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.

III. The Bank of Mongolia’s Gold Operations23

A. Introduction

56. The Bank of Mongolia (BOM) has been engaged in gold operations since the early 1990s. The main purpose of its engagement is to provide liquidity to market participants and economies of scale. Until 2001, the BOM acted as a monopolistic buyer of gold from local miners, but since 2002, designated commercial banks have also been allowed to purchase gold from local miners. Gold production has leapt fivefold from 1995 to 2005, contributing to a large increase in Mongolia’s international reserves.

57. As the volume of gold production has increased, various questions have been raised regarding the appropriateness of the BOM role in gold operations, which is more extensive than in most other gold-producing low-income countries.24 One of the main concerns is whether the BOM’s gold operations could interfere with the conduct of monetary policy because, without adequate sterilization, gold purchases lead to an increase in reserve money. A second concern relates to governance issues such as the quality and transparency of the BOM’s risk management practices. A third concern is that adverse gold price movements could erode the BOM’s capital base.

58. This chapter describes the BOM’s current involvement in gold operations, assesses their contribution to the economy, and raises some concerns. Despite its beneficial roles, including supporting the gold mining sector, boosting up the economy by promoting gold exports and contributing to accumulate foreign reserves, there have been growing concerns as well. Those primarily relate to the ineffectiveness of monetary policy, inefficiency of foreign reserves management, and weakening of central bank governance. The chapter concludes with policy recommendations to address the concerns.

B. The BOM’s Involvement in the Domestic Gold Market

59. The BOM started its gold market operations under the first “Gold Program” in 1991. At that time, Mongolia’s economy was at a relatively early stage of transition from a planned to a market economy. While the exploitation of natural resources (e.g., copper and gold) was seen as an important engine to growth, the domestic gold market was underdeveloped, with few participants on both the supply and demand sides. Local gold mining companies did not have sufficient capital to expand gold exploration, and commercial banks did not have the capacity to provide adequate intermediation in the gold market. As a result, the BOM was instructed by the government to step in to support the gold mining industry.

60. The BOM further stepped up its involvement in gold operations under the so-called “Gold 2000 Program.” Under the program, the BOM’s role in gold trading was upgraded, granting the BOM a buyer’s monopoly of gold from miners. Furthermore, the BOM started providing gold mining companies with financial support (e.g., credit guarantees) to facilitate their access to working capital. As a result, the number of gold mining companies doubled from the mid-1990s, to reach 133 at end-2005, while gold output increased sharply.

61. The BOM’s monopoly ended on January 1, 2002, when the gold market was deregulated under the amended Central Bank Law. The main purpose of the deregulation was to reduce the BOM’s involvement in quasi-commercial activities and to promote competition in the gold market. Thereafter, commercial banks began purchasing gold and building their institutional capacity. As a result, their share in gold trading has increased gradually. It reached more than half of total gold purchases in 2005, for the first time ever, although it declined again in 2006 after the implementation of the new windfall tax in mid-2006, which has also affected the BOM’s gold purchases, but to a lesser extent. Despite the liberalization of the market, however, commercial banks continue to resell most of their gold purchases to the BOM due to their liquidity constraints, small scale of operations, and lack of risk management capacity.25

Gold purchased by the BOM and Commercial Banks

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Sources: “Mongolian gold market and Mongol Bank” BOM, April, 2006.

62. The BOM’s involvement in the domestic gold market has supported the gold mining sector and changed the composition of Mongolia’s exports. Gold exports rose at an average annual growth rate of 40 percent during 1995-2005, reaching 23.8 tons in 2005 compared with merely 4.2 tons in 1995. Out of 15.2 tons of gold purchased by the BOM in 2005, 13.8 tons were exported, accounting for 58.0 percent of Mongolia’s total gold exports.26 Also buoyed by rising gold prices, the value of total gold exports increased to US$331.0 million (31.4 percent of total export) in 2005 from US$51.9 million (10.7 percent of total export) in 1995.


Shares of Main Exports in Total Exports

(In percent of total exports)

Citation: IMF Staff Country Reports 2007, 039; 10.5089/9781451826937.002.A003

63. Gold monetization also acts as a main contributor for the increase in Mongolia’s international reserves. It explains about two thirds of the international reserve inflows in 2005, and about half in 2006 up to July. The other sources, such as the loan transfer from abroad and foreign exchange purchases by the BOM are relatively small. As a result, net international reserves (NIR) reached US$576.6 million at end-October 2006 from U$105.4 million at end-1999.


