Mongolia: 2015 Article IV Consultation—Staff Report; Press Release; and Statement by the Executive Director for Mongolia
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International Monetary Fund. Asia and Pacific Dept
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Publication Date:
30 Apr 2015
eISBN:
9781484346341
Language:
English
Keywords:
ISCR; CR; deficit; DBM spending; GDP; authority; DBM governance; swap line; current account; exchange rate; banking system; Budget planning and preparation; Social security contributions
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Medium- to long-term prospects are promising given Mongolia’s large natural resources.

Abstract

Medium- to long-term prospects are promising given Mongolia’s large natural resources.

Context

1. Mongolia has been one of the world’s fastest growing economies as a result of large FDI in the mining sector. In 2011–12, FDI averaged 40 percent of GDP and annual growth exceeded 15 percent, and over the past decade, growth averaged 9 percent. One project alone—the Oyu Tolgoi (OT) copper and gold mine—brought more than $6 billion (50 percent of GDP) in investment during its first phase of development, with another $5 billion planned for the second phase, and ongoing negotiations over the Tavan Tolgoi (TT) coal mine could potentially yield $4 billion in investment over the next five years (see Annex I). Per capita income has reached $4,000, and with mineral wealth estimated at $1 to $3 trillion for a population of just 3 million, the future looks bright. Within 5 years, when OT-2 comes into production, Mongolia should be in a position to start running large fiscal surpluses and accumulating savings for future generations.

2. Mongolia’s narrow economic base has, however, left the country highly vulnerable to shocks. Minerals account for 90 percent of all exports, and 90 percent of these are bound for China. This lack of diversification has made the economy prone to repeated boom-bust cycles, with the balance of payments falling under intense pressure twice in the past five years, and public finances remaining vulnerable despite a fiscal framework intended to reduce procyclicality. Meanwhile, there have been symptoms of Dutch disease—the REER appreciated by nearly 30 percent from mid-2009 to mid-2013 (though this has now been reversed), and non-commodity exports have performed anemically.

3. Over the past two years, the economy has faced sharp declines in FDI and coal exports. FDI related to OT slowed as the first phase was completed and the second phase was caught up in a contentious dispute between the two main partners, Rio Tinto and the government. The dispute on the country’s premier project also cast a pall on the general investment climate, which had already suffered a blow when a moratorium on new mining exploration licenses—since reversed—was introduced in 2010. As a result, FDI fell by half in 2013, and again in 2014. Compounding this situation were China’s slowdown and weakness in the coal sector—prices are down almost two-thirds from their 2012 peak, and volumes are down 8 percent—and more recently copper prices have also fallen sharply. (These declines have been offset only partially by the decline in oil prices).

4. In response to these shocks, the authorities resorted to expansionary policies to tide the economy over until FDI and exports could recover. The fiscal expansion had already started in 2012 when the government implemented universal transfers to the population and the new Development Bank of Mongolia started to promote infrastructure development. When FDI inflows tumbled and coal prices fell in 2013, the authorities maintained expansionary fiscal policy in an effort to sustain growth as well as boost infrastructure spending to realize the country’s potential. During 2012–14, combined on- and off-budget public capital expenditure averaged nearly 15 percent of GDP, the consolidated deficit averaged nearly 10 percent, and debt surged to more than 75 percent of GDP, most of it external and nonconcessional.1 Monetary policy was loosened substantially: the policy rate was cut by 275 basis points and easing programs amounting to 20 percent of GDP were introduced (at an average cost to banks of 4 percent while the policy rate was 10½ percent). Credit growth surged to 54 percent y/y by end-2013, keeping GDP growth above 11 percent and the current account deficit at around 25 percent of GDP, and sowing the seeds for banking asset-quality deterioration.

5. The authorities’ approach soon proved unsustainable. With FDI falling, a growing share of the current account deficit has been financed by a drawdown of reserves. From more than $4 billion (almost 6½ months of imports) in early-2013, reserves are now down to $1¼ billion (two months) even after substantial drawing from a swap line provided by the People’s Bank of China (PBOC). The currency has weakened against the U.S. dollar by almost 15 percent over the past year—and by more than 40 percent since 2013—and as a result, inflation was well into double digits during most of 2014. The credit boom has strained the financial system, with reported gross NPLs rising substantially and liquidity pressures emerging. These developments have been noted by global markets—Mongolia has suffered sovereign rating downgrades, and its spreads have widened sharply. Although growth has now slowed and the current account deficit has narrowed, the overall balance of payments remains under pressure.

6. A durable solution to Mongolia’s economic challenges requires significant macro policy adjustment. The economy is still relatively small, and one or two developments—such as new FDI or portfolio inflows sparked by agreements on OT-2 or TT, offers of substantial, new financing from donors, and/or a sharp rise in commodity prices—could materially change the outlook, at least temporarily. But such developments cannot be counted upon, and the economy would, at any rate, remain vulnerable to future shocks. Instead, the centerpiece of any strategy to close financing gaps should be macro policies that keep the current account deficit at a sustainably financeable level, and that strengthen the fiscal position. Such policies would still promise prosperity, though perhaps at a somewhat slower pace, and with reduced risks of a crisis along the way.

7. Political conditions are now more conducive to decisive economic policymaking, but they are still far from easy. Following a long period of uncertainty, a new government took office in November 2014, vowing to fix the economy, and backed by a grand coalition of the major political parties. The authorities have already taken important steps to strengthen fiscal, monetary, and other policies, but further adjustment will be needed. The new Prime Minister’s SMS-based referendum revealed public support for moving ahead with negotiations on large investment projects including OT and TT, but achieving the necessary political consensus, both for these deals and for further macro policy reforms, will remain challenging, with general elections scheduled for mid-2016.

8. Against this backdrop, the Article IV discussions focused on policies needed to stabilize the economy and achieve sustained growth over the medium- to long-term. Policy discussions centered on an adjustment scenario, with a package of economic and financial-sector measures to eliminate financing gaps and stabilize the economy and banking sector. They also covered the medium-term fiscal policy framework, policies to boost FDI and support growth, and efforts to ensure that the most vulnerable in society are protected.

