Mongolia: Selected Issues and Statistical Appendix

This Selected Issues paper analyzes the main determinants of inflation in Mongolia using empirical tests based on a structural model approach and vector autoregression model, with a view to assessing whether inflation is predominantly affected by commodity prices or by money supply developments. Simulation and impulse response analyses are used to estimate components of the inflation dynamics under various exogenous shocks. The paper also addresses the mineral wealth management issues faced by Mongolia, and describes the mining sector and its envisaged development over the medium term.


This Selected Issues paper analyzes the main determinants of inflation in Mongolia using empirical tests based on a structural model approach and vector autoregression model, with a view to assessing whether inflation is predominantly affected by commodity prices or by money supply developments. Simulation and impulse response analyses are used to estimate components of the inflation dynamics under various exogenous shocks. The paper also addresses the mineral wealth management issues faced by Mongolia, and describes the mining sector and its envisaged development over the medium term.

II. Long-Term Fiscal Sustainability in Mongolia7

A. Introduction

16. Mongolia’s public finances are heavily dependent on revenues from the non-oil mineral sector. Overall, revenues from copper, gold and coal mining made up 13¼ percent of total budget revenue in 2005. With further increases in copper prices since 2005 and recent mineral tax increases this ratio is expected to exceed 33 percent in 2006. However, the longer-term outlook is uncertain, as copper prices are expected to decline substantially over the medium term.8 Also, prospects for major foreign investment in the mining sector could be affected by recent tax increases and changes in the mining regime. Under these circumstances, revenues from mining sector may remain volatile.

17. The design of a sustainable fiscal policy in view of these developments is challenging and crucial for safeguarding growth prospects and reducing poverty. The authorities need to plan public expenditure taking into consideration revenue shocks arising from the volatility and unpredictability of mineral resource prices. They also need to adopt policies aimed at ensuring the sound management of the country’s mineral wealth for future generations. Mongolia faces similar problems as other countries that rely on their nonrenewable resources to finance government spending under the constraint of an uncertain and volatile revenue stream and an exhaustible supply of mineral resources.

18. The mineral resource boom, if effectively managed, could provide Mongolia with an opportunity to address a wide range of the country’s economic problems. Mineral revenues can potentially provide large resources to finance essential economic reforms to diversify the economy, strengthen is efficiency and alleviate widespread poverty, while cushioning the most vulnerable against the adverse impacts of future shocks.

19. International experience shows that resource booms can result in inefficient ad hoc spending decisions, particularly in countries that lack a clearly formulated medium-term policy framework. Thus, rather than using natural resource revenue to stabilize revenue flows or finance growth-enhancing capital expenditure, some countries have embarked on unsustainable policies based on short-lived natural resource booms.9 In some cases, countries borrowed heavily against their anticipated future income (e.g., Venezuela), while in other cases, governments granted large permanent wage increases (e.g., Nigeria) or launched ambitious investment projects with low economic rates of return (e.g., Algeria, Iran, Trinidad and Tobago).10

20. In addition to possible policy mismanagement, the volatility of the real effective exchange rate could have negative effects on the economy’s competitiveness. Dutch disease—which refers to the loss of competitiveness or deindustrialization of a country’s economy—could occur when the natural resource inspired boom raises the value of the domestic currency, making manufactured goods less competitive, increasing imports, and decreasing nonmineral exports. While some real effective exchange rate appreciation is inevitable during a boom, saving some of the income from the booming sector abroad in safe foreign assets or using it to pay off external debt ahead of schedule can help contain the growth in domestic demand and limit the real exchange rate appreciation and its adverse consequences.

21. This paper addresses the mineral wealth management issues faced by Mongolia. Section B describes Mongolia’s mining sector and its envisaged development over the medium term. Section C provides an analysis of Mongolia’s mineral wealth and discusses criteria on which the government could rely for deciding on the allocation of the country’s mineral wealth between saving and consumption. Section D assesses Mongolia’s medium-term fiscal sustainability. Section E discusses possible institutional responses to fiscal sustainability challenges, including a brief overview of country experiences. Section F concludes.

