June 23, 2009

Introduction

1. The Mongolian authorities wish to express their utmost appreciation to the Fund and its staff for the long-standing and wholehearted cooperation in addressing the economic crisis facing the authorities. We must mention that staff’s recommendations and timely guidance are indicative of their keen interest in the Mongolian economy.

2. The economy is projected to slow this year, spurred by the sharp decline in copper prices, so that the first-quarter growth in 2009 is somewhat lower-than-expected. However, it is clear that the authorities have benefited considerably from the Stand-By Arrangement (SBA) with the Fund. In this light, market conditions have stabilized; inflation is falling from the peak of around 34 percent in August 2008 to single digits in May 2009 with the assistance of the authorities’ tightening measures and global price declines; the exchange rate has appreciated somewhat as market conditions have stabilized; the Bank of Mongolia (BOM) has continued foreign exchange auctions and has built buffers in gross international reserves from $625 million at end-April to $658 million in early June. On the other hand, the authorities are fully aware of the challenges and risks in the period ahead, in particular in the areas of fiscal consolidation and the banking system, and thus they will press ahead with strong implementation of the Fund program.

Program Performance and Objectives

3. All performance criteria (PCs) for the first review (end-April target) were successfully met with a comfortable margin. Although the definition of the domestic payment arrears has caused some confusion, this will be resolved with a minor revision in the Technical Memorandum of Understanding, which was submitted along with the new Letter of Intent (LOI) by the authorities.

4. As the next targets are set at end-June 2009, immediately after the Board discussion on the first review, the staff and the authorities closely discussed whether these coming targets would be achievable from the forward-looking perspective. They broadly agreed that the following targets would be smoothly observed if the authorities continue to pursue the program objectives with close monitoring of market developments.

5. The authorities have reaffirmed their strong commitment to the policy objectives, as expressed in the LOI. They strive to restore health to the public finances and put the emphasis on ensuring a fiscal deficit of under 6 percent of GDP this year and 4 percent in the following year. Given the increasing risks in the banking system, they continue to reform the financial supervisory and regulatory framework as part of ongoing efforts to monitor and support financial system stability. In addition, protecting the poor and the vulnerable during the crisis period will be continuously pursued.

Fiscal Policy

6. The authorities effectively restrained expenditure through end-April and successfully contained the fiscal deficit in line with the Fund program in the face of weak revenue. During the mission, staff repeatedly emphasized the significance of achieving 6 percent fiscal deficit of GDP this year, in terms of program objectives as well as the implication to international support, and this point has been sufficiently taken by the authorities. With this in mind, the authorities promised to adhere to the 6 percent target. In the same vein, they are also committed to achieving 4 percent deficit target next year.

7. In addition, staff underscored the importance of contingency measures to prepare for a possible revenue shortfall. The authorities fully agreed to staff’s advice on this issue, while promising to make a full use of their current fiscal forecast system.

8. Protecting the poor is another main task. The authorities made it clear that, as the resources are limited in the face of growing needs for social transfer, the authorities are focusing on the prioritization of resources or retargeting of the subject groups. Two already-established working groups are doing analyzing work very intensively. Staff emphasized that social transfer reform should be comprehensive and designed to lower costs while safeguarding the poor through better targeting, and thus urged the authorities to fully work with the World Bank and the Asian Development Bank. In this regard, the authorities are working hard to prepare a comprehensive reform plan for social transfer to be announced in end-June, and will expedite the implementation process thereafter.

9. On the establishment of the Fiscal Responsibility Law, end-December Structural Benchmarks (SB), the authorities plan to start the discussion with the relevant parties in July, with a goal of preventing the boom-bust policies experienced in the past. In the meantime, the TA team from the Fiscal Affair Division will soon visit Mongolia to provide guidance on this topic.

Monetary and Exchange Rate Policies

10. On March 10, the authorities increased the policy rate from 9.75 percent to 14 percent to prevent reserve loss and provide support to the exchange rate. Although these monetary measures have contributed well to stabilizing market conditions, private sector credit has been somewhat squeezed due to the slowing economy and concerns about the creditworthiness of borrowers, in addition to the policy rate hike. Tight credit conditions are adversely impacting some industries, such as the construction and manufacturing sectors. There is some room for monetary easing, and the BOM is in the process of cautiously easing monetary policy. The policy rate as of early-May was lowered to 12.75 percent and, on June 11, the BOM lowered the policy rate again to 11.50 percent. Staff agreed with the authorities that a further monetary easing is helpful, including through injecting liquidity. The BOM is committed to carefully monitoring the market situation and assessing the various impacts to the economic entities of their decision before making a monetary decision going forward.

11. The inception of a foreign currency auction mechanism in April has worked well in improving price discovery and the transparency of foreign currency sales, so that interbank spreads have narrowed and the exchange rates have been stabilized at a somewhat appreciated level. In addition, exchange restrictions were removed on June 1, thereby allowing the exchange rate to adjust to a level consistent with economic fundamentals. The authorities reaffirmed that they will continue to maintain a flexible exchange rate to facilitate the needed adjustment, while safeguarding their international reserves.

12. Given the importance of developing the foreign exchange market as part of floating exchange rate regime, there has been meaningful progress in establishing screen-based system for inter-bank foreign exchange transactions (end-June SB). Ten banks have installed the terminals and banks’ quotes are now displayed in the public website. However, the system is not yet fully active, and the BOM is working to put in place a master agreement and a code of conduct. Thus, the authorities indicated that the official launch of such system will be postponed to sometime in the third quarter of the year.