Recent Developments and Outlook

9. A sharp investment slowdown has dampened economic growth. Declining FDI, continued uncertainty about OT-2, problems in the coal sector, and the contractionary impact of depreciation (see below) have weighed on growth, which slowed from 11½ percent in 2013 to 7¾ percent last year. While investment has fallen, consumption has remained robust, growing at nearly 9 percent, reflecting continued loose policies. Growth is expected to slow further, to around 4 percent during 2015–17 as OT-1 enters a relatively mineral-poor layer of earth, and then pick up sharply, particularly from 2020, when OT-2 enters production. Inflation rose substantially in 2014, given currency depreciation and policy stimulus, peaking at over 15 percent in July, and while it has since eased, it remains substantially above the target of 7 percent.

10. While the current account deficit has narrowed, the overall BOP remains weak. Exports are up, largely on account of OT-1, which began production in mid-2013. At the same time, equipment imports have decreased sharply, tracking the continued decline of FDI. Other imports, however, have been robust despite currency depreciation—mirroring the strength of consumption—and building materials are up significantly, reflecting policy stimulus to the construction sector. Although a trade surplus was registered in 2014, the overall BOP stayed in substantial deficit on account of service account outflows related to OT and weak FDI. At end-2014, gross reserves at the BOM amounted to 3¼ months of imports, equivalent to 75 percent of short-term debt, 29 percent of broad money, and 62 percent of the IMF’s risk-based metric.

11. On existing policies, Mongolia’s external finances are expected to stay under pressure (see baseline scenario in Tables 1–4). Exports will likely weaken for a few years as the OT project faces unfavorable geological conditions, and imports are expected to rise on the start of OT-2 construction. There may also be difficulties in rolling over maturing public- and private-sector debts (around $2 billion in 2017 alone, excluding the PBOC swap line which also matures that year). Given continued easy macroeconomic policies, the current account deficit should average 15 percent of GDP over the medium term, and staff analysis suggests the currency is overvalued by 10 to 15 percent (see Annex II). The overall BOP is expected to remain in substantial deficit through 2017, implying continued pressure on reserves and the exchange rate.

Table 1.

Mongolia: Selected Economic and Financial Indicators, 2011–20 (Baseline)

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Sources: Mongolian authorities; and IMF staff projections.

Includes DBM spending.

Debt data reflects general government debt (including quasi-sovereign bonds issued by DBM) only before 2013, and starts to cover SOE debt from 2013 onwards.

Table 2.

Mongolia: Summary Operations of the General Government, 2011–16 (Baseline)

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Sources: Mongolian authorities; and IMF staff projections.

Reflects 2015 supplementary budget passed in January 2015, with privatization receipts reclassified below the line.

Includes DBM spending.

Only part of DBM spending is included in the 2015 supplementary budget

Table 3.

Mongolia: Monetary Aggregates, 2011–17 (Baseline)

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Sources: Mongolian authorities; and IMF staff projections.

Starting in 2014, some of the BOM’s unconventional easing programs are reflected in OIN (e.g., mortgage loans have been securitized, and the corresponding mortgage-backed securities assumed by the BOM).

Table 4.

Mongolia: Balance of Payments, 2011–20 (Baseline)

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Sources: Mongolian authorities; and IMF staff projections.

12. Fiscal deficits remain large. With revenues falling short of target, the on-budget structural deficit registered 4¼ percent of GDP in 2014, exceeding the 2 percent limit laid out in the Fiscal Stability Law (FSL). In addition, the DBM undertook significant spending—much of it on fiscal activities such as public infrastructure projects—outside the budget, pushing the consolidated deficit to 11 percent of GDP (see Annex III). In 2015, a supplementary budget has brought much of the DBM’s spending on budget and targets a combined deficit of 5 percent. This, however, depends on several unrealistic assumptions, and it also excludes 2½ percent of GDP in so-called “commercial” DBM spending which should also be considered fiscal.2 All told, the overall deficit is expected to approach 10 percent of GDP, only slightly down from 2014. The authorities are considering additional expenditure cuts on the order of 5 percent of GDP, and, if successful, these would move the fiscal accounts toward staff’s “adjustment scenario” (see below).

13. Public debt has risen sharply and is now extremely high. On the authorities’ definition—i.e., in NPV terms, and excluding the PBOC swap drawings—debt amounted to 55 percent of GDP at end-2014, in excess of the FSL’s 40 percent limit. Subsequent FSL amendments laid out a path to return to the 40 percent debt limit by 2018 (and to the 2 percent deficit limit as well), while the recent Debt Management Law departed from international best practice by redefining debt to exclude state enterprise debt and certain government guarantees. On staff’s definition—in nominal terms, and including the PBOC swap—public debt reached 76½ percent of GDP last year (for the entire public sector, including state enterprises) and, given ongoing deficits, is expected to peak at 92½ percent of GDP in 2017, before declining rapidly as mining growth picks up.3 As detailed in the accompanying DSA, the key debt indicators exceed the relevant thresholds for a few years, and Mongolia is thus assessed to be at high risk of debt distress. At the same time, debt is not on an ever-increasing path, and it is relatively small compared to the country’s resource wealth, if the latter can be realized.4

14. Monetary conditions have tightened but are still too loose. Over the past year, the BOM has hiked the policy rate by 250 basis points, to 13 percent, which is within the range suggested by a Taylor-rule analysis and substantially positive in real terms.5 Reserve money growth has been close to zero, reflecting the decline in NFA. Structural liquidity in the banking system—excess reserves on MNT deposits plus amounts mopped up on a short-term basis—is tight. Credit growth, including securitized mortgages, has slowed substantially (though it was still high at 23 percent y/y at end-2014). And the exchange rate has continued to weaken, which is likely to be contractionary in an economy so dependent on imported inputs, and where the export sector is largely dollarized. Still, growth of NDA on the BOM’s balance sheet has been substantial, on account of increasing net credit to government as well as unconventional easing programs, and with inflation and the BOP both remaining under pressure, further tightening is needed.

15. As the economy has cooled, banking-system vulnerabilities have become apparent. Banks’ balance sheets have doubled in just two years, driven by the BOM’s large stimulus programs,6 while foreign currency lending was substantial (a quarter of the banks’ loans). On the back of weak underwriting standards, credit risks increased significantly. In 2014 nonperforming loans (NPLs) as well as loans past-due by less than 90 days were up by 48 percent and 131 percent y/y, respectively. Although the reported NPL ratio remains low at 3.1 percent, asset quality problems seem to be understated especially given the inadequate classification of loan restructurings at some banks. The real estate market is cooling, further increasing credit risk, and, as noted above, liquidity is becoming tight. Stress tests suggest that some banks are vulnerable to economic shocks and that capital buffers should be strengthened in recognition of the balance-sheet deterioration that has already occurred as well as possible future deterioration given the risky environment.