B. The Mining Sector in Mongolia

22. Mongolia’s mineral output stems mainly from copper, gold and coal mining. This paper illustrates fiscal sustainability challenges mainly in relation to these main natural resources. There are other important minerals, zinc for instance, but for lack of information these were not included in the analysis. This section first reviews the framework for mining taxation and mineral revenues derived, and then assesses expected mining sector developments.

Mining Sector Revenues

23. In addition to general taxes, firms in the mining sector are liable for royalties and a recently introduced “windfall tax”. The royalty is charged at a rate of 5 percent (increased from 2.5 percent in September 2006) on the value of sales of gold and copper. It does not allow for any deduction of costs. The “windfall tax” is levied at a rate of 68 percent on the difference between the actual world copper price (US$6,936 per ton at end-November 2006) less both smelting costs (estimated at US$1,580 per ton in 2006) and a fixed amount of US$2,600 per ton. For gold it is levied on the difference between actual gold prices (US$638 per ounce at end-November 2006) and a fixed level of US$500 per ounce.

24. The current structure of mining taxes could have undesirable effects on investment incentives. Since royalties do not allow any cost deductibility and the “windfall tax” only allows the deduction of smelting costs, these taxes could apply not only to rents and profits, but also to costs, which will create inefficiencies.11 As a result, some deposits may not be developed, even though they could be exploited profitably, yielding a positive rent. The current tax structure could be also harmful to the mines nearing the end of their lifespan, because in such mines, incremental investment will only take place as long as the return less royalty and “windfall tax” exceeds the marginal cost. Mines may therefore be abandoned prematurely, and since the cost of reopening abandoned mines is prohibitive, some portion of the country’s natural resource will remain unexploited. Moreover, the windfall tax on gold has so far proved difficult to enforce, with many gold traders either smuggling their gold out of the country or delaying sales with the expectation that the windfall tax may be repealed.

25. The corporate income tax (CIT) regime for mining sector is the same as in other sectors. It is a split rate system, and from January 1, 2007 its rates are 10 percent on profits up to tog 3 billion and 25 percent on any additional profits. Losses can be carried forward for up to two years and reduce profits by no more than 50 percent.12 While the law is the same as in other sectors, its impact on the mining sector may still be different, because of the sector’s special characteristics. Specifically, the long delay between the first investment expenditure and the first profit means that the limited loss carry-forward is potentially a greater concern for mining than other firms.13 Economies of scale imply that mining firms tend to be larger, which in turn means that they are more likely to fall under the higher of the two tax rates.

26. In addition, mineral revenues are received for licensing fees, but these are relatively small. Even though the new Minerals Law adopted in mid-2006 has increased such fees, their contribution to the budget remains negligible. However, licensing fees do have an important role in limiting speculation on licenses. Moreover, the law allows, but does not demand, auctioning of mining sites, which has not occurred yet.

27. Significant revenues are also received in the form of dividends from Erdenet, a copper mining company, which is 51 percent owned by the Mongolian state, with the remainder owned by the Russian government. The Mongolian share of the dividend goes into the budget, usually with a delay of two years after the completion of the accounting year in which they are earned.

28. Total mineral revenues have been very volatile over time. Over the last decade, they have ranged from less than 1 percent to more than 6 percent of nonmineral GDP. CIT revenues from Erdenet have historically accounted for the largest share and most volatility. However, since its introduction in mid 2006, the windfall tax has become the most important source of revenue, and total mineral revenues have reached unprecedented levels.


Tax Revenues From the Mineral Sector

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 039; 10.5089/9781451826937.002.A002

Sources: Mongolian authorities; and IMF staff estimates.Note: Data for 2006 and 2007 are projections.

Current and prospective mining operations

29. The copper sector has long been dominated by the public company Erdenet. Erdenet has been exploiting a major copper mine since the 1970s, and it expects to be able to continue extraction at the current rate for a further 50 years. Historically, Erdenet has tended to pay out two-thirds of profits as dividends, and this is expected to continue, although it is far from clear whether this is an optimal ratio. Moreover, as stated earlier, Erdenet has tended to pay its dividends with a significant lags, typically reaching the budget two years after the tax year in which they were earned. While a speedier distribution would be useful, it is assumed that this delay continues as it is, although it clearly reduces the value of dividends in present value terms.

