmental Impact  D. Sustainability  IV. KEY ISSUES FOR THE FUTURE   A. Overall Environment  B. Institutional and Human Capacity  C. Post-Privatization Issues  D. Unfinished Agenda  V. CONCLUSIONS   A. Overall Assessment  B. Lessons Learned  C. Follow-Up Actions  APPENDIXES  
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BASIC PROGRAM DATA Industrial Sector Program (Loan 1244-MON[SF])  Program Preparation/Institution Building TA No. TA Name Type Person- Amount Approval Months ($) Date 1586-MON Restructuring and Development of the AOTA 30 635,000 29 Oct 1991  Industrial Sector 1929-MON Strengthening the Industrial Sector AOTA 24 545,000 17 Aug 1993 1930-MON Developing Mongolia’s Legal Framework AOTA 10 500,000 17 Aug 1993     As Per ADB Key Program Data ($ million) Loan Documents Actual Total Program Cost 30.0 32.2 Foreign Currency Cost 30.0 32.2 ADB Loan Amount/Utilization 30.0 32.2  SDR 21.7 21.7 ADB Loan Amount/Cancellation 0.0 0.0 Amount of Cofinancing 0.0 0.0    Key Dates Expected Actual Fact-Finding 28 Sep 92-10 Oct 1992 Appraisal 20 Apr 93-11 May 1993 Loan Negotiations 15-16 Jul 1993 Board Approval 17 Aug 1993 Loan Agreement 26 Aug 1993 Loan Effectiveness 15 Nov 1993 30 Aug 1993 Second Tranche 28 Aug 1995 Loan Closing 28 Aug 1995 Program Completion 1 Aug 1996 31 Dec 1996 Months (effectiveness to completion) 32.25 40.07  BorrowerGovernment of Mongolia  Executing AgenciesMinistry of Industry and Trade (formerly Ministry of Agriculture and Industry and Ministry of Trade and Industry) and Bank of Mongolia Mission Data Type of Mission No. of Missions Person-Days Reconnaissance 1 26 Fact-Finding 1 26 Appraisal 1 110 Program Administration  Review 4 31  Program Completion 1 24 Operations Evaluation 1 24    ADB = Asian Development Bank, AOTA = advisory and operational technical assistance, SDR= special drawing rights, TA = technical assistance.
EXECUTIVE SUMMARY
Until 1990, the Mongolian economy was based on the central planning system and was covered under preferential trading and financing arrangements of the former Council for Mutual Economic Assistance. Prior to the collapse of these arrangements in January 1991, the Mongolian economy was receiving 30 percent of gross domestic product as aid. With the sudden withdrawal of this aid, the Government of Mongolia initiated a program to move to a market-based system. The Industrial Sector Program Loan (the Program) was the first attempt to restructure the industrial sector in Mongolia and was an integral part of the medium-term adjustment program under the enhanced structural adjustment facility of the International Monetary Fund. The principal objective of the Program was to bring about efficiency and international competitiveness in the industrial sector through policy and institutional reforms. It aimed to increase reliance on market forces and create a policy environment to promote private investment. The Program included seven major components: (i) abolishing price and supply controls, (ii) liberalizing the international trade and foreign exchange regimes, (iii) institutionalizing enterprise governance through privatization, (iv) encouraging commercial operations in the financial sector, (v) developing an institutional and legal framework, (vi) restructuring sector institutions, and (vii) supporting the social safety net. The Program was approved on 17 August 1993 for SDR21.667 million ($30 million equivalent) from Asian Development Bank’s (ADB’s) Special Funds resources. The funds were disbursed in two tranches: the first tranche of $15.3 million equivalent upon loan effectiveness in August 1993 and the second tranche of $16.9 million equivalent upon approval of the program progress report in August 1995. Two technical assistance (TA) grants totaling $1,045,000 accompanied the Program. The first TA was designed to assist the Government in implementing the policy measures to manage, monitor, and assess the impacts of the Program. The second TA helped develop the legal framework. The program completion report was finished in November 1998 and the Program was rated generally successful on the basis of positive key indicators that suggested signs of sustainable recovery. The program completion report highlighted three constraints: policy reversal relating to an export ban on cashmere, unfamiliarity with ADB procedures, and frequent changes at official level that disrupted program administration. It emphasized the need to recognize linkages between the industrial and financial sectors, and highlighted the weaknesses in institutions, especially in terms of promoting foreign investment. This program performance audit report presents important design and implementation issues as well as lessons for future operations. Out of 31 policy actions, the Government fully complied with all except three. One condition relating to