IMF: MONGOLIAN ECONOMY OVERHEATING, RETURN OF BOOM-BUST APPROACH, GLOBAL ECONOMIC OUTLOOK WORSENING FOR MONGOLIAN COMMODITIES

International Monetary Fund (IMF) mission visited Mongolia during September 14 – 20, 2011, to hold Post-Program Monitoring discussions. The team met with the Mongolian authorities and others to discuss recent macroeconomic developments and policies and at the conclusion made the following statement:

• The Mongolian economy has made a remarkable turnaround from the recent crisis. This success reflected the authorities’ commitment to pursue sound macroeconomic policies, a recovery in copper prices, and timely support from the international community. With coal output rapidly increasing and two massive mining projects in the pipeline, Mongolia has a bright economic future and an opportunity to spread prosperity to all of its citizens.

• Against this backdrop, we have decided to withdraw our resident representative at the end of the month. We would like to thank Mr. Ramlogan for his dedication and service over the past few years. Our decision reflects the Mongolian economy’s speedy recovery from the recent crisis, rapidly rising income per capita, and our own budget constraints. We place great value on our relationship with the Mongolia and are fully committed to maintaining our close cooperation.

• we have had in-depth discussions with the authorities on the economic outlook and policy challenges. We believe that Mongolia has a bright economic future as it continues to develop its vast mineral resources. In the near term, however, we see substantial risks to the economic outlook.

• First, the economy is overheating. Inflation is already high and likely to rise further, which is exacting an especially heavy burden on the poor, and eroding the ability of Mongolia’s private sector to operate effectively. Rather than contending with these pressures, macroeconomic policies have returned to the boom-bust approach that culminated in the last crisis in 2009. Second, this heightened domestic risks of macroeconomic instability come at a time when the global economic outlook is worsening. Should international commodity prices fall sharply Mongolia’s exports and budget revenues would both be hit hard. The policies to address both high and rising inflation and to lessen vulnerabilities are clear: restrain fiscal spending and tighten monetary policy.

• The 2011 budget already included a sharp increase in spending of around 30 percent. This is a key factor behind the current overheating. Now the government has proposed a further increase in spending of 6½ percent of GDP just in the fourth quarter of this year. Such an increase would be highly risky and ill-advised. GDP growth in the second quarter already exceeded 17 percent and imports of consumer goods have risen by more than 80 percent. Further fiscal spending would only add to fuel to this overheating economy at a time when it least needs it.

• Similarly, in the 2012 budget, spending should be kept at or below the level that parliament already approved in the medium-term budget framework. Within that budget envelope the government should introduce a targeted system of social transfers.

• Finally, the newly created development bank is of significant concern. The development bank should not be used as a means to circumvent the fiscal stability law or as a vehicle for off-budget government spending. Doing so will add to fiscal risks, reduce fiscal transparency, and undermine the credibility of the landmark fiscal stability law passed last year.

• The recent tightening of monetary policy is welcome, but more needs to be done. The central bank should use a variety of tools. The policy interest rate should be further increased. For much of the year it has remained below the pace of increase of underlying inflation, allowing for a very rapid pace of credit growth (now reaching nearly 50 percent in real terms). Interest rate hikes alone, however, will not be sufficient. In addition, a range of macro-prudential measures should be implemented to help slow the pace of credit growth. These include measures to increase capital adequacy requirements, start to require provisions on new lending, raise reserve requirements, and tighten liquidity ratios. At this stage in the business cycle it is especially important to proactively manage risks and strictly enforce prudential regulations in order to prevent the buildup of future credit quality problems in the banking system (as become painfully evident in 2009).

According to Frontier Research,

• While Mongolia has enjoyed significant economic growth over the past decade it is still a very small economy on the verge of another major expansion. Much of Mongolia’s fortunes will depend on future copper and coal prices which are significantly higher now than baseline scenarios in past GDP growth projections. While commodity prices might moderate we see a higher base as the more realistic scenario.
• Mining is the driving force behind the Mongolian economic expansion but also the reason for the current trade deficit; major investments lead to large imports of machinery and equipment. We see this reversing from 2013 when exports will start outpacing imports. Currently mining comprises 22% of overall GDP and the sector expanded an impressive 40% in 2010. Agriculture, the second largest sector expanded at “just” 21%. This trend will continue in the future not only accelerating growth but also making the country more prone to “Dutch disease”. The challenge for Mongolia is to not fall in the trap that many other resource rich countries ran into. The fact that 85% of total exports go to China and more that 60% of mining exports are either coal or copper further concentrates Mongolia’s prospects. Nevertheless we are optimistic that Mongolia will overcome most challenges since the country should be able to deliver coal and copper more cost efficiently than any other producer to two major markets; China and Russia. The current reliance on China forces Mongolia to sell coal at a 40% discount; while this is obviously a disadvantage it means current revenues are coming from a low base with more upside in the long run. For this reason, market diversification is needed and hence railways will be crucial; while there are plenty of plans for new lines, financing is difficult and significant results are probably many years down the road.
• On the monetary front inflation has been very volatile ranging from 30% to flat out deflation in the course of just one year (2008/2009). Inflation has recently picked up again and is currently 9% and with recent rapid money growth, food price increases and expected fiscal expansion we expect this to be towards 14% by the end of 2011 only to moderate post-election in 2012.
• From 2013 the new fiscal stability law will come into force limiting the ability of the government to spend and borrow. It will then also become easier for the Bank of Mongolia to manage money flows as most major mining equipment investments for Oyo Tolgoi will have been dealt with. The Mongolian Tögrög (MNT) has been the second best performing currency vs. the USD in 2010 and we expect further mild appreciation or at least stability due to large capital inflows. With continued high real GDP growth the real exchange rate will have to adjust, either through nominal appreciation or inflation. It will likely be a combination of both with most adjustment coming through inflation. A sharp depreciation would cause issues for both government debt (relatively modest at 43% of GDP) and the banking sector. It would also import inflation thus the BOM will remain vigilant to prevent any major moves.

• The regulatory framework and the banking sector, while improving, are still fragile. In a small economy like Mongolia many interests are linked leaving the system open to shocks. We do see efforts by politicians to implement reforms and believe that after the election next year the need for populist policies will diminish. Overall, as expected in any frontier growth market, there are many opportunities but also plenty of challenges in Mongolia. On balance we are confident that Mongolia is set for some spectacular growth and that risk factors will not derail its progress, perhaps only slow it down.

CHIEF INVESTMENT STRATEGIST

Dale Choi

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