30. Another major firm, Ivanhoe, is expected to start extracting copper and gold from 2009 and to surpass Erdenet as the largest copper producer from around 2011. Making predictions about future mineral revenues is difficult, because (i) the government’s equity participation is under consideration, which will affect the government’s revenue structure; and (ii) it remains unclear to what extent Ivanhoe will be liable for the windfall tax, as Ivanhoe is considering the construction of an on-site smelter, which apparently would exempt the company from being liable for the windfall tax, as it applies only to raw copper ores.

31. The gold sector is more diverse with over 100 companies of different sizes. So far gold companies have not paid CIT as they have been covered by tax holidays or other exemptions. Although Boroogold, the largest, is exempt from the windfall tax, it recently agreed to pay the government an additional US$10 million this year and to begin paying CIT at the full income tax rate from 2007. Boroogold is also currently negotiating a new investment contract for the development of another deposit. Given the imminent abolition of tax holidays, it is likely to have to pay taxes on profits from the new deposit from the beginning, although details of the contract are not known yet.

Mineral reserves

32. Mongolia has considerable mineral resources, although estimates of proven and potential resources are subject to large uncertainties. Overall, only 15 percent of the total area has been geographically mapped (USGS 2004), and therefore, estimates are very approximate. The table below provides an overview of operating and prospective mines in Mongolia. The Baganuur site is particularly noteworthy, as its estimated reserves include 6 billion tons of coal and 2.4 billion tons of coke.

Largest Operating and Prospective Mines in Mongolia

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Sources: Mongolian authorities; company reports, and websits.

C. Mongolia’s Mineral Wealth

33. When a significant share of government revenue is derived from the exploitation of nonrenewable resources, the finite nature of the resource needs to be considered. This is important to ensure fiscal sustainability as well as intergenerational equity. Considerations of long-run fiscal sustainability would generally imply saving a portion of today’s nonrenewable resource revenue and setting normative limits on the nonresource fiscal deficit. This approach would both stabilize usable revenue and provide for the accumulation of financial resources that make up for the depletion of the natural resource, thereby helping to implement fiscal policies that are set within a longer-term framework.

34. Estimating Mongolia’s mineral wealth is the first step in assessing long-term fiscal sustainability. The value of wealth is derived, among other things, from the amount of total proven mineral reserves, the production profile, extraction costs, the tax system, the assumptions on the long-term world mineral prices, the discount rate, and the real rate of return on financial assets.14 The estimates of the net present value (NPV) of Mongolia’s mineral revenues for 2006-50 provided in this paper are based on the assumptions detailed in Box II.1. 15

Mongolia: Assumptions Underlying Mineral Wealth Calculations

Total Production:


  • Erdenet: 23 747 000 tons.

  • Ivanhoe : 41 549 000 tons.1


  • Ivanhoe: 10 336 000 oz.

  • Others: 28 215 000 oz.

Prices: Copper and gold price estimates are based on World Economic Outlook (WEO) projections. Beyond the seven year-period of forecasts provided by the WEO, it is assumed that copper and gold prices increase in line with world inflation (i.e., 2 percent).

Tax regime: It is assumed that tax regime remains unchanged as described above, except that the windfall tax is assumed to be abolished after 2011. Note that stability agreements/investment contracts mean that even if a tax change takes place, it may have limited effects, as existing operations would not be affected until their arrangements run out.

Discount rate: Nominal rate of return (5 percent); real rate of return on financial investment (3 percent).


Ivanhoe also considers an expanded production plan, which would increase this figure to 50,363,000 tons, see Ivanhoe (2005). We assume that the smaller production plan is followed, and, based on information from Invanhoe, that it is delayed by one year.

35. Estimates of mineral wealth depend on a number of assumptions, but are particularly sensitive to mineral price assumptions. This note therefore considers three different scenarios. The central scenario is based on the best available estimate of copper prices(Box II.1). Two further cases are considered: one in which copper prices stay at the high level of 2006, and one in which they fall back immediately to their long run average of $2,000 per ton. Even in the latter case, Mongolia’s mineral wealth (the NPV of mineral revenues) would be sizeable at almost twice the nonmineral GDP.