1. Net Inflows of NIR

Citation: IMF Staff Country Reports 2007, 039; 10.5089/9781451826937.002.A003

64. The rise in world gold prices since 2001 has ballooned the value of the international reserves, 27 because Mongolia’s Central Bank Law requires that monetary gold be valued at market prices. 28 In the London market, gold prices jumped to US$627 per troy ounce at the end of the second quarter of 2006 compared with US$269 at the end of 2000. As a result, gold valuation has contributed to the increase in the BOM’s international reserve holdings. For the same reason, however, a drop in gold prices could deflate the international reserves.


World Gold Prices and Net International Reserves in Mongolia

Citation: IMF Staff Country Reports 2007, 039; 10.5089/9781451826937.002.A003

65. To reduce the risks from its gold operations, the BOM has taken a number of steps. It has amended its internal rules to improve the internal reporting system and strengthened risk management of gold operations. It also introduced detailed operating manuals which include the limits on individual traders’ daily open position taking and stop-loss. The internal rules also require that a long-term open position be closed before the end of each year.

C. Main Concerns on BOM’s Gold Operations

66. Despite these measures, the BOM’s gold trading activities have given rise to concerns about their potential adverse macroeconomic impacts. The BOM’s gold operations may pose significant challenges to the conduct of monetary policy, international reserves management, and central bank governance.

Impact on the Conduct of Monetary Policy

67. Without sterilization, the BOM’s gold purchases lead to reserve money injection into the economy. In fact, the increase in the reserve money in Mongolia has been largely driven by an increase in NIR. Thus, despite a marked drop in net credit to government, reserve money grew by 19.7 percent in 2005, stemming from a sharp increase in net foreign assets (82.3 percent from end-2004). As of end-August 2006, reserve money increased by 33.3 percent from end-December 2005, mostly driven by the increase in NIR (70.9 percent). In contrast, during the same period, outstanding CBBs issued declined from tog 125.7 billion to tog 65.3 billion. These developments are clear evidence that sterilization through CBB issuance was not sufficient to mop up the excess liquidity generated through the BOM’s gold purchases.


Trends in NIR, Reserve Money and Central Bank Bills

Citation: IMF Staff Country Reports 2007, 039; 10.5089/9781451826937.002.A003

68. A regression was used to estimate the degree of sterilization in Mongolia (Box III.I). The sterilization coefficient29 is defined as the ratio of the change in CBBs to the change in NIR. The short-term elasticities are estimated at around 60-70 percent and even long-run elasticities are less than 80 percent. This result may indicate that the BOM’s gold operations are not sufficiently sterilized. As a result, the effectiveness of monetary policy may be dampened, thereby preventing the BOM from meeting its inflation objective. Notwithstanding some benefits from the BOM’s gold operations, the BOM should address more forcefully their negative impact on the monetary policy framework.

69. The BOM’s gold operations have a seasonal pattern. Since 2003, most of the BOM’s gold purchases were made between the second and the third quarter of the year, while the BOM sold most of the gold it held in the fourth quarter, as required by the internal rule. This pattern partly reflects the strong seasonality of both the mining sector, including gold production, and agriculture. As a result, money supply may expand further in response to the BOM’s increasing gold purchases given that it is not closely coordinated with monetary policy operations.

Estimation of Sterilization Coefficient

In order to gauge the degree of sterilization in Mongolia, net issuance of CBBs is estimated through several exogenous variables, including net international reserves, consumer price index, lending interest rates, and currency in circulation. The coefficient of NIR is a proxy of the sterilization coefficient.

The regression results show that the net issuance of CBBs is positively related, with high statistical significance, to the increase in NIR and the rise of CPI. The elasticity of changes in CBBs with respect to changes in NIR is about 59-67 percent and less than 80 percent in the long-run (0.78 = 0.324/(1-0.584) in equation 2 and 0.70 = 0.294/(1-0.579) in equation 4).

Frequency : monthly data

Number of observation : 121

Sample period : Dec. 1995–Dec. 2005

Estimation method : OLS

Dependent Variable: Log (CBB)

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*** and ** indicate 1 percent and 5 percent significance levels.