13. Staff reiterated that greater coordination between monetary operations and foreign exchange activity would help strengthen the BOM’s policy framework. Toward this end, the authorities already initiated coordination work by organizing a single unit which has the comprehensive oversight on monetary and exchange markets. They expected this unit to function well in coordinating the Central Bank Bill issuance and foreign exchange auctions in line with policy objectives.

Banking Sector

14. With the slowing economy and decreasing demand, the strain in the banking sector has been deepening. The ratio of non-performing loans is in a rising trend from 7.1 percent at end-2008 to 11 percent on April 2009. In particular, the construction and manufacturing sectors have been hit hard by the ongoing financial crisis. Thus, the BOM stands ready to undertake a vigilant and close monitoring of the banking sector and to act decisively to address banking vulnerabilities by preparing a bank consolidation plan. The authorities have had extensive discussions with IFIs on the possible recapitalization and treatment of troubled assets of systemically important banks. In addition, the BOM plans to discuss with the Ministry of Finance the considerable fiscal burden which a banking restructuring framework entails.

15. Announcement of a resolution plan for Anod bank, the fourth largest bank in Mongolia in terms of outstanding loans, is an end-June SB. USAID funded experts identified three options: (i) liquidation, (ii) good bank-bad bank scheme and (iii) recapitalization, and recommended liquidation through purchase and assumption as the preferred option. Given the timeline of end-June, staff urged the authorities consider fully the fiscal consequences and their potential impact on the entire banking system. The authorities’ decision will be made in due course after comprehensive and balanced considerations.

16. In terms of bolstering the legal framework for the banking system, the government, the BOM and the Financial Regulatory Commission are in the process of preparing the submission of a revised Banking Law and other related legislation to the parliament by end-June 2009. The authorities are committed to maintaining vigilant monitoring of the banking system and to further take prompt and decisive measures against banks that are non-compliant with prudential regulations, if necessary.

Other Issues

17. The authorities are facing drastic seasonality owing to very long and cold winter season. This seasonality peculiar to Mongolia tends to create a fiscal burden in the first half and cause fiscal imbalance. The slowing economy and shrinking domestic demand within a short window for investment before the start of winter call for fiscal stimulus in a timely manner. In this regard, the authorities are cautiously checking the possibility of financing for such stimulus, while being wary of the deterioration of the fiscal deficit. They bear in mind staff’s view that such financing should be approached with great caution. In pursuit of Fund program for fiscal tightening, the authorities adhere to the fiscal deficit target and contemplate on the wise solution for financing such stimulus along with staff’s advice.

18. The US$ 100 million one-year loan with a foreign commercial bank to finance lending to gold mining companies is being carefully monitored. Fully appreciating staff’s advice that such loan is within the performance criterion on non-concessional borrowing, the authorities confirmed that the 6 percent target of GDP deficit will be ensured, with the banks paying back the loan within the end of year.

19. A swap arrangement with China is currently being negotiated and staff emphasized its possible Article VIII implications, as well as its relation to the ceiling of the non-concessional external borrowing. The authorities stance is very clear and straightforward. As they view as first priority the restoration of the economy with the help of the Fund program, they are committed not to signing any such agreement until Fund staff ensure its consistency with Article VIII obligation. The authorities also fully recognize the non-concessonality of such agreement and would limit disbursements under the swap arrangement to the program ceiling.

20. Since the authorities have started contact on external arrears with Paris Club creditors early this year, there has been sizable progress in resolving the arrears with creditors. Depending on the creditors’ situation, the authorities are currently waiting for the creditors’ response respectively and, in some cases, will arrange bilateral meeting with the responsible officials. In case of Spain, the arrears have been settled. The authorities reiterated their commitment to their good faith effort to finalize the arrears in due course with the relevant creditors.

21. Presidential elections were held on May 24 and the whole process was smooth and free of disruptions that occurred in the past. More importantly, the result of the election has caused little change on the current policy framework. During the first review mission, many top-ranking officials confirmed the president-elect’s strong and sustained support for the Fund program. This point was also confirmed by the Speaker of the parliament, who commended the mission team for their timely and dedicated assistance in stabilizing the economy and further promised their continued cooperation in implementing the policies consistent with the Fund program.

Conclusion

22. Given the success of the program to date and the observance of the end-April program targets, the authorities request the completion of the first review. While not being complacent with the short-term economic stabilization achieved thus far, the authorities are committed to maintaining a close policy dialogue with the Fund. As this is just the starting stage for the long road to recovery, they stand ready to take additional measures, if needed, to accomplish the government’s social and economic objectives under the SBA. They believe that the frequent and close consultation with the Fund on the important policy measures is very crucial in leading to a quick recovery. The authorities will try to entrench sound macroeconomic policies to allow them to consolidate achievements made so far and create a more enabling environment for growth.

23. Finally, my Mongolian authorities wish to express their special appreciation to the Fund and its staff for their timely and appropriate policy advices in unraveling the economic crisis facing the authorities. They also extend their deepest gratitude to the Fund’s mission chief, Mr. Steven Barnett, and his team for their hard work and precious guidance in developing Mongolia’s economic reform program.