Mongolia: Crisis as an Opportunity
Mongolia has managed the transition of its economy and politics since 1991 very well.
It has a functioning democracy, market economy, robust press, active civil society, incomes have risen, and new growth areas like services have increased. Mongolia is amongst the top reformer among transition economies.
Mongolians should feel proud about these achievements.
But even if Mongolia does well on these rankings today, it must continue to improve, because other countries are trying to do better. Each competes to make its economy, market and institutions more attractive.
With the global economy in recession, credit flows still tight, businesses are holding back on expansion. In such a situation, having a stable economy and good investment climate that is predictable and transparent is critical. What lessons can we draw from other countries in going about this task?
Let me focus on just 3: those that are particularly relevant to commodity and mineral based economies.
I. Ensuring macro-economic stability
Mongolia’s economic growth has slowed down significantly and may barely reach 3% this year, down from the 9% on average it has enjoyed over the past four years.
What went wrong?
It is well known that Mongolia’s downturn was led by the copper price collapse, an external factor. What may be less understood is that policy errors have magnified this impact.
Natural resources contribute significant amounts to Mongolia’s GDP so large fluctuations in commodity prices increase the tendency towards extreme boom-bust cycles. These effects are increased by pro-cyclical access to capital markets and pro-cyclical spending. Everyone wants to lend money when people don’t need it! And everyone wants to spend when they should actually be saving!
Mexico got hit badly when it borrowed heavily against incorrect expectations of increasing real oil prices after 1981. And Nigeria whose spending increases outpaced revenue increases up to 1984 before it was forced to drastically cut spending because of the debt it had amassed.
During the “boom” years when copper was $8900 per tonne back in mid-April 2008, Mongolia saved a bit but it also funded large increases in untargeted social expenditures, civil service wages and poorly screened investment projects. When the “boom” turned “bust” and the copper price fell to $2700 the modest fiscal surplus quickly turned into a large deficit. At the same time, the current account also switched into deficit and the financial sector, which had been overheating during the boom period, encountered problems.
High spending from current mineral income translates income volatility into expenditure and exchange rate volatility with potentially serious negative macroeconomic consequences. Volatility can be a tax on investment as businesses are unable to plan with confidence. Experience has shown that high volatility slows down productivity growth substantially, especially in countries with a relatively underdeveloped financial sector.
So what policy objectives should be pursued in such circumstances?
Because mineral revenues are temporary, how can future generations share in the wealth? So the first aim is to distribute fairly the benefits over generations.Resource income unavoidably leads to real appreciation. So one has to worry about competitiveness of the economy and most of the resources going into the mining sector so the goal here should be to spread spending out into the future and smoothing its time profile: more in times of need, less when there is plenty.
Mineral revenues are tied closely to world commodity prices and therefore excessively volatile. How should this volatility be managed? Here, the aim should be to isolate instability by channeling volatile revenues through a fund from which a stable flow is released to the budget for spending purposes.
This issue became clear in Mongolia when revenue fell sharply in 2008 and total expenditure remained steady and as a result a large fiscal gap opened leading to a 5% of GDP fiscal deficit for the 2008 fiscal year.
So how to prevent this kind of thing happening again and again as cycles continue?
There are options to do this which should be debated in Mongolia but one possible way is to transfer all the mining revenues to a dedicated resource fund, like what was done in Chile and Norway, and to then introduce a rule governing the transfer of resources from the Fund to the budget. Mongolia has a development fund. But the rules for spending are very much linked to current revenue. Instead, Mongolia could consider rules other countries use:
The permanent income rule whereby transfers from the resource fund are set at a level that can be maintained given
expectations about future extraction and prices; Expenditure from the fund are restricted to its real interest income, as is done in Norway; and a reference price mechanism to stabilize fiscal spending around the longer term trend. Chile ’s Copper Stabilization Fund works, together with a structural surplus rule to stabilize its spending. These rules have different implications for the three policy objectives. I can’t say which will work best for Mongolia. That’s for you to debate. But the time to consider such policies is NOW.
On the monetary and exchange rate side negative real interest rates, high inflation and an inflexible exchange rate policy led to liquidity shortages and weakening of the Tugrik.
In response, The Central Bank has raised interest rates to boost Tugrik deposits and restored the saving-borrowing balance which allowed it to better manage the exchange rate, without incurring further loss of international reserves.
These measures are helpful and will help provide macro-stability. The next thing is to keep the environment attractive for business.
II. Improving the climate for doing business
To broaden its comparative advantage and overcome the physical and geographical barriers of being remote and landlocked, Mongolia should establish man made advantages. Improving the investment climate is the best way. In doing so what areas should Mongolia focus on?
Developing good logistics to reduce business costs. In doing business, Mongolia does okay. I understand Mongolia aims at becoming a top-10 destination for doing business in Asia. That is welcomed. But, Mongolia scores poorly in the Logistics Performance Index. It is ranked 136th of 150 countries.
Poor logistics due to geography don’t necessarily condemn a country to poor export performance. Mauritius has been successful in diversifying away from sugar production to textiles, garments and financial services even though it was ranked 132nd on the Logistics Performance Index. So, better coordination between transport, customs, clearance, and warehousing will go a long way to improving the current situation.
Reliable infrastructure. Infrastructure bottlenecks mean costly transport, complex logistics and long transit times. In Mongolia, one third of windfall gains collected by the Development Fund are spent on infrastructure as is significant amounts received through development aid. It is important these funds are used efficiently. Good economic management and governance can reduce infrastructure bottlenecks and other business costs by improving roads, power systems, security and financial systems. This will increase Mongolia ’s competitive advantage in its established markets, including copper, gold and cashmere, and provide the foundations for a wider range of other industries to become competitive.
