The data needed to empirically estimate (5) are not available in most low-income countries, in general, and in a transition economy like Mongolia<sup>5</sup> in particular. Therefore, an application of the Hausmann, Rodrik and Velasco (2005) framework requires one to analyze carefully each group of factors that affects the rate of return or the cost of capital and represents a branch of the “growth diagnostic tree” (Figure 1) in order to select the ‘most’ binding constraints to private sector investment and entrepreneurship in a country.

It is important to note that governments face other important welfare improving objectives, for instance, improving social safety nets and addressing other social concerns including environmental problems but these may not be necessarily or directly related to country’s growth priorities in the short-term.<sup>6</sup> While this growth diagnostics methodology seems simple, in practice as cited in Leipziger and Zagha (2005) it is “a disciplined art” that requires in-depth knowledge of the Mongolian economy.

Recent economic growth literature suggests that when constraints are “binding”, they result in activities that are designed to get around them.<sup>7</sup> Symptoms that one sees under these circumstances include: high taxes; high degree of informality in economic activities; poor legal institutions; high demand for informal mechanisms of conflict resolution and enforcement; poor financial intermediation; and internationalization of finance through business groups/connected lending operations; among others.

In applying the growth diagnostic methodology to the case of Mongolia we rely both on direct and indirect evidence to identify “bottlenecks” to economic growth. In addition, since the aggregate picture typically hides important details at the industry level, we use aggregate as well as industry and firm-level data. With the exception of livestock herding, the official GDP statistics on which we rely do not capture the activities of Mongolia’s large and growing informal sector, which produced output equivalent to 18 percent of GDP<sup>8</sup> and employed as much as 35 percent of Mongolia’s working-age population in 2005,<sup>9</sup> compared to 20 percent in the early nineties. Official export data understate the importance of cashmere exports since a large share of raw cashmere gets smuggled to China every year.<sup>10</sup> The rise of artisanal mining activities implies a downward bias in statistics of output and employment in the mining sector (World Bank 2003).

> 5 Consistent data series prior to Mongolia’s 1993 transition are unavailable for most key variables and at the desired level of disaggregation.

> 6 Economic growth is also influenced by religious, cultural, social conditions and beliefs. These factors while not explicitly part of the growth diagnostic framework can be addressed successfully through effective implementation of judicial laws. Examples from the countries in Central and Eastern Europe which joined the EU in recent years suggest that harmonization of legal frameworks is as an effective way of addressing differences including those stemming from religion and culture.

> 7 See Hausmann, Rodrik, Velasco (2005) and Rodrik (2004a and 2004b).

> 8 Source: World Bank (2006a).

> 9 Authors’ estimates based on data from the Government of Mongolia that indicate an increase of 23 percent in the number of “non-employed” people and a forty percent decline in registered unemployed. 10According to World Bank (2003) in 2002 over 38 percent of the raw cashmere produced was smuggled to China.

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