Numbers in parentheses indicate t-values.

CBB: outstanding of Central Bank Bills issued; NIR: net international reserves; CPI: consumer price index; LR: lending interest rates; CIC: currency in circulation

International Reserve Management

70. The share of gold in Mongolia’s total international reserves has been large but volatile. The share peaked at 57.4 percent at end-November 2004 before declining to zero in December 2005. Subsequently, it rose to 44.5 percent at the end-June 2006 but fell again to 25.3 percent at the end-September. Mongolia’s share of total international reserves held in the form of gold is large compared with other gold producing countries. In the case of South Africa, for example, the share of gold in total international reserves stood at around 10 percent at end-September 2006.


Composition of International Reserves

Citation: IMF Staff Country Reports 2007, 039; 10.5089/9781451826937.002.A003

71. The BOM’s gold operations may hamper the management of international reserves. The BOM has relied on derivative instruments (e.g., forwards and options) to hedge the gold price risk. However, the BOM has used derivatives to take positions in the market for the purpose of maximizing returns on foreign reserve assets. Such activities can expose the BOM to significant risks that could damage the BOM’s reputation and credibility.30 Therefore, it is crucial that the BOM’s risk exposure in connection with its gold operations be monitored continuously through reliable information, efficient reporting system, and an independent audit function.

72. Holding international reserves has both costs and benefits. Because the BOM has to pay interests on CBBs used to sterilize international reserves, domestic interest rates or GDP growth rates could serve as proxies for assessing the cost of holding international reserves. Conversely, adjustment costs from external imbalances could be viewed as a gain from holding international reserves, because any international reserve shortage may require strong and costly policy adjustment to phase out the imbalances. Propensity to import could be a proxy for estimating the benefits from holding international reserves, since the higher the propensity to import, the more likely is the emergence of external imbalances. International interest rates are also considered as a benchmark of the return from holding international reserves because most foreign reserves in central banks are invested in safe assets abroad with interest income. For this reason, the interest rate differential, instead of domestic interest rate, is regarded as a net cost of holding international reserves.

73. Given the sizeable gold holdings, there is a need to assess the cost of holding international reserves in Mongolia. Although not as large as it was in the past, the spread between domestic and international interest rates spread remains very high. In contrast, the propensity to import, a proxy for the benefits from holding international reserves has been decreasing rapidly. This may imply that there is diminishing needs for the BOM to build up excessive international reserves at high costs.

Interest Rate Spread and Average Propensity to Import

article image


3-months on U.S. dollar deposits.


IMF Staff estimates.

BOM’s Income Statements

74. The BOM’s gold operations affect its income statement in three ways. These include: (i) the profit or loss from the spot trading of monetary and nonmonetary gold; (ii) revaluation and (iii) profit or loss from derivative transactions. The income from gold spot trading itself has two parts. The first part is the fees that the BOM charges on domestic gold sellers for gold insurance, shipping, and refining cost. The second component on spot transactions arises when the BOM sells or buys gold from the over-the-counter (OTC) market, thereby generating income and expenses.

75. The bulk of income and expenses from gold operations comes from revaluation reflecting changes in both gold prices and the exchange rate. Whenever the BOM has a long position on nonmonetary gold or monetary gold, the increase in gold prices yields profits. Likewise, when the togrog depreciates against US$, the gold value denominated in togrog increases and profits arise. Gold revaluation was the main contributor to the BOM’s income surplus in 2005.

Income Statement of BOM in 2005

(In Millions of togrogs)

article image

76. Gold derivative transactions also contribute to the BOM’s income. The BOM usually sells forward and calls options in the OTC market to hedge its gold position. In 2005, the BOM realized a profit of about US$2 million from the option premiums. The BOM also books to market the price movements of forward and options positions. For example, if the price of the option that the BOM wrote increases before maturity, the BOM will record a loss under the item “unrealized derivatives”. Upon the expiration of the options, the income or losses recorded under the “unrealized derivatives” item will be moved under the “realized income or losses” item.