the financial sector was integrated with subsequent programs. However, the broad picture on manufacturing sector performance in Mongolia is not very encouraging. What seems particularly disappointing is that the reform program has not resulted in sufficient restructuring of existing units nor promoted new areas of growth and productivity enhancement in the industrial sector. The overall share of industrial activities in the economy declined significantly from 35 percent in 1990 to 24 percent in 1999. The Program was ADB's first attempt at sector restructuring in a transition economy that adopted the "big bang" approach. ADB's interim operational strategy was designed to facilitate transition of Mongolia's economy to market principles. The economy had been relatively small, largely isolated with its landlocked geography, and heavily dependent on the former Union of Soviet Socialist Republics. In retrospect, it is evident that the transition process was not a simple matter of reforming policies, redefining the role of the Government, or liberalizing foreign exchange,
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investment, and price regimes, but effectively dealing with the challenges posed by the sudden withdrawal of significant volumes of aid and serious disruptions in trading links and vital infrastructure supplies. Instead of imposition of the orthodox view that establishing market conditions would automatically generate economic growth, the Mongolian economy needed a strategy for a smooth transition with investments in infrastructure, energy, and basic needs, and a gradual approach to reforms. Though a TA preceded the Program, its recommendations were not based on rigorous sector analysis to see whether any industrial activity could have survived the complete and sudden opening of the economy. About 70 percent of domestic investment at present is financed from external aid and this is not sustainable in the long term. Greater flows of private capital, improved efficiency of financial sector entities, and better information flows are crucial to attract investments to generate positive impact of the reforms undertaken so far. The program period coincided with rapid political reforms in Mongolia and so the design of reforms was influenced by political factors as much as economic challenges. This meant that agreements on the actual instruments of reform were a result of political bargaining between different interest groups rather than the technical efficacy of the instruments. The Government was strongly committed to moving Mongolia to a market economy; however, this was not translated into an appropriate strategy or strong implementation apparatus. Unfamiliarity with market instruments within the Government and the lack of an overall framework for restructuring the economy led to a weakening of support and commitment when the reforms imposed costs. The Program made no systematic assessment of institutional capacities or of existing skills, nor any human resource planning for the required tasks at the design stage. The program risks identified did not include human or institutional capacity as a serious risk. Privatization in the Program was seen as a simple exercise of transferring ownership; first with voucher schemes and later with secondary trading in shares. Empirical evidence indicates that private ownership does not automatically lead to efficiency gains or improved corporate governance. A number of post-privatization issues (such as diffused ownership, problems of weak capital markets, large residual government ownership, and continuation of soft budget constraints due to a weak banking sector) did not get the required attention and this limited the overall positive impacts of changes in incentive structure. The Program is rated less than successful because the basic objective of bringing about efficiency and international competitiveness in the industrial sector has not yet been achieved. Though the Program met almost all policy covenants, initial design flaws influenced the ultimate impact. Four important lessons emerge: (i) Program design for a sector like industry that has important forward and backward linkages needs to identify overall barriers to efficiency and growth. Future program loans need to be based on the premise that though policy reforms are necessary, they arenotown to make the industrial sector efficient or sufficient on their competitive. Long-term approach and strategy are needed for sectoral reforms to generate sustainable positive impacts. (ii) In the Mongolian context, ownership changes have not resulted in growth and efficiency improvements in the privatized units. Due to weak legal and regulatory structures and inadequate financial infrastructure, private ownership alone will not result in more accountable corporate governance.