Net Present Value of Mongolia’s Mineral Revenues (Mineral Wealth)

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Source: Authors’ calculations.Notes: The low price case assumes copper prices of $2,000 per ton until 2011, which is the average price of the last ten years. The high price case assumes copper prices of $6,300 until 2011, which is the WEO copper price assumption for 2006. Beyond 2011 copper prices grow by 2 percent per year in all scenarios.

D. Assessing Long-Term Fiscal Sustainability

36. The fiscal stance in Mongolia is better assessed in terms of the nonmineral primary balance. This is a useful indicator for fiscal analysis in mineral rich countries, because it removes most of the cyclicality that is caused by volatile commodity prices and instead reveals the part of the budget that is financed from sustainable sources.16 Given the mineral wealth, it is not necessary for the nonmineral primary balance to remain in surplus. The next section will address the question of how large a deficit in the nonmineral primary balance can be sustained permanently by the mineral wealth of the country.

37. The concept of a sustainable nonmineral primary deficit ceiling would introduce an upper bound restriction for the permissible government deficit consistent with the savings objective. It defines what the government can afford to spend over the long term without exhausting its assets, and corresponds to a path of expenditures that can be financed from the use of mineral revenue.

Constant Real Expenditure Approach

38. A sustainable nonmineral primary deficit ceiling shows how much the government can afford to spend over the long term without exhausting its assets. It corresponds to a constant real expenditure amount that can be financed out of mineral wealth. In order to determine a sustainable constant real expenditure level, the discounted government’s net worth should be multiplied by the assumed real rate of return. This represents a fixed annual amount in constant U.S. dollar terms that can be spent indefinitely without ever running out of mineral wealth. Over time the composition of this amount will change from being mainly tax revenues and dividends to interest on the accumulated wealth.

39. The level of constant real expenditure per year during 2006-50 is estimated at $113.3 million (5.9 percent of projected nonmineral GDP in 2006). This amount will decline gradually relative to nonmineral GDP, as nonmineral sectors expand over time while the fixed annual dollar amount from mineral wealth stays constant indefinitely. By 2050 it declines to 0.6 percent of nonmineral GDP. This is shown in the figure below, which also shows the development of the constant fixed expenditure under a higher and lower copper price scenarios.


Constant Real Expenditure as a Share of Nonmineral GDP

Citation: IMF Staff Country Reports 2007, 039; 10.5089/9781451826937.002.A002

The Current Budgetary Position

40. The 2007 budget proposal is budgeted to achieve a nonmineral primary deficit as a share of nonmineral GDP of 16.3 percent.17 Based on the calculations above, this would be sustainable under the most optimistic copper price assumption only. If copper prices drop back as expected under the WEO, however, this would imply that in 2007 more than twice as much of the mineral wealth will be spent as will be possible in the long run. And if prices return to their long-term average, three times the sustainable expenditure would be spent.

E. Possible Institutional Arrangements18

41. The analysis above has suggested that mineral revenues in any given year may be different from the share of the mineral wealth that can be sustainably spent. In years of exceptionally high commodity prices or production levels, governments should thus prudently save some of the mineral revenues. In years of low prices, or when production begins to decline, governments may spend more than current revenues. In principle, this is feasible within the normal budgetary framework. There may, however, be some political difficulties in justifying budget surpluses, particularly in low-income countries such as Mongolia. Some countries have, therefore, set up special commodity funds for managing their mineral revenues. The main types of funds are described in the following subsection.

Nonrenewable Resource Funds19

Stabilization funds

42. The main aim of a stabilization fund is to deal with the volatility of commodity prices. Payments to and withdrawals from the fund can, for example, be triggered by the position of the market price compared to a reference price. By doing so, the fund can help avoid stop-and-go changes in government expenditure, which are likely to hamper efficient government spending. Clearly the process cannot be completely automated, as the long-term reference price is unknown and subject to change. It is thus necessary to adapt the reference price as new information becomes available, particularly, following long periods of deviation between market and reference prices.

Savings funds

43. The main aim of a savings fund is to save a share of the revenues stemming from exhaustible resources for future generations. This could be either a fixed proportion, or a varying proportion, in which case the fund would combine elements of a savings and stabilization fund. Typically, withdrawals from such a fund are restricted by tight rules that prevent the fund from being used up. Withdrawals could, for example, be limited to the real return achieved on assets in which the fund invests.