77. The BOM has also at times conducted gold derivative transactions on behalf of gold mining companies. The BOM levies a fee31 for conducting derivatives transactions for mining companies.32 The BOM’s internal guidelines describe the instruments (spot, forward, and options) used for managing gold operations, the procedures for gold mining companies to submit requests, the BOM’s responsibilities, and the penalties imposed on mining companies for late payments. These operations, which are recorded in the BOM’s balance sheet as a receivables or payables from the mining companies, could impair the BOM’s reputation and may result in a breach of the Central Bank Law.

78. The BOM’s gold operations have been the predominant source of the BOM’s profits and losses. In 2005, total BOM’s revenue from gold operations was tog 94.8 billion, accounting for 67 percent of the BOM’s total income. Meanwhile, expenses related to gold transactions were tog 74. 2 billion, or about 56 percent of the BOM’s expense. The net profit from gold transactions was tog 20.6 billion, largely explaining the BOM’s net profit of tog 11.4 billion in 2005.

79. The BOM’s heavy reliance on gold operations for its income could contain greater cost than the benefit it bears. The benefits could arise from the fact that the gains from gold operations could be used to finance potential fiscal deficits. Nevertheless, a possible dramatic reversal of past gains in the wake of a sharp decline in world gold prices would erode the BOM’s capital base. This would damage the BOM’s credibility, even threatening financial system stability. In other words, BOM’s recapitalization would put further strain on the budget, which could fuel further inflation expectations and would weaken confidence in the togrog. As a result, debt sustainability could deteriorate.

D. Conclusion

80. Despite the benefits of the BOM’s gold operations, there have also been growing policy concerns. Gold operations injects high powered money into the economy. The sterilization process through issuing CBBs has been insufficient to mop up the liquidity caused by gold purchases, which may mitigate the effectiveness of monetary policy and jeopardize the inflation target aimed at maintaining price stability. It may also give rise to uncertainty and risks regarding the management of international reserves. Moreover, the BOM should consider the high level of domestic interest rates as a cost of holding international reserves. The significant reliance of BOM’s income statement on gold trading could also bear more concerns regarding central bank governance. Even though of BOM’s profits through gold operations could finance part of the fiscal deficit, the Mongolian authorities should consider the risks in the event of world gold price declines.

81. A key task ahead for the BOM is how to reduce these risks without adversely affecting the gold mining sector, particularly small producers who do not have the financial expertise or scale of operation necessary to export directly. In view of the still-limited capacity of domestic banks and other market participants, an immediate withdrawal of the BOM from domestic gold market purchases could be counterproductive. However, the BOM should adopt more prudent guidelines for its gold risk exposures, refrain from entering into risky speculative positions in gold and other speculative financial derivatives, and begin preparing a timely exit strategy from the gold market.


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Prepared by SeungHo Lee and Yinqiu Lu.


For example, since 1997, South African gold miners have been allowed to sell their output independently of the South African Reserve Bank (SARB), provided that the SARB has granted the necessary exemption from relevant Exchange Control Regulations. This led to a gradual but dramatic decline in the central bank’s involvement in the gold market.


Of 16 commercial banks operating in Mongolia as of end-September 2006, TDB, Golomt, Anod, Zoos, Shuudan, and the Savings Bank are most actively involving in the gold trading.


An additional 10 tons was exported by the Boroo Gold Mine Company, 95 percent equity of which is owned by Centerra Gold, a Canadian listed company.


Except in December 2003, when Mongolia made an US$ 250 million payment to settle pre-1991 debt to Russia.


The Central Bank Law (Article 37) requires that unrealized gains or losses arising from the revaluation of the BOM’s international reserve assets and liabilities be reallocated in a revaluation reserve account. In contrast, under the IMF’s IAS 21 (“The Effects of Changes in Foreign Exchange Rates”) reevaluation gains and losses should be recorded in the income statement, rather than in a reserve account.


It is more generally estimated by analyzing the relationship between changes in net domestic assets and changes in net foreign assets in most countries that rely primarily on open market operations for liquidity control.


The main issues of transparency in the context central bank governance and accountability in reserve management are addressed in the IMF’s ‘Code of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles in September, 1999 (MFP transparency Code).


5 percent of the premium for a call option and forward gain, respectively.


Only gold mines with an annual gold production of more than 500 Kg within the last 2 years are eligible for these transactions.

Mongolia: Selected Issues and Statistical Appendix
Author: International Monetary Fund