16. Risks are to the downside. Elevated BOP pressure constitutes a major threat to economic stability. Prolonged delay of OT-2 could further undermine business confidence, slow growth, and worsen both external and fiscal indicators. Banking-sector conditions could worsen. Externally, a further slowdown in China could reduce Mongolia’s export demand, and surges in global volatility could also affect Mongolia’s ability to borrow externally (see Annex IV).

Authorities’ Views

17. The authorities agreed that the economy had gone through a difficult period because of severe BOP shocks and argued that the policy response had stabilized the situation. Some interlocutors argued that Mongolia had faced massive external shocks that could have led to a BOP crisis, a credit crunch, and economic contraction. These dire outcomes, however, were avoided on account of the countercyclical policy response, which helped the economy to achieve a “soft landing.”

18. As for the outlook, the authorities had a more benign view than staff. While the baseline scenario was developed jointly by the IMF team and the technical staff of the MOF and BOM, the authorities expected that their policy responses (see below) would be sufficient to turn the situation around, combined with other options for managing BOP pressure, including additional borrowing from the international market as well as donors. Finally, they noted that about 50 percent of DBM spending, which includes the projects with government guarantees, was included in the budget and opined that DBM commercial spending should not be included.

Policy Discussions

A. Macroeconomic Policies

19. Comprehensive policy adjustment is urgently required to address external and fiscal imbalances and stabilize the economy. Public debt is too high and inflation above target, but the most pressing concern is the severe BOP pressure that the country continues to face. Fiscal and monetary tightening, along with exchange-rate flexibility, is needed. Much the same advice was offered during the 2013 Article IV consultation, with limited takeup (see Annex V). Policies on investment, social protection, and banking also need to be strengthened.

Summary of Key Policy Recommendations

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20. The authorities have taken policy steps in the right direction, but further measures are needed:

  • 2015 Supplementary Budget. Facing likely revenue shortfalls, the authorities revised down the revenue target and correspondingly cut expenditure in a 2015 supplementary budget, passed in January. Non-commercial spending of DBM was brought on budget, and the consolidated deficit targeted at 5 percent of GDP. This target, however, will be difficult to reach as revenues are still over-estimated.

  • Amendments to Fiscal Stability Law. Recognizing that public debt had exceeded the ceiling enshrined in the Fiscal Stability Law (FSL), the authorities in February 2015 amended the FSL and enacted a new Debt Management Law (DML) that narrowed the coverage of debt as previously defined in the FSL. The new legal framework also raised the debt ceiling and set a path to bring debt (albeit more narrowly defined) and the fiscal deficit down to the previous limits by 2018 (which will be hard to achieve on current policies).7

  • CMAP. Parliament on February 18, 2015 approved a “Comprehensive Macro Adjustment Plan” (CMAP), which comprises macro-financial adjustment and structural policies. CMAP retains the target fiscal path in the supplementary budget. It envisages phasing out the BOM’s Price Stabilization Program (PSP) and transferring remaining PSP loans to the government. The CMAP does not, however, comprehensively transfer all of the BOM’s easing programs—including funding for new mortgages and financial support at the request of commercial banks for their corporate clients—to the budget. On the structural front, CMAP calls for steps to strengthen social welfare, enhance the investment climate, facilitate FDI inflows, promote exports, and encourage import substitution.

21. Staff recommended a stronger package of macro policy measures, as follows:8

  • Fiscal policy:

    • A new budget amendment for 2015 would be needed to bring the consolidated deficit (including all DBM spending) down to around 4½ percent of GDP this year. The deficit would continue to fall until reaching around 2 percent in 2017, and it would be possible to move toward fiscal surpluses a few years after that. (Staff analysis does not find grounds for loosening the long-term deficit target specified in the FSL (see Annex VI), nor do staff support the redefinition of debt in the DML.)

    • Within the overall budget envelope, total spending by the DBM (commercial and non-commercial) would be limited to around 2½ percent of GDP in 2015 and would decline thereafter. Furthermore, authority over the budget and the DBM—including its “commercial” spending—would be unified in the Ministry of Finance, and reporting would be consolidated. Reforms to strengthen governance of the DBM could also be enacted.

    • Capital expenditures are very high in international comparison, and while part of this is explained by existing infrastructure deficiencies and the country’s low population density, substantial cuts nonetheless appear to be possible; moreover, given the openness of the economy, the associated fiscal multipliers are likely to be small.

    • At the same time, there is scope to cut current expenditure and raise revenue: large, untargeted subsidies should be phased out in favor of programs (like food stamps) that more directly reach the poor. Moreover, recent growth in the public wage bill could be addressed and procurement inefficiencies reduced. Some social benefits could be made taxable and customs duties increased.

    • Going forward, a new budget law amendment could be considered to restrain Parliament’s ability to increase the aggregate budget envelope.

  • Monetary policy. The stance should be tightened without delay, including by restricting deficit monetization, and credit growth should be further slowed, following the harmful credit boom in recent years (see Annex VI). The BOM’s unconventional programs (PSP, mortgages, and financial support at the request of commercial banks for their corporate clients) should be transferred to the budget, where—in a transparent manner and with Parliamentary oversight—they can compete with other spending priorities for limited resources. The nature of BOM operations should change—unconventional easing programs targeting particular industries or providing financial support at the request of commercial banks for their corporate clients should be ruled out, while open market operations may need to be enhanced to ensure sufficient liquidity in the banking system. Further BOM governance reforms should also be considered, such as giving Monetary Policy Committee members a vote on BOM decisions.

  • Exchange rate flexibility. The BOM would limit its involvement in FX markets to preventing excessive market volatility, and as a result, the exchange rate would move more flexibly. The strategy is to contain further sharp depreciation through adequate macro policies, and to limit intervention to addressing excessive volatility.

