Mongolia Quarterly Economic Update - January 2011

January 28, 2011

The economy continues to recover with most sectors rebounding strongly from the sharp drop in output in late 2008 and early 2009. Preliminary estimates suggest that real GDP grew by 6.1 percent year-on-year in 2010, following an outturn of minus 1.3 percent in 2009. However, winter arrived in Mongolia with the agriculture sector still feeling the impact from last year’s dzud. The sector has now experienced double-digit contractions for the third quarter in a row.

Consumer prices continued their upward trend, with the latest December data showing a rise in the headline UB inflation to 14 percent yoy following 12 percent yoy increase the previous month. On the inflation front, a perfect storm is gathering, created by a powerful combination of external and internal pressures. Global monetary policies and food supplies, and rising food inflation in China and Russia, from which Mongolia imports several food products such as vegetables and grain, suggest that continued inflationary pressures can be expected from the external environment. Domestically, Mongolia’s booming economy is running into capacity constraints, while the adverse impact of the recent dzud continues to be felt through high meat prices. Finally, the 2011 budget approved a large increase in public spending, including substantial cash handouts to the population. Hence, we expect continued strong upward pressure on prices during 2011.

The exchange rate against the US dollar has been slowly appreciating back to the pre-crisis level. In December 2010, the average monthly exchange rate against the US$ appreciated by 3.0 percent, compared to the previous month, or 15 percent compared to December 2009.

The latest fiscal data show continuing improvement in Mongolia’s public finances, reflecting the underlying improvement in the economy and the recovery in commodity prices. The outturn for 2010 is a balanced budget. However, the recently approved 2011 Budget of Mongolia envisages a steep increase in government spending, together with a sharp rise in the fiscal deficit to an unprecedented 9.9 percent of GDP. It sets the record of the largest budget in the history of Mongolia (MNT 4.0 trillion) amounting to more than half of GDP. Our analysis shows that it will compound already existing inflationary pressures caused by the sharp economic rebound and the lack of spare capacity in the economy. This pro-cyclical spending pattern goes against the spirit of the new Fiscal Stability Law and will make it difficult to make the transition to a cyclically-adjusted fiscal deficit of no more than 2 percent of GDP starting 2013.

And while the 12-month rolling trade deficit improved considerably over the past year, narrowing to US$ 146 million in June 2010, from US$ 1086 million in February 2009, in recent months it started to widen again, reaching US$ 379 million in December 2010. Imports are rising sharply as the economy expands, driven by fuel, transport equipment and machinery as the construction of the Oyu Tolgoi copper mine and related infrastructure projects are ramped up. As a result, the current account deficit widened to around 9.8 percent of GDP in the third quarter of 2010, after narrowing to 7.4 percent in the previous quarter on 4-quarter rolling sum basis.

In the banking sector, NPLs and loans in arrears still stand high at 16 percent of total outstanding loans in December. While real interest rates on deposits are falling, MNT deposits continue to rise fuelled by currency appreciation expectations and supported by the deposit guarantee law. However, interest rates on US dollar deposits are also very high, with time deposits offering rates reaching 14 percent, reflecting the continued perception of risk by the market. There is a significant increase in private overseas borrowing. This development merits close monitoring by the central bank: they are likely to be unhedged, and could leave borrowers vulnerable to unexpected reversals in capital inflows. It is vital that the banking restructuring reforms, driven by the need to improve bank balance sheets, move forward in order to strictly enforce the existing regulatory policies without fear or favor.

The latest survey conducted in informal labor markets in December 2010 revealed a reduction in number of casual workers by about 40 percent compared to September due to the seasonal closure of construction labor markets, and reduced outdoor sales activities due to cold weather. Workers’ real informal market wages on average decreased by about 30 percent from September to December 2010. Reduced job opportunities during the winter months, combined with rising inflation, explain the decline in real wages of the most vulnerable in society.

Mongolia has made significant progress in improving budget transparency, but there is still considerable room for improvement vis-à-vis public investment management. The recommendations of a recent World Bank technical assistance mission to Mongolia on improving the public investment planning and budgeting system are delivered at a critical time when several draft laws on public finance issues — the Integrated Budget Law (IBL) and the Law on Development Policy and Planning, as well as a revised law on public procurement — are under discussion, and the implementation of public-private partnerships (PPPs) is being considered. Mongolia also plans to establish a Development Bank during 2011. The Bank will use a portion of the proceeds from the Fiscal Stability Fund to finance its long term infrastructure needs. In this Update, we discuss some of the principles that should be taken into consideration when setting up the Development Bank, based on international experience.

Finally, although Mongolia’s laws are easily accessible online and court processes are generally impartial and transparent, the predictability of court decisions is limited and the courts, enforcement and registration agencies are often perceived as corrupt by the public. However, the Ministry of Justice and Home Affairs of Mongolia has adopted a program to increase awareness and training on legal rights and how to access these.