Korea is a good example, whose infrastructure had been completely destroyed by the end of the Korean War in 1953. It is now one of the wealthiest countries in Asia with very advanced infrastructure, and a Logistics Performance Index ranking of 25th.
Improvements in the financial sector. Problems in the financial sector are central to confidence concerns. Establishing strong foundations may prevent future crises. Measures are needed to improve financial and capital market oversight and regulations, to raise standards around corporate governance and to improve financial institutions, perhaps most immediately those involved with trade finance. Instituting measures that improve transparency and accountability in the financial sector are critical to rebuilding and maintaining confidence off-setting, at least in part, higher costs of capital. More overseas investment would encourage more Mongolians to keep their money in the Mongolian banking system.
Keeping mining development competitive. Mongolia must compete forcefully to attract investments because of the economic crisis. This means examining what policies make most sense for the mining sector in the current environment and the future. Mongolia’s mining sector could contribute significantly to economic growth but its development is being limited by a lack of clear and stable policies, regimes and legal frameworks. Mongolia can maximize this industry’s potential and build best practice governance, by developing:
- A clear policy stating the role of government in promoting and enhancing the sector;
- A competitive, stable and predictable fiscal regime for mining;
- A stable and transparent legal and regulatory framework to manage the development of its mineral wealth,
- Policies and procedures to attract, and retain, world class investors with the resources, management and technology to locate and sustainably exploit mineral deposits;
- Efficient sector institutions and strong administrative capacity for oversight,
- Appropriate policy responses to, and transparent management of expected increases in mineral revenues to avoid the “resource curse” and ensure lasting benefits,
- Ensuring sound corporate governance and
- Protecting the environment.
Public-Private Partnerships to encourage new sectors. Export diversification does not need to mean diversification towards manufacturing or heavy industry, which could go against Mongolia. Chile has active policies that encourage a range of new exports such as salmon, fruit and wine. These have involved Public-Private Partnerships with industry groups - supporting knowledge sharing and setting high standards, etc. The need to be competitive on external markets has always been the driving force behind such policies not to protect the domestic market against imports.
III. Maintaining and Improving Governance and Institutions
Most global measures of governance rank Mongolia in the middle and in the top quintile when compared to countries with similar incomes. Compared with transition economies, EBRD ranked Mongolia top in 2007, and among the top in 2008. In Doing Business, Mongolia ranked between 41-58 among 181countries in the last 3 years, and among the top 10 out of 57 lower to middle-income countries. However, the Doing Business indicators suggest the trends are in the wrong direction.
Mongolia starts from a good institutional basis. Despite recent political uncertainty and frequent turnovers it is a relatively well functioning democracy. Unlike many undeveloped mineral exporters, it is a peaceful country with a good world image. These assets are important for its long-term development.
The quality of institutions is critical in determining whether countries avoid the resource curse or not.
Studies show that natural resources only have a negative impact on growth performance among countries with inferior institutions.
Chile, Malaysia and Indonesia share elements that support good resource management and the effective use of resource income:
- They have two goals: preserving social stability and widely-shared growth,
- There is a fairly broad basis of support for these goals, and
- There are close relationships between politicians and technocrats equipped to deal with resource management problems.
Mongolia should consider three things to ensure the maintenance and improvement of its institutions and avoid the resource curse.
Ensuring political stability and building capacity and understanding amongst Mongolian politicians and people can contribute to resources being used to promote long-term sustained growth. Amidst failures around it in Afriaca, Botswana has been successful because of good institutions and stable politics. Politicians understand the management issues involved and work with technocrats effectively.
A transparent political system and a long-term focus are important to ensure natural resources are used to benefit the entire population. Many commentators have drawn attention to the low levels of transparency and accountability in many natural resource exporting countries and the implications for development.
Poor governance is a problem not only between the citizen owners of the resource and their agent (the host government), but between the host government (acting as principal on behalf of the citizens to manage and spend income) and the foreign mining companies (the ultimate agent). Whether governments can successfully play this double role depends on whether transparency is good enough to ensure the government acts as an effective principal and the extent to which it is accountable to the citizenry. It is important to develop transparent mechanisms to enhance public oversight of mining revenue expenditures and ensure accountability. With completion of the EITI validation process Mongolia stands a chance to be among only two countries in the world next year to become EITI compliant which is heartening.
Stemming corruption can significantly reduce business costs. Unofficial payments required for obtaining licenses, starting businesses and exporting or importing products pose a serious obstacle to growth. An expansion of patronage networks embedded in political parties and regional and business networks leads to serious consequences for corruption levels and therefore growth.
No reform is complete unless it takes care of the poor and vulnerable. More can and should be done for the poor particularly regarding targeted social welfare transfers, improved access to education and health services, and developed safety nets for both urban and rural dwellers. This is so each time a crisis comes the poor aren’t forced to start their lives again.
Mongolia is not alone. The World Bank will assist it weather this economic storm and to support the poor and vulnerable get through this crisis. The Bank can help strengthen policies and build institutional capacity to reduce future vulnerability; this will include coordinated complementary support to help the Government overhaul its system of social protection.
Our projects aimed at improving rural livelihoods and the hardships of herders will continue. Our agenda to ensure the vulnerable in Ulaanbaatar have support and access to basic needs will be ongoing. And we will work with out external partners to make sure the effort is effective.
I have met many here in Mongolia who are optimistic for the future and I agree with them. There is great potential in this great nation and I believe that once the dust settles from this economic storm Mongolia’s march will continue…..