22. These policy efforts would help stabilize the economy, but reserve buffers would remain thin, suggesting the need for additional financing. As shown in Tables 5−9 and Figure 5, growth in this adjustment scenario would slow somewhat in 2015 given the policy tightening, and inflation would rise by a moderate amount for several years, given exchange-rate pass-through. The fiscal adjustment would also put public debt on a more sustainable path. Imports would moderate, and strengthened policies would support market confidence and facilitate rollovers of several large bonds maturing in 2015 and 2017 (a total exceeding $2 billion).9 As a result, foreign-exchange reserves would stabilize at around 1¾ months of imports for several years (before rising in 2019–20). This is substantially stronger than in the baseline but still lower than desirable, suggesting the need for additional financing in support of the adjustment effort.

Table 5.

Selected Economic and Financial Indicators, 2011–20 (Adjustment Scenario)

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Sources: Mongolian authorities; and IMF staff projections.

Includes DBM spending.

Debt data reflects general government debt (including quasi-sovereign bonds issued by DBM) only before 2013, and starts to cover SOE debt from 2013 onwards.

Table 6.

Mongolia: Summary Operations of the General Government, 2011–16 (Adjustment Scenario)

article image
Sources: Mongolian authorities; and IMF staff projections.

Reflects 2015 supplementary budget passed in January 2015, with privatization receipts reclassified below the line.

Includes DBM spending.

Only part of DBM spending is included in the 2015 supplementary budget

Table 7.

Mongolia: Monetary Aggregates 2011–17 (Adjustment Scenario)

article image
Sources: Mongolian authorities; and IMF staff projections.

Starting in 2014, some of the BOM’s unconventional easing programs are reflected in OIN (e.g., mortgage loans have been securitized, and the corresponding mortgage-backed securities assumed by the BOM).

Table 8.

Mongolia: Balance of Payments, 2011–20 (Adjustment Scenario)

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Sources: Mongolian authorities; and IMF staff projections.
Table 9.

Mongolia: Baseline and Policy Adjustment Scenarios, 2013–20

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Sources: Mongolian authorities; and IMF staff calculations.

Excludes DBM spending.

The baseline scenario assumes no rollover of maturing bonds. The policy adjustment scenario assumes bond rollover of maturing sovereign debt ($500 million), DBM debt ($580 million) and MMC bonds ($600 million), as well as TDB bonds ($414 million).

Figure 1.
Figure 1.

Real Sector Developments

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Figure 2.
Figure 2.

Fiscal and Monetary Sector Developments

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Figure 3.
Figure 3.

External Sector Developments

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Figure 4.
Figure 4.

Inclusive Growth Indicators

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Figure 5.
Figure 5.

Key Indicators in Baseline and Policy Adjustment Scenarios

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

23. Looking ahead, prudent macroeconomic management must be maintained to ensure that resource wealth can be harnessed effectively. Many resource-rich countries have failed to realize the promise of prosperity. Avoiding procyclical fiscal policy, saving resource revenues and investing them wisely, ensuring cautious monetary policy, and maintaining a competitive exchange rate to avoid the effects of Dutch Disease, are all essential components.10 Mongolia has a relatively large resource endowment compared to some other resource-rich economies, and managing that wealth wisely is of critical importance.

Authorities’ Views

24. The authorities saw the benefits of additional fiscal adjustment. They agreed that the fiscal path in the supplementary budget and CMAP faced risks and that further measures were thus needed. They expressed their intention to cut budget spending further via a government resolution, supported by another supplementary budget later in the year, and to reduce DBM spending as well, with total cuts amounting to around 5 percent of GDP. They also saw an important role for additional financing to bridge short-term BOP difficulties.

25. The authorities broadly shared staff’s views on monetary policy going forward. The BOM noted that they had intentionally been phasing out their unconventional programs, and the government also expressed its agreement with this objective. The BOM envisaged transferring the outstanding program loans to the government by end-June. They noted that the Price Stabilization Program had basically achieved its goals, as supply-driven inflation had continuously been low and stable over the past 26 months, and the economy had achieved a soft landing. They continued to see the mortgage program as highly beneficial, noting that it aimed to make households’ expenditures more efficient and to boost middle-class savings. They believed that this program should be continued as part of the government’s long-term saving policy, in conjunction with ongoing structural reforms of the pension fund. Finally, they suggested that it would be more appropriate to consider changes to the central bank law only after economic conditions had improved. On exchange rate policy, they noted that they are fully committed to the flexible exchange rate regime.

B. Structural Reforms and Social Policies

26. Structural measures are needed to boost investment and growth, and an enhanced effort is needed to protect the poor. To return the economy to a sustainable, rapid growth path, a focused effort is needed to improve the investment climate, which was harmed by previous policy changes, boost FDI, and move ahead with large mining projects. Many of these are included in the authorities’ CMAP. Given resource constraints, subsidy programs should be targeted better to protect the poorest and most vulnerable in society.

27. The authorities are redoubling efforts to boost investment. The CMAP, now approved by Parliament, includes reaching agreement on OT and TT as key goals, and a former prime minister has been appointed minister in charge of “mega projects,” charged with moving those negotiations forward. The government has also proposed a host of measures—under the CMAP and through other initiatives—to increase investment, boost exports, and support appropriate import substitution. Finally, the tax law is being amended to improve clarity and avoid conflicts in the judicial system with foreign investors.

28. Special efforts must be made to ensure that the most vulnerable in society are adequately protected. Compared to other similarly placed countries, Mongolia has a large budget for subsidies and transfers, amounting to some 8 percent of GDP. Most of these are targeted to different categories of the population—mothers, children, the elderly, the disabled, et al.—without regard to income. Economic adjustment policies, while necessary for medium-term growth and stability, will create short-term dislocations, and it is vital that policies be designed to protect the poor. In the short-term, the income-targeted food stamp program could be expanded, and looking forward, the proxy means-tested subsidy programs currently under design should be implemented expeditiously. The World Bank has done significant work in this area (see Informational Annex), and there exists sufficient technical capacity to improve targeting.

Authorities’ Views

29. The authorities noted that, as a policy matter, income targeting of subsidies is controversial in Mongolia. They had proposed this in the first supplementary budget for 2015, but Parliament rejected many of the relevant measures. Cultural values prioritize children and the elderly, regardless of income level. That said, they firmly agreed on the need to protect the poorest, which may require difficult choices given hard budget constraints.