 
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(iii) In-country monitoring was largely by a TA consultant, mainly in terms of tasks and time frame. To ensure success, effective monitoring should include continuous impact assessment of reforms by Government. (iv) ADB needs to revisit the adequacy of program loans as an instrument to deal with sector restructuring in a transition economy. Program loans, with predetermined schedules for policy covenants, are not flexible enough to deal with the inherent uncertainty that such restructuring efforts involve. It is necessary to develop a number of different lending instruments (flexible program loans) that can deal with such challenges. The Mongolian industrial sector has a large unfinished agenda. Many units remain state owned and in others, the State has a large shareholding. These units will need a systematic approach to privatization and restructuring both to secure positive results for the Government and a large number of existing shareholders, and to provide a stimulus for developing the financial sector. This should be an important area of future assistance and should be included in the medium-term pipeline of possible ADB investments. The Government needs to build human and institutional capacity in the area of policy options, analysis, and monitoring. External aid cannot replace continuous internal assessment and analysis. ADB should begin to focus on building capacity for procurement and disbursement as soon as a new member joins because it takes time to develop familiarity. The Mongolian experience confirms that success and speed of transition crucially depend on three sets of factors: initial conditions, external factors, and reform strategies. In future program loans, ADB needs to avoid using standard blueprints of reform. The transition economies are particularly vulnerable to large-scale negative impacts if program design does not adequately reflect local conditions and constraints. ADB needs to keep the Mongolian experience in mind in all upcoming program loans for transition economies.  
 
A. Rationale
I. BACKGROUND
1. Until 1990, the Mongolian economy was based on the central planning system and was covered under preferential trading and financing arrangements of the former Council for Mutual Economic Assistance. Prior to the collapse of these arrangements in January 1991, the Mongolian economy was receiving 30 percent of gross domestic product (GDP) as aid. With the sudden withdrawal of this aid, the Government of Mongolia joined multilateral institutions and initiated a program to move to a market-based system. In 1991, as a part of joint donor efforts, the Asian Development Bank (ADB) provided a Special Assistance Loan to Mongolia for emergency support for the transition process.1the same time, ADB initiated analysis of the industrial sector so as toAt design future assistance programs. The Industrial Sector Program Loan (the Program) was the first such attempt to restructure the industrial sector in Mongolia and was an integral part of the medium-term adjustment program under the enhanced structural adjustment facility of the International Monetary Fund.
B. Formulation
2. The Program was based on the findings of a technical assistance (TA) provided by ADB as a part of its commitment to support Mongolia’s transformation to a market-oriented economy.2 The main objective of the TA was to gain an understanding of the industrial sector in Mongolia. The final reform agenda was based on the findings of this TA and consultations with the Government. An ADB Fact-Finding Mission visited Mongolia in September-October 1992 followed by an Appraisal Mission from 20 April to 11 May 1993. Loan negotiations between ADB and government representatives were held in Manila from 15 to 16 July 1993. The loan was approved on 17 August 1993. The program period was three years.
C. Objectives and Scope at Appraisal
3. The principal objective of the Program was to bring about efficiency and international competitiveness in the industrial sector through policy and institutional reforms. It aimed to increase reliance on market forces and create a policy environment to promote private investment. The Program included seven major components: (i) abolishing price and supply controls, (ii) liberalizing the international trade and foreign exchange regimes, (iii)iinstitutionalizing enterprise governance through privatization, (iv) encouraging commercial operations in the financial sector, (v) developing an institutional and legal framework, (vi)0restructuring sector institutions, and (vii) supporting the social safety net. Appendix 1 provides details of actual progress on program implementation for all policy actions and paragraphs 14 to 20 summarize actual progress until now.
D. Financing Arrangements
4. The Program was approved for SDR21.667 million ($30 million equivalent) from ADB’s Special Funds resources. The funds were disbursed in two tranches: the first tranche of $15.3 million equivalent upon loan effectiveness in August 1993 and the second tranche of $16.9 million                                                   1 1109-MON(SF): LoanSpecial Assistance, for SDR22.113 million, approved on 29 October 1991. 2 1586-MON: TARestructuring and Development of the Industrial Sector, for $635,000, approved on 29 October 1991.
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equivalent in August 1995 after the approval of the program progress report and its submission to the ADB Board. Two TA grants totaling $1,045,000 accompanied the Program.3 first TA was The designed to assist the Government in implementing the policy measures to manage, monitor, and assess the impacts of the Program. The second TA provided assistance in developing the legal framework.
