offices of Mongolian banks in South Korea. The sharp drop in Mongolia’s exports of textiles and apparel has had a modest net external effect because garments were manufactured mostly using imported inputs.<sup>22</sup> Given the excess liquidity in the banking system in 2005, we conclude that it is not low domestic saving, but poor financial intermediation that has been primarily responsible for the high cost of capital in Mongolia. The Work Bank’s recent investment climate report (World Bank 2006b) provides compelling evidence that, with the possible exception of the wholesale and retail trade sector,<sup>23</sup> the degree of bank-based financial intermediation in business activity, even though improving is still very low in Mongolia.<sup>24</sup> Domestic commercial bank deposit rates remain high in Mongolia compared to other emerging countries, in part due to intensive competition among financial institutions in recent years that has exerted an upward pressure on bank deposit rates, and in turn, on the commercial bank lending rates. In spite of ample liquidity in the banking system, banks—motivated, by the desire to expand their market shares—remain aggressive in attracting depositors by offering high deposit rates, and compressing their interest margins (Figure 5).<sup>25</sup> In fact, the average returns on commercial bank assets have declined from around 4 percent in 2002 to only 1.4 percent in 2005. In an attempt to consolidate the banking sector, the Bank of Mongolia stipulated an increase in the minimum paid-up capital requirement for commercial banks in Mongolia (from MNT 4 billion to MNT 8 billion). This attempt seemed to have failed since the vast majority of existing banks (16 out of 17) met this new threshold quickly without having to close down or merge with other banks.

The spreads between deposit and lending rates are also high compared to other countries (Figure 5). This is largely due to the difficulty banks have in assessing credit risk. In addition, the profitability of bank’s non-lending assets remains low since their operating costs and required reserve ratio are high by international standards. According to firm findings of the Mongolia’s Investment Climate Report (World Bank 2006b), the difficulty in assessing credit risk derives from a number of sources. The most important ones being poor corporate governance, and the lack of transparency in business operations, which makes it difficult for potential lenders to assess borrowers’ creditworthiness.

The weakness of the bankruptcy and debt recovery framework in Mongolia translate into increased risks and costs of banking business. World Bank Investment Climate survey data show that bankruptcy claimants recover only 17 percent of total claims from insolvent firms in Mongolia, on average, compared to 24 percent for East Asia as a

> 22 The lifting of quotas on exports of textiles and apparel from China in 2005 had a negative effect on Mongolia’s textile industry as many foreign-owned companies left Mongolia and relocated in China.

> 23 The wholesale and retail sector was not covered by the Productivity and Investment Climate Survey (2004), which was the basis for the investment climate report. Also not covered by the survey are firms that failed and startups that did not make it.

> 24 The degree of bank-based financial intermediation has increased in 2005 as the M2/GDP ratio rose to 52 percent from 47 percent in 2004 and credit expanded at the highest pace since 1996.

> 25 In 2005 the Central Bank reduced the coupon rate on its bonds and augmented liquidity in the banking system (World Bank 2006c).

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