for copper and gold, when previously profitable operations may become non-viable, thereby potentially leading to a severe drop in economic activity and trade volumes. Finally, high trade costs impede the process of economic diversification in Mongolia – an issue that we turn to next.

# **_3.3.2 Do Mongolian Firms Innovate?_**

According to Hausmann and Rodrik (2003) diversification of the productive structure requires “discovery” of an economy’s cost structure. Firms must experiment with new product lines, adapt new technologies from abroad to local conditions, and “discover” which products they can produce at low enough cost to be profitable and competitive. Mongolia is the 37<sup>th</sup> least diversified economy among a group of 100 developing countries. Mongolia is less diversified than its comparators, which include other landlocked, resource-rich countries, except Cambodia (Figure 9).

Since 1990 Mongolia’s dependence on primary goods has grown and the top five exports in terms of value have claimed an ever increasing share of exports, which in 2004 was 90 percent (Figure 10). The manufacturing base is very narrow and in 2005 comprised of three product groups – metals, which accounted for 61 percent of manufactured exports, textiles (18 percent), and apparel (13 percent). All remaining products – including metal products - add up to just 8 percent of exports.<sup>47</sup> Even though Mongolia’s manufacturing base is narrow, it is not because firms do not _attempt_ to diversify into and export new products. As a way to assess the level of entrepreneurial effort or “self discovery” in Mongolia, we looked at the composition of newly exported goods in recent years. When measured at the 4 digit level of the Harmonized System the number of exported products has grown from 351 in 2002 to 462 in 2005 – an increase of 32 percent. The increase could have been much higher had Mongolian firms managed to lower the number of discontinued exports and had they not failed to continue exporting the majority of their new export lines. According to UN COMTRADE database every year during the period 2002-06 Mongolia exported on average 135 new product lines, but discontinued 98 products, of which 62 percent were new exports (Table 14).

While manufactured goods represented a large share of new exports, they also represented a large share of new exports that were _discontinued_ the following year. In 2003 and 2004 this share was 83 percent and 72 percent, respectively. This suggests that some Mongolian firms attempted to “innovate”, but failed to market these products abroad and maintain these export volumes. Table 15 displays the lists of discontinued new manufactured products in 2004 and 2005. The process of “self-discovery” has been hampered by high trade costs and a variety of negative coordination externalities discussed next.<sup>48</sup>

> 47 See also UNIDO (2002) – a report on Mongolia’s manufacturing sector.

> 48 Although economic diversification of a resource based economy poses many challenges, successes in a number of countries (such as Australia, Chile and Finland) show that it is possible to use natural resources to diversify within the natural resource sector, as well as move into new sectors. It is also possible not only to use mineral wealth to diversify within and out of mining, but to start exporting mineral know-how.

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