to free up the funding that is needed for the large infrastructure projects to develop the Southern Gobi mines. Why? Because (a) this risks hurting their re-election chances and (b) without some safeguarding of the mega-projects, a few privileged MPs — those who are able to secure these large contracts — will gain at the expense of a majority whose projects cannot get funded. The identity of these winners will be uncertain ex ante. The collective result will be that such projects will not be developed, which will hurt all MPs. Therefore, budget, planning, and procurement reforms that put in place checks and balances and collectively limit all MPs ability to influence these projects, and do not advantage or disadvantage any one particular faction will be incentive compatible.

- The corollary to the above, given the strong public demand for seeing some of the benefits of natural resources, some constituency specific projects are politically necessary.  Indeed, protection of mega-projects would need to be part of a bargain that also allows geographical targeting of some percentage of the capital budget.  These projects will most likely be uneconomic; but without them, MPs cannot get re-elected.  The focus should therefore be to ensure that (a) these projects are properly prepared, in particular that their cost estimations are accurate and community consultation is institutionalized; and (b) that they cumulatively amount to a small proportion — less than 20 percent — of the annual capital budget.

- The functional form for safeguarding large, strategic national infrastructure projects will also need to be incentive compatible.  In Mongolia, MPs will reject an all-powerful Ministry of Finance that combines the planning and budgeting function as this will privilege one political faction (e.g. led by the Minister Finance) over others.  Instead, a division of responsibilities between a central planning agency (e.g. a Ministry of Planning), the Ministry of Finance, and line ministries will be incentive compatible as it provides representation to the various political factions.  The focus of reforms should then be to ensure that proper coordination mechanisms exist between the three agencies.

- A similar logic of safeguarding large projects that benefit all constituencies while allowing targeted benefits to flow from smaller projects applies to procurement arrangements. International procurement standards of competitive bidding and transparency will be incentive compatible for the large mining infrastructure projects precisely because the stakes are so high and a particular political faction could become too powerful.  However, for smaller projects collusive practices will be difficult to prevent, particularly given the less interest of international companies.

The paper is inductive in its structure. Section 2 analyzes the broader public expenditure patterns in Mongolia in order to identify policy-makers priorities (i.e. revealed preferences), and then digs deeper into the public investment management system, identifying the main technical and structural weaknesses in the system.<sup>3</sup> Section 3 analyzes what interests of key political actors are served by poor investments. Given these political incentives, section 4 then proposes some incentive-compatible reform options.

# **2. Key Issues in Public Investment Management in Mongolia**

Mongolia, like many revenue rich and former socialist countries, has a big government as measured by revenue collection and public expenditures. As Figure 1 shows, public expenditures have averaged 30 percent to 40 percent of GDP over the past 5 years. Also like many resource-rich countries, expenditures have been highly pro-cyclical, in large part reflecting the trend in copper prices. Mongolia has gone

> 3 This section draws on World Bank (2010) and Finch & Fritz (2010).

4