Financing funds

44. A financing fund is the most comprehensive of the three funds, receiving all revenues from mineral resources. Withdrawals are made to finance budget deficits and any remaining funds are invested. A financing fund thus achieves transparency about mineral wealth without restricting fiscal policy by any rigid rules. It also prevents some financially costly behavior that may occur under the previous two funds, such as simultaneous saving and debt issuing.20

Fiscal Rules

45. In addition or instead of savings funds, fiscal rules may be used to limit spending choices of governments. The fiscal rules could, for example, specify that the overall balance may not exceed the real return on mineral wealth, or restrict the nonmineral primary balance to a fixed share of nonmineral GDP.21 However, just as there are ways to circumvent restrictions implied by funds, fiscal rules can also be avoided.

Suggestions on a Nonrenewable Resource Fund for Mongolia

46. Other countries’ examples show that success did not lie in the creation of such funds, but rather in fiscal discipline and sound macroeconomic management. In other words, funds are no guarantee that nonrenewable resources will be sustainably managed. This requires prudent fiscal policy, which cannot be guaranteed by a fund. For example, the government could simultaneously accumulate debt to finance deficits and build up large assets inside the fund. However, a well-designed fund could help the government achieve its sound fiscal policy objectives. Some best-practice design principles are given in the following paragraphs.

47. The fund should be coherently integrated into the budget process. This is best achieved by ensuring that the fund operates only as a government account rather than a separate institution. Budget formulation and reporting should focus on the consolidated presentation and expenditure should be executed by the Treasury. The fund should ideally be a “financing” fund, where the fund’s balance reflects government saving of its mineral wealth and is presented in the context of all the government’s financial assets and liabilities. Because of Mongolia’s access to highly concessional debt though, the fund should not finance the part of the overall deficit that can be financed by concessional debt. Instead the fund should invest equivalent amounts in the currency of the debt to reduce risks.

48. Fund assets should be prudently managed, coordinated with other government financing operations and largely invested offshore. Funds can accumulate large amounts of resources and excessive risk-taking would not be appropriate. Holding the assets offshore reduces the impact on the domestic economy, such as through the exchange rate. Funds should also not lend or otherwise encumber their assets.

The Financing Fund of Timor-Leste1

Timor-Leste recently introduced a non-renewable resource fund to manage its revenues from oil production. The fund is based on the Norwegian fund, which is considered international best practice, with some differences to address the particular situation of the country.

The fund is a financial fund, in that it receives all petroleum revenues and finances the budget deficit. This setup appears particularly appropriate to a new country, with high and immediate investment needs. However, in order to deal with political economy concerns, the concept of “sustainable income” was introduced. Up to that amount, which is defined in law, the fund automatically finances budget deficits. Budget deficits in excess of the sustainable income can still be financed by the fund, but require an additional process of parliamentary consideration and approval.

The fund thus tries to combine two conflicting goals:

1. Avoiding a systematic overspending of sustainable income from petroleum, and

2. Allowing sufficient flexibility to deal with revenue needs, without the need to circumvent the fund by costly borrowing.

49. The rules and operations of the fund should be transparent with stringent mechanisms to ensure accountability and prevent misuse. This requires regular and frequent disclosure and reporting on the principles governing the fund, its inflows and outflows, and the allocation and return on assets. The fund’s activities should be audited by an independent agency, and investment performance should be periodically evaluated.

50. The current development fund is unlikely to play a useful role in shaping a sustainable fiscal policy. The fund receives just the windfall tax rather than all mineral revenues. If copper prices fall as expected, it will receive only negligible funds from 2008, when the copper price is expected to fall below the threshold for windfall tax liability, and only the smaller windfall tax revenue from gold would continue. Given the arbitrary thresholds for the windfall tax, it is unlikely that these revenues represent the entire windfall from temporarily high copper prices. Even if they did though, the low savings rate of one third would not achieve much stabilization or intergenerational equity. Finally, the provisions of the fund can easily be circumvented, by using its components to replace other spending or saving, so that its main impact may be on administrative costs.