C. Financial Sector

30. A comprehensive approach to addressing problems in the banking system is needed to contain systemic risks. The BOM has taken some good steps, but more needs to be done (and the IMF stands ready to support the authorities with further TA, as needed). Risk weights for unhedged FX loans were increased in August 2014, and the 1-percent general provision for performing loans was restored, though only for new loans. Nevertheless, loan classification is heavily reliant on days overdue rather than on more qualitative assessments of borrowers’ creditworthiness and future cash flows, while the prudential treatment of restructured loans is weak. The banking system has already seen balance-sheet deterioration, and it remains vulnerable to a further deterioration of economic conditions and the crystallization of hidden losses.

31. As a priority, provisioning and capital buffers need to be reinforced (see Annex VII for a detailed list of banking-sector recommendations). The level of provisions (70 percent of NPLs) appears to be low given the likely understatement of NPLs, the inadequate treatment of loan restructuring, the uncertain value of recoveries (certain Civil Code provisions make foreclosures difficult, and there is significant uncertainty regarding the valuation of collateral, and the cooling of the real estate market. Thus, current capital levels (e.g., a system-wide Tier 1 ratio of 12.5 percent) are likely overstated. The BOM should take immediate measures to increase provisions and capital across the banking system, and particularly for the most vulnerable banks. This could usefully be informed by an independent asset quality review of the major banks.

32. The BOM should eliminate forbearance and strengthen risk recognition. Asset-classification and provisioning regulations should be enhanced by introducing a stricter treatment and regular reporting of restructured loans. The rules should also be changed to embed more qualitative and forward-looking assessments of the borrower’s condition, including hedging capacity against foreign-exchange risk. The 1-percent general provision should apply to the entire stock of performing loans, and the BOM should discontinue forbearance vis-à-vis loans made under the Price Stabilization Program (PSP). Capital requirements for systemically important banks should be raised—the Tier 1 ratio should be increased to 10.5 percent—and targeted additional capital requirements should be imposed on banks that have large concentrations (loan, deposit, and foreign exchange). The BOM should move quickly to resolve non-viable banks, if needed.

33. The supervisory and the crisis preparedness frameworks need to be strengthened. Legislative changes are needed to secure for the BOM flexible powers for early intervention. Current supervisory assessments (CAMELS) should be turned into robust and forward-looking tools for early identification of risks and prompt corrective action. Finally, the Supervisory Committee should be empowered as the key decision maker. Cooperation on financial stability and crisis preparedness matters should be strengthened via the Financial Stability Council, which should be expanded to include the Deposit Insurance Corporation. The legal framework should prevent the reversal of resolution actions and provide early and flexible intervention triggers as well as better safeguards against misuse of public funding. Emergency liquidity assistance should be provided only to solvent and viable banks, and should be priced at penalty rates.

34. AML/CFT. In 2011, the Financial Action Task Force (FATF) designated Mongolia as a jurisdiction not making sufficient progress in implementing the agreed action plan to enhance its Anti-Money-Laundering / Countering the Financing of Terrorism (AML/CFT) framework. Since then, with the support of ongoing IMF TA, Mongolia has strengthened its framework considerably, and it is no longer subject to the FATF’s on-going global AML/CFT compliance process.

Authorities’ Views

35. The authorities welcomed staff’s suggestions on strengthening the banking system. They considered that the recent tightening of policies, including in the area of prudential regulations, would help contain the risks in the banking system. Looking ahead, the BOM agreed that further policy attention should be devoted to monitoring and pre-emptively responding to potential risks in the banking sector, and welcomed the recommendations of the recent Fund TA mission, which could be integrated into the Medium Term Supervisory Strategy.

D. Other Issues

36. Article VIII. There are two previously identified multiple currency practices, relating to the BOM’s calculation and use of reference exchange rates. No action is planned.

Staff Appraisal

37. Mongolia has a bright future, but the next few years will be challenging. If managed prudently, the country’s massive resource wealth could spell prosperity for all Mongolians, nearly one-third of whom still live below the poverty line. These are not just fond hopes for a distant future; it could be as early as 2020 that OT-2’s exports begin, boosting GDP dramatically and generating fiscal revenues to transform the economy, improve living standards, and build up an endowment for future generations. In light of its resource wealth, and assuming this can continue gradually to be realized, Mongolia is projected to be solvent given the strong projected revenues from mining over the long term. The country does, however, face serious liquidity pressures and risks in the short run, before mining inflows ramp up. Until then, financing outsized prospective fiscal and BOP deficits will be difficult.

38. Loose macro policies have helped create the difficulties the economy faces today. Mongolia’s present problems were driven in large part by major external shocks, to FDI and to coal exports. But policy errors also contributed. Policies were loosened first to share the benefits of prospective mineral wealth broadly, and then to buffer the economy from shocks. This succeeded—for a while—in maintaining high growth, but at the cost of exacerbating economic and financial vulnerabilities. Fiscal discipline was undermined by large off-budget spending, and monetary policy was eased dramatically. This stimulus fueled inflation, compounded BOP pressure, laid the seeds for asset-quality problems in the banking system, and generally undermined confidence at home and abroad.

39. Policy adjustment is needed to provide a sustainable solution to Mongolia’s economic challenges. Macro policies need to be tightened to keep current account deficits at more manageable levels and to improve the fiscal position. If additional external financing can be marshaled in support of such policies, the adjustment will be less disruptive. At the same time, measures are needed to strengthen the banking system, and it is vital that steps be taken to improve the targeting of subsidies and thus ensure protection of the most vulnerable in society.

40. The authorities have already taken a number of steps to strengthen the economy. Part of DBM’s spending has been brought on budget, and the consolidated fiscal deficit is expected to decline this year. A government resolution to cut spending administratively is envisaged, to be backed up by a second supplementary budget later in the year. The BOM has hiked the policy rate twice, slowed the pace of PSP and mortgage lending, and proposed transferring the existing stock of program loans to the government’s balance sheet. The authorities have redoubled efforts to reach agreement with investors on large projects and introduced other structural measures to boost exports and reduce imports. Steps have been taken to strengthen the banks and to improve bank supervision and crisis preparedness.