E. Program Completion and Self-Evaluation
5. The program completion report (PCR) was finished in November 1998, three years after loan closing. The PCR provides information on the status of implementation of the program components and a discussion of the elements comprising an appropriate policy environment. The PCR rated the Program generally successful on the basis of positive key indicators that suggested signs of sustainable recovery. Real GDP growth was positive for the first time in 1994 since 1989 and continued throughout 1997. Industry and merchandise export shares of GDP stabilized following a downtrend since 1989. With continued efforts in support of financial sector restructuring and further strengthening of macroeconomic stabilization efforts, it was expected that resource flows would gradually improve, leading to greater investment and strong, sustainable, economic growth. 6. The PCR highlighted three constraints: policy reversal relating to an export ban on cashmere, unfamiliarity with ADB procedures, and frequent changes at official level that disrupted the continuity of program and loan administration. On substantive issues, the PCR emphasized the need to recognize linkages between the industrial and financial sectors at the design stage and highlighted weaknesses in institutions, especially in terms of promoting foreign investment.
F. Operations Evaluation
7. This evaluation by the Operations Evaluation Office focuses on the overall impact of the Program on the industrial sector and the economy generally. The evaluation presents analysis of relevance and efficacy of the design and implementation of the Program to draw lessons for future operations. Institutionalizing enhanced governance was an important objective of privatization efforts and so this evaluation documents privatization experience in Mongolia. 8. An Operations Evaluation Mission (OEM) visited the country from 20 August to 3 September 2000. The final program performance audit report (PPAR) is based on a review of the PCR, the report and recommendation of the President, material in ADB files, discussions with ADB staff, the Executing Agencies, other agencies of the Borrower, and the larger development community in the field. A draft PPAR was sent to the Borrower and the Executing Agencies with a request to provide comments in four weeks. Comments received have been appropriately incorporated in the final report.
II. PROGRAM IMPLEMENTATION AND RESULTS
A. Effectiveness of Design
9. The Program was ADB's first attempt at sectoral restructuring in a transition economy that had adopted a "big bang" approach to economic reforms. The prime thrust of ADB's interim operational strategy for the medium term was to facilitate the transition of Mongolia's economy to                                                   3 TA 1929-MON:Strengthening the Industrial Sector, for $545,000, approved on 17 August 1993 and TA 1930-MON: Developing Mongolia’s Legal Framework, for $500,000, approved on 17 August 1993.
 
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market principles.4 Though the interim strategy recognized the rising social concerns, the primary focus continued to promote efficient and sustainable growth. ADB identified three areas of focus: creating a competitive and efficient market economy, developing human resource skills for a market economy, and developing infrastructure to achieve the goal of efficient and sustainable growth. This was to be achieved by keeping fiscal and environmental sustainability at the core of all programs. 10. In retrospect, though these thrust areas were important, ADB’s program designs had to recognize constraints facing Mongolia. The Mongolian economy had been relatively small, largely isolated with its landlocked geography, and heavily dependent on the former Union of Soviet Socialist Republics (USSR). The production, transportation, and electricity systems of Mongolia were completely integrated with a rigid division of labor and specialization that enhanced interdependence and reliance on the former USSR. In retrospect, it is evident that the transition process to a market economy was not just a simple matter of reforming policies; redefining the role of the government; or liberalizing foreign exchange, investment, and price regimes. It also meant effectively dealing with the challenges posed by the sudden withdrawal of amounts of large aid, and serious disruptions in Mongolia’s trading links and vital infrastructure supplies. 11. The Program adopted the orthodox view that establishing market conditions would automatically generate economic growth and thus it contained a typical blueprint of reforms of price and trade liberalization, privatization, encouragement of inward foreign investment, and setting up an institutional and legal framework.5In terms of priorities, the Mongolian economy needed a strategy for smooth transition with investments in infrastructure, energy, and basic needs and a gradual approach to reform. There was a need to begin work on the financial sector restructuring to enhance resource flows. Though a TA preceded the Program, the sector analysis was weak and no effort was made to check whether any industrial activity could have survived the complete and sudden opening of the economy. Given the weak design, the Program did not facilitate a smooth transition as was envisaged in the interim strategy.
