MONGOLIA'S INFORMAL SECTOR Size and Trends 14

## **The Current Situation: Aggregate Informal Income in Ulaanbaatar**

34. The SSO household survey data can also be used to make inferences about the contribution of the informal sector to household income in Ulaanbaatar. The average household in Ulaanbaatar receives 22% of their income from informal sources. However, the aggregate impact is larger due to the fact that low income household are weighted the same as middle and higher income households. Many of the poorest households are pensioner households with no informal income. Reweighting to generate appropriate aggregates we find that 32% of household income in Ulaanbaatar is generated by informal activities.<sup>3</sup> "

# Trends and Current Size of the Informal Sector Implied by Monetary Aggregates

35. One family of techniques for estimating the size of the "underground economy" (economic activity hidden from authorities for the purpose of evading taxation or regulation) utilizes monetary aggregates.<sup>3</sup> " Most of the techniques in this family are based on the premise that cash is the preferred medium of exchange for underground activity, and the population's preference for cash relative to bank deposits serves as an indicator of the size of the underground economy. This concept is certainly no stranger to Mongolian policy makers. Citing "widespread violation of clauses" of several laws "including such practices as not registering their cash transactions in financial statements, hiding revenue for tax evasion purposes and illegal lending and usury activities," the Ministry of Finance and Mongolbank issued a joint resolution in 1993 mandating that cash in excess of 100,000 togrogs must be deposited in commercial banks on a daily basis"<sup>9</sup> A brief survey on informal finance undertaken as part of this study (discussed in more detail later in the report) confirms the isolation of the informal economy from the formal banking system. Of 30 informals questioned about their financial activities, not one used a commercial bank in any way.<sup>40</sup> 36. The simplest method utilizing monetary aggregates is the currency-ratio method: a base period is chosen for which it is assumed that little underground activity existed, and changes in the ratio of currency to demand deposits are therefore attributed to changes in the level of underground activity. The difference in the currency-ratio relative to the base period is multiplied by the actual income velocity of money to arrive at the estimate of the size of the underground economy. However, the currency-ratio method requires a degree of modification before being applied to the case of Mongolia. Even in the United States, this method has been criticized for failing to account for changes in household money management preference, and technological and financial innovations. In Mongolia, there have been sizable changes in the structure of the banking sector and shifting government policy toward banks. There have also been changes in the type of account preferred by consumers in response to changes in the rates payed by the banks.<sup>4</sup> ' Thus, applying the currency ratio technique to MI risks attributing to the underground economy some preference for cash that can be easily explained by a simple currency demand model.42 So, the technique is somewhat modified here by using M2 as the indicator of aboveground economic activity.

37. The results on the relative size of the "underground" economy are consistent with those found earlier. Applying the simple currency-ratio method to Mongolia, made somewhat more conservative by the use of M2, yields an estimate that the underground economy has grown since 1990 by an amount equal to roughly 23% of the "above-ground" economy at the end of 1996.4 Although there is no information about the size of the Mongolian underground economy in 1990, baseline assumptions of 10-