41. More, however, is needed:

  • The fiscal path needs to be secured with Parliamentary approval for measures to control spending, both on-budget and off, as part of a coherent, medium-term macro framework.

  • The BOM should cease unconventional easing programs targeting particular industries or providing financial support at the request of commercial banks for their corporate clients, and should instead return to traditional central-banking functions; these programs should, if desired, by conducted by the government, competing with other spending priorities for funds within the budget.

  • The monetary stance should be tightened further, to control credit growth and support the BOP.

  • Foreign-exchange intervention should be limited to dealing with episodes of excessive volatility, and the exchange rate should be allowed to move flexibly.

  • Banks’ provisions and capital buffers should be bolstered, informed by an independent asset-quality review, and supervisory and crisis-preparedness frameworks enhanced.

  • DBM and BOM governance should be strengthened.

  • The investment climate should be enhanced, and progress made on mega-mining projects, so as to boost FDI.

  • Especially important, social safety nets should be strengthened and better targeted.

42. With a comprehensive adjustment strategy in place, Mongolia will be well placed to realize its economic potential. Today’s challenges are serious but surmountable, and the country’s medium-term prospects remain strong. With prudent management, Mongolia should be able to raise adequate external financing in support of its adjustment policies and build reserve buffers, while safeguarding external and public debt sustainability.

43. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Annex I. Economic Impact of Mongolia’s Natural Resource Endowments

Mongolia is unusually rich in mineral resources. The population of 3 million inhabits a country with an estimated $1 to $3 trillion worth of copper, gold, coal, oil, and other resources, close to growing markets in China and elsewhere in Asia. To exploit these reserves, Mongolia has in the last several years attracted very large FDI inflows into the sector that now accounts for around 20 percent of GDP and close to 90 percent of exports. Joint ventures between Mongolian companies (both public and private) and multinationals account for a significant proportion of mining production. Currently almost all production is for export, and transport links—especially with China—are being substantially improved, which will allow unit costs to be reduced. A number of mega projects are underway that will significantly boost the mining sector and catalyze other investments. These include:

A. The Oyu Tolgoi copper and gold mine

  • Mongolia is on track to become a globally significant copper and gold producer, with the Oyu Tolgoi (OT) mine one of the largest in the world. The project is jointly owned by the Government of Mongolia (34 percent stake) and Turquoise Hill Resources (THR). Rio Tinto has a 50 percent stake in THR and is the project manager. The first-phase open-pit mine began construction in 2010 with investment exceeding $6 billion, and production commenced in 2013. The second phase (OT-2) will be underground, and output will markedly increase once production comes on stream toward the end of this decade (associated FDI inflows are estimated at over $5 billion).

  • The commencement of the OT-2 project has been delayed by ongoing negotiations between Rio Tinto and the authorities over a number of issues. These include the appropriate treatment of significant cost overruns in OT-1, resolution of outstanding tax issues, the exact specification of activities, government permits, and a number of social and environment issues. However, both sides have stated that they remain committed to the project, with the intention for the project to commence in 2015.

B. Tavan Tolgoi (TT) coal mine

  • Coal reserves are estimated at well over 6 billion tons. Mongolia is already a major exporter of coal to China for both power generation and for use in the heavy industrial sector; South Gobi Resources (in which THR has a 47.9 per cent interest) and Energy Resources (a subsidiary of the Mongolian Mining Corporation (MMC)) are major producers currently. Production is set to increase sharply with the commencement of the TT coal mine. The tender has been won by a consortium that includes leading Mongolian, Chinese and Japanese companies (MMC, Shenhua Energy, and Sumitomo Corporation, respectively). Negotiations on the production modalities are reported to be at an advanced stage.

  • The total investment in TT is expected to be $4 billion. The business model is based on the export of coal to China and third countries, with the value added increased through more domestic processing including washing and power generation. Related investments also include a new railway that will substantially improve export potential and a new power station that will supply power to OT and also to China.

The continued development of the mining sector will have a number of important macroeconomic implications.

  • Growth and development. Mongolian extraction costs are among the lowest in the world, meaning that the sector should be relatively unscathed from current price falls and may benefit as marginal producers exit. And while logistics have traditionally been a challenge in this landlocked nation, transport links—especially with China—are being substantially improved, notably through the construction of a new railway. Mining exports to third countries will also benefit from recent agreement on duty-free access to Chinese ports. Over time, the intention is for more value-added processing to take place in Mongolia, creating potential for local employment growth and supporting the outlook for GDP.

  • Supporting the external position. Resource wealth promises prosperity in the long run, but also substantial dividends in the next five years. OT-1 brought $6 billion of investment into a $10 billion economy over just a few years, during which time Mongolia was one of the world’s fastest growing economies. That first phase went into production last year and led to a 30 percent y/y increase in mining exports. OT-2 would bring in another $5 billion in FDI over the next few years. It would start production within a few years, and even on conservative projections, mineral exports would increase by another 25 percent.

  • Strong mining prospects imply a fairly rapid improvement in fiscal and external imbalances. From 2017 to 2020, rapid growth would bring the public debt ratio down sharply, from 92½ percent of GDP to 80 percent. While loans to Rio Tinto would have to be repaid, the fiscal balance could possibly move toward surplus and facilitate the accumulation of wealth for future generations in a planned sovereign wealth fund. The current account deficit is projected to narrow to just 6 percent of GDP in 2020, and pressure on reserves would steadily disappear. While this outlook would be less favorable if OT-2 remains undeveloped, macroeconomic imbalances would still be reduced substantially.

An important implication is that the national balance sheet will be strengthened as these resources are extracted. While Mongolia presently faces an acute liquidity problem, accompanied by sovereign stress, it is solvent given the strong projected revenues from mining over the long term. Assuming the commencement of the large projects in 2015, the impact on GDP growth and external accounts will allow debt to start to decline sharply after 2017. (And even without OT-2, debt would still decline from 2018, albeit more slowly.)

Annex II. External Sector and Exchange Rate Assessment

Mongolia’s external position is weaker than desirable, and the togrog overvalued by 10 - 15 percent.

Balance of Payments, Exchange Rate Movements, and Reserve Adequacy

  • The balance of payments has continued to face pressure. Despite substantial borrowing from abroad, GIR fell from 4 months of imports at end-2013 to around 2 months at end-February 2015.