B. Implementation of Policy Reforms
12. Appendix 1 provides detailed information on the implementation of all 31 policy actions of the Program at the time of the PCR, and progress made since then. All policy actions except three policy covenants were complied with. The following paragraphs summarize actual progress for seven major components identified in the Program. 13.Dismantling Price and Supply Controls.The Program aimed to accelerate dismantling of the price and supply controls imposed on the Mongolian economy during the supply shock of the early 1990s. A rationing system had been put in place in January 1991. The economy was subject to state procurement orders for domestic and foreign trade for food and raw materials. The prices for these procurements were predetermined, rather than market driven. Though all these measures were temporary, they were in force at the design stage of the Program. The policy covenants required these controls to be dismantled prior to ADB Board consideration. Except for the utility tariffs and energy prices, all controls on wholesale and retail prices were removed. This was considered an essential first step in industrial sector restructuring. 14.Liberalization of Foreign Exchange and Trade.Mongolia abolished the export registration system and export prices are now market driven. Mongolia officially joined the World Trade Organization in January 1997. During loan implementation, the Government introduced an export                                                   4 Bank's Interim Country Strategy in Mongolia, October 1991. The 5 With hindsight, one could conclude that it was unrealistic to expect large foreign investment in remote areas such as Mongolia at a time when the breakup of the former USSR in the early 1990s presented large-scale investment opportunities in Europe and Central Asia.
 
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ban on raw cashmere that was withdrawn in October 1996. This was later changed to an export tax of Tug4,000 per kilogram or about 10 percent of the market price. Other commodities subject to export tax are raw camel wool, wood and wood products, gold, and copper scrap material. The foreign exchange regime was liberalized and the scheme for surrender of foreign exchange by all enterprises was abolished. All importers have access to foreign exchange. As a World Trade Organization member, Mongolia has also adopted transparency in overall trade policy and all relevant regulations and orders are subject to public notice. An amendment to the Foreign Investment Law was submitted to Parliament last year, but could not be passed due to the elections. Recently, the Government introduced a "one stop service" for foreign investments to streamline various government approvals (such as those from the Customs Office, Tax Department, State Registry Office, and labor coordination units). 15.Privatization and Enhanced Enterprise Governance. The Program aimed to institutionalize enterprise governance including autonomy and accountability, to ensure effective performance of industrial enterprises. To achieve this objective, the Program included phased divestments of government ownership in the medium and large state-owned enterprises (SOEs) under the “blue voucher” scheme. The first phase included divestment of state holdings in 250 medium- and large-sized units to less than 50 percent in December 1993 and to less than 40 percent by the end of the Program in March 1996. The data on privatization are fragmented and not very accurate. As per the State Property Committee (SPC), at the end of June 2000 the Government held substantial shares in 110 units accounting for about $1 billion in equity.6As per data from the Mongolian Stock Exchange (MSE), 328 listed companies are fully privatized, but these are relatively small companies. The Government continues to hold significant shareholdings in 85 listed companies accounting for over 45 percent of total equity listed on the MSE even for these partially privatized companies. Appendix 2 presents a detailed account of privatization in Mongolia. The other components for corporate governance improvements for privatized units included training for managers of privatized units and the launch of secondary trading in shares. A three-day residential training course was held at the Mongolian Management Institute for 25 senior managers of SOEs. Several practical sessions for on-the-job training were held. Secondary share trading of shares began on 28 August 1995, but trading volumes have always been very thin, partly because the listing requirements are very complicated.7Though there was an initial delay, secondary trading has helped to consolidate ownership in some companies. A bankruptcy law was seen as a centerpiece of the exit policy and this was approved in 1997, but it has never been used and not a single unit has been closed under this law. 16.Commercial Operations in the Financial Sector.The Government was to prepare a time-bound action plan for transferring ownership and governance of commercial banks to the private sector. This policy covenant became part of the subsequent financial sector program loan; a large number of banks have been privatized and only three banks remain state owned. Plans for restructuring and privatizing two banks, including the Trade and Development Bank, are in preparation using bilateral assistance. 17.Legal and Regulatory Framework.A TA was provided to carry out a comprehensive review of existing and pending laws affecting the industrial sector, i.e., laws relating to companies, contracts, security transactions, bankruptcy, foreign investments, and the industrial environment. The Government has introduced 10 laws and amendments to laws for establishing a legal framework for the industrial sector. The Government has also approved several action plans relating                                                   6units were transferred to local governments or deleted from the This only reflects what remains with SPC. A number of  original list to be privatized. As per the data published by SPC in January 1998, 126 large units had full state ownership and 134 units had significant government shares. 7 The listing requirements reflected developed country concerns and maturity of institutions, whereas what Mongolia needed was a simple tool for consolidating shareholdings. Most companies do not meet these requirements, which, in practice, are simply ignored.