Herders have lacked access to finance, information and infrastructure in order to improve the quality of their cashmere. Processors could have helped herders to improve the quality of raw cashmere but have been reluctant to enter into direct marketing or vertical relationships with them because of lack of transparent and enforceable contracting rules, and the difficulty to police such arrangements due to the small size of herds per household and the long term nature of the investment.

The problem has been compounded by lack of market information available to herders, and the fact that processors have had no incentive to form strategic links with downstream agents and to improve their productivity<sup>50</sup> as government policies generally favor them. The export tax on raw cashmere has provided incentives to processors to offer the same price regardless of quality. Herders have responded by smuggling cashmere to China, selling quality raw cashmere to Chinese buyers, depriving domestic processing firms of high quality raw material, and forcing them to operate below capacity. High labor costs, unreliable energy supply, lack of technical skills, non-tax administrative barriers, and high transport costs have added to the problems of Mongolian cashmere processing firms.<sup>51</sup> Another example of a coordination failure is the government’s inability to regulate the use of critical inputs such as land and water which have led to overgrazing, near saturation of land-use capacity, and soil erosion in Mongolia. Lack of regulation of water well use and poor public sector maintenance have decreased agricultural productivity and have left herders searching long distances for water facilities. The combination of these failures and the lack of risk management have worsened the impact of bad weather on the farm sector. Since sustainability considerations preclude further growth in the size of Mongolia’s herds, it is essential to improve quality and efficiency by providing additional services to farmers.<sup>52</sup> There remains the need to coordinate the development of an international rail/road network to facilitate transit, international, and domestic trade, and air transport to facilitate tourism and international trade. Mongolia’s poor transport network is a severe constraint to most activities in Mongolia including. Custom facilitation and transit procedures also need to be improved, as well as marketing, export promotion and product quality information, which is critical to the success of companies but somewhat scarce in Mongolia.<sup>53</sup> Many medium and small companies and companies operating in the informal

> 50 Labor productivity in Mongolia’s cashmere processing companies is much lower than that in other countries (USAID, 2006)

> 51 A study by USAID (2006) found that overall the manufacturing quality of cashmere apparel makers is good.

> 52 With the outbreak of the Hoof and Mouth Disease in Mongolia in 2001 China and Russia banned exports of all animal products causing substantial losses in income of herders and processors and a dramatic decline in exports of meat products. Surveillance, diagnosis and mitigation (including vaccination programs) need to be strengthened in Mongolia, as well as access to information on sanitary and phyto-sanitary standards in other countries.

53 According to Otsuka (2006) information about and access to markets, and access to specialized skills needed to improve product quality are critical to multi-faceted innovation, while access to credit matters only after multi-faceted innovation has taken place. His findings are based on research in a number of countries including China, Taiwan, Vietnam and Africa.

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