  • The nominal exchange rate depreciated by 14 percent in 2014, and while the REER initially depreciated somewhat, it later appreciated strongly, reflecting still high inflation and the BOM’s FX intervention.

  • By almost all indicators, gross reserves are too low—below the traditional 3-months-of-imports benchmark, below the “Greenspan-Guidotti” rule suggesting 100 percent coverage of short-term debt, and only just above 20 percent of broad money. And according to the IMF’s risk-based metric, the optimal range of reserves is 4½ to 7 months of import cover.1

A01ufig1

Reserves Adequacy Under Different Approaches

(In months of imports)

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Estimate of Current Account Gap and Exchange Rate Misalignment

  • Methodology. This assessment adopts the External Balance Assessment-lite (EBA-lite) approach for frontier economies in addition to the External Sustainability (ES) and Equilibrium Real Exchange Rate (ERER) approaches in the CGER framework. The EBA-lite methodology has been developed as a successor to the macro balance approach used under CGER. One key difference is that EBA-lite makes a sharper distinction between a positive (descriptive) understanding of current accounts and real exchange rates and normative evaluations. Another is that EBA-lite takes into account a much broader set of factors—including policies, cyclical conditions, and global capital market conditions—that may influence the current account and real exchange rate. As before, the ES approach measures the exchange rate adjustment needed to sustain a certain level of net foreign assets of the economy; the ERER approach is based on empirical studies of the exchange rate that would be consistent with the economy’s productivity, fiscal soundness, external position, and other factors.

  • Result. According to the EBA-lite approach, Mongolia’s current account deficit is 4 percent of GDP above the level consistent with desirable policies. This implies overvaluation of 11 percent. The External Sustainability approach points to a current account gap of 6 percent, indicating real overvaluation of 13 percent. The ERER approach implies an overvaluation of 14 percent.

Estimates of Togrog Overvaluation

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Source: IMF estimates

Annex III. Development Bank of Mongolia

The Development Bank of Mongolia (DBM) was established in 2011 as a state-owned, for-profit legal entity with the specific functions of conducting activities aimed at financing major projects and programs for the long-term development of Mongolia. One of the stated rationales is that domestic commercial banks have relatively high financing cost and their small sizes impose limits on the maximum amount of loans that can be granted to any single project.

Financing. Nearly all DBM financing is either directly provided by the government or obtained through external borrowings that are fully guaranteed by the government. In addition to its equity contribution, the government has also transferred the proceeds of the 2012 sovereign “Chinggis bond” to finance DBM operations. Though DBM hopes to borrow in the future on the strength of its own balance sheet, so far all of its bond issuances and loans have been government guaranteed. This includes the $580 million DBM bond in 2012, the JPY 30 billion samurai bond in 2013, a $162 million loan from China Development Bank, and a $300 million syndicated loan from Credit Suisse in 2014.

Spending. DBM broadly classifies its projects into two groups: those that are repayable from the state budget (i.e., non-commercial projects), and those that are self-financing, or commercial. The non-commercial projects include roads and other infrastructure and are implemented through line ministries, while the commercial projects include power plants, railway, aviation, housing finance, mining, housing construction, agriculture, light industry, and construction materials. The relative share of these two types of projects varies by year: in 2013, commercial projects accounted for around one-third of the total DBM spending; the share increased to nearly 60 percent in 2014; and it is expected to decline again, to less than half, in 2015. The projects DBM undertakes typically require parliament and government approval, and there is no clear link between the sources of financing and the types of projects.

Statistical treatment. International statistical manuals (GFSM 2014, SNA 2008 and BPM6), suggest an “institutional unit” approach under which all activities of an institutional unit should be allocated to one and only one institutional sector. In this case, all activities of DBM should be included in the (general) government sector since the majority of its activities are non-commercial/government in nature. In limited circumstances, international statistical manuals allow for commercial or market activities of general government units to be split out, but such “quasi-corporations” should be well defined units themselves, with separate accounts, separate management, and full autonomy of operation. The current commercial activities of DBM clearly do not satisfy these conditions.

Annex IV. Risk Assessment Matrix1

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Annex V. Implementation of Past IMF Recommendations

The authorities have agreed on the need for policy adjustment and responded to some of the recommendations made in past Article IV consultations.

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Annex VI. Summaries of Background Analytical Work

A. Analyzing Alternative Fiscal Paths for Mongolia1

This paper uses a simple spreadsheet-based approach to analyze different long-term fiscal paths for Mongolia and shed light on the country’s appropriate deficit and debt targets. It concludes that the country should be running small surpluses and that there is no justification to adjust the FSL’s targets on a permanent basis.

1. There has been considerable public debate about the right fiscal targets for Mongolia. Short-term balance of payment pressures clearly suggests the need for consolidation, and good budgetary practice suggests that DBM spending should be brought on budget. But should the consolidated deficit be brought down to the FSL’s target of 2 percent of GDP, or is this too tight to permit needed infrastructure investment? Also under debate is the appropriate debt limit—is the FSL’s threshold of 40 percent of GDP too restrictive?

2. This paper applies some basic fiscal concepts for resource-rich economies. The permanent-income hypothesis (PIH) would suggest that revenues from exhaustible resources be shared equally with future generations, either in terms of constant dollars per capita, or in terms of a share of nonmineral GDP. But with current generations poorer than future ones, and thus likely to have a higher marginal utility of consumption, a modified PIH (MPIH) framework, which allows some frontloading of consumption and then a payback period of larger fiscal surpluses later, may be more attractive. It is also possible to take a broader perspective, and instead of focusing solely on the consumption-savings decision, to also consider the possibility of investment. Under the so-called “Fiscal Stability Framework” (FSF), spending can be frontloaded to develop infrastructure, and depending on the rate-of-return, the extent to which future fiscal surpluses are needed can be reduced or eliminated, without compromising future generations’ welfare. The paper simulates fiscal paths for Mongolia under these three different frameworks using a spreadsheet template developed in conjunction with the 2012 Board papers on resource-rich developing countries.2

3. Under reasonable parameter values, the PIH prescribes that Mongolia should currently be running a small fiscal surplus. Table A1 summarizes a sensitivity analysis showing the appropriate fiscal balance for different assumptions about the value of Mongolia’s mineral wealth, the rate at which minerals prices rise, and the government’s tax take from the sector. As shown in the highlighted row, if mineral wealth is $1½ trillion, prices grow at 3 percent (broadly in line with historical averages), and the government earns 20 percent of exports in taxes, then delivering an equal share of nonmineral GDP to all generations would require a primary surplus this year of nearly 5 percent of GDP. This translates to an overall surplus of 2 percent of GDP. Even if the most optimistic parameters are chosen (wealth of $3 trillion, price growth of 5 percent, and a revenue take of 25 percent), the overall deficit should be no more than 3 percent of GDP. According to this analysis, Mongolia’s current consolidated deficit of 10 percent of GDP is far out of line, and, most likely, even the 2 percent of GDP deficit allowed by the FSL is too large.