F. Conclusion

51. Mongolia will receive substantial revenue from its mineral resources in the coming years. The authorities would benefit from undertaking regular estimates of the country’s mineral wealth, which is essential for formulating a medium-term fiscal strategy. The estimates given in this paper provide a first approximation, which will need to be refined as more accurate and complete information becomes available and as new deposits are discovered and developed.

52. Fiscal policy should take the mineral wealth into account when setting targets for the fiscal balances. A rule limiting the nonmineral primary balance to the real return on the mineral wealth would ensure both stabilization and intergenerational equity. However, even if the government does not wish to follow this approach fully, either because it doubts the accuracy of the estimates or because it may wish to save less in order to invest in growth-enhancing capital, the calculation can still serve as an important input into the fiscal policy considerations.22 For practical reasons, the government could initially work with a shorter term horizon and target a nonmineral primary balance that would yield stable debt ratios over the medium term.

53. This paper finds that the authorities’ current fiscal strategy envisaged in the 2007 budget would be sustainable only under very optimistic copper price assumptions. Any fall in copper prices would put the government on an unsustainable path, with enormous adjustments necessary, if copper prices follow instead the WEO assumptions.

54. Nevertheless, even if mineral prices fall, mineral revenues will remain important and should be managed in a sustainable way. This would imply limiting the nonmineral primary deficit to about 6 percent of nonmineral GDP in addition to what would have been sustainable in a country without any mineral wealth. Any additional funds received from temporary mineral price swings or concessional loans should be saved.

55. While not indispensable, a special fund could help achieve a sustainable fiscal policy. Based on international experience, a fund of the financing variety would be ideal, though with the particular feature for Mongolia, the fund should not crowd out concessional loans. The detailed design of the fund is important for its success; however, some features of the existing development fund raise doubts that it can play a useful role.


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Prepared by Selim Cakir and Alexander Klemm.


According to the WEO, copper prices are expected to fall steadily from their current (mid-November 2006) level of US$6,760 per ton to US$2,400 by 2011.


See for example the analysis in Boccara (1994) covering CFA Franc countries. Some further cases of both good and bad policy responses are discussed in Cuddington (1998).


The current basic deduction is high enough to recover all other costs. However, given that it is fixed at $2,600 per ton of copper, the unindexed basic deduction could fall short of recovering other operating costs in an inflationary situation.


The tax system that will apply until the end of 2006 has rates that are higher by 5 percentage points, and a much lower threshold for the higher rate. It does not allow any loss-carry forward and disallows deductions of many expenses (e.g., advertising). It does, however, provide for tax holidays for foreign firms undertaking major investment projects. These tax holidays exempt them from CIT for five years and provide an exemption for half of the CIT liabilities for a further five years. These are particularly inefficient in the mining sector, where positive economic rents as a result of the scarcity value of resources are to be earned.


This is slightly mitigated by allowing exploration costs to be amortized over five years.


See Gvenetadze (2006) for a full discussion of calculation of mineral wealth.


Coal is excluded from the calculation of Mongolia’s mineral wealth since current revenues from coal mining are very small. However, it should be noted that Mongolia has very large, but as yet unexploited, coal deposits.


See also Chalk (1998) which argues for the use of a “core” deficit, which also excludes net transfers.


The staff report and other documents often present the nonmineral primary or overall balance as a share of total rather than nonmineral GDP. This is mainly for convenience, as it allows a direct comparison to the fiscal balances including the mineral sector. However, as total GDP is also strongly affected by mineral prices, the measures defined in terms of the nonmineral GDP are theoretically preferable and should be used if comparing scenarios with different mineral prices.


For a more general overview of the operational aspects of fiscal policy in mineral resource-rich countries, see Barnett and Ossowski (2003).


For a fuller discussion of such funds, including international experience, see Fasano (2000) and Davis et al. (2001).


For a description of the Norwegian financing fund, which is considered international best practice, see Skancke (2003).


Recent examples of such rules are Sao Tome and Principe (see Segura 2006) and, with an adjustment, Timor-Leste (see Box II.2).


For a theoretical argument that countries whose initial capital stock is small should spend a larger share of the mineral revenues upfront, see Takizawa et al. (2004).