Table A1.

Fiscal Balances Under PIH

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Source: IMF staff calculations.

4. An appeal to the MPIH framework does not change the conclusion that Mongolia’s fiscal stance is currently too loose. The top-right chart in Figure A1 presents alternative paths for the overall fiscal balance over time. While the PIH requires a surplus for the next fifty years or so (when resource revenues are strong) and a deficit only thereafter, it is possible to construct an MPIH path that features the 10 percent deficits that are currently observed; however, as shown in Figure A1, to allow such frontloaded consumption, the next generation would need to run substantially tighter fiscal policy to compensate—an unrealistic intergenerational social contract.

Figure A1.
Figure A1.

Mongolia: Sustainability Assessment Indicators

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

5. Neither does the conclusion change under the FSF framework. Observed deficits stem largely from heavy infrastructure spending, rather than from handouts/consumption. If spending is indeed devoted to investment, then no future payback period is needed under the FSF paths, and indeed, lifetime wealth is higher. However, even if it is assumed that the return on investment for infrastructure projects that are properly selected and managed could reach 25 percent in Mongolia, reflecting its pressing infrastructure needs, constraints on both absorptive capacity and capacity to borrow would substantially lower this return when spending is as high as observed in the past few years. As a result, an FSF path with more moderate frontloading is shown to deliver similar consumption (primary, current expenditure) but higher wealth for every generation.

6. Finally, even if there were a justification for temporarily running large deficits, permanent FSL limits should not be adjusted. As shown in Figure A1, while certain constellations of parameters may support a path of heavy upfront investment, it would soon be expected that the fiscal balance would turn to substantial surplus, permitting the buildup of a large sovereign wealth fund. In other words, the fiscal deficit will naturally evolve over the lifecycle of the mines. The FSL, however, sets a single deficit limit for every year. This should not be loosened for all years just to permit a (hopefully) short-lived increase in deficits. Similarly, there appears to be little justification for raising the gross debt limit of 40 percent of GDP. As wealth is accumulated, there may still be a need for some gross debt, in order to allow fiscal maneuverability, but this would presumably be a small amount.

B. A Sustainable Public Investment Path for Mongolia: A Model-Based Analysis3

This paper complements the first by looking at optimal fiscal paths, but using an entirely different methodology. Rather than a spreadsheet-based analysis focused on fiscal variables alone, this paper offers results from a DSGE model tailored to resource-rich economies. This permits an investigation of the implications of different fiscal policies for key fiscal and non-fiscal variables such as debt, consumption, investment, and the real exchange rate. This paper also finds that fiscal consolidation is needed and that the FSL limits should not be adjusted.

7. This paper adopts a structural model-based analysis to help assess policy decisions regarding the management of natural resources in Mongolia. The study uses a dynamic stochastic general equilibrium (DSGE) model with natural resource wealth in a small open economy. The model combines elements of frameworks developed in Araujo et al. (2013), Buffie et al. (2012), Berg et al. (2013), and Melina et al. (2013), in analyzing natural resource management for developing countries. The DIGNAR toolkit is used to analyze various public investment plans in Mongolia. The model captures the investment-growth nexus as well as investment efficiencies and absorptive capacity constraints.4 It thus helps to inform the authorities about the tradeoffs involved in investing resource revenues to boost growth while maintaining fiscal sustainability and macroeconomic stability.

8. The model captures the key features of resource-rich developing countries and is carefully tailored to Mongolia’s particular circumstances. It features two types of households, including poor households with no access to financial markets, and includes traded and non-traded sectors as well as a natural-resource sector. Public capital, subject to inefficiencies and absorptive capacity constraints, enters production functions in both the traded and non-traded sectors. The government has access to different types of debt (concessional, domestic, and external commercial) and a resource fund, which can be used to finance public investment plans. The resource fund can also serve as a buffer to absorb fluctuations of fiscal balances for given projections of resource revenues and public investment plans. Fiscal adjustments through tax rates and government non-capital expenditures—which may be constrained by ceilings and floors, respectively—may be triggered to maintain debt sustainability. The model is calibrated using historical data for Mongolia and parameters widely accepted in the literature.

9. The model is estimated under two different public investment paths. Under a fiscal consolidation path, the government restrains public investment so as to manage the debt. The aggressive investment path, by contrast, maintains currently observed investment levels to develop infrastructure and boost growth.

10. Since uncertainty and volatility are intrinsic to resource economies, the public investment paths are each analyzed under a baseline scenario and an adverse scenario.

  • Baseline scenario: Copper mining production is estimated to increase from 0.2 million tons in 2013 to around 1 million tons by 2020, when the second phase of OT goes into production. It is also assumed that political constraints make it impossible to increase consumption or labor taxes, and the government thus relies on external commercial borrowing.

  • Adverse scenario: Resource revenues are hit by a negative shock—e.g., a further delay in OT-2, or a drop in copper prices similar to that observed in 2009.

11. As shown in Figure A2, the aggressive investment path substantially increases fiscal risk. While it yields faster growth than under fiscal consolidation, it also implies that public debt—and external, commercial debt in particular—rises substantially. And the situation is even worse if the adverse scenario obtains. Finally, rapid investment will quickly lead to investment inefficiencies (poor planning, higher-than-expected costs, bad governance, supply bottlenecks, lack of complementary infrastructure, etc.), further underscoring the need for fiscal restraint.

Figure A2:
Figure A2:

Resource Output, Revenues, and Fiscal Variables

Left column: Baseline Scenario; Right column: Adverse Scenario)

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

12. The aggressive investment path would also put pressure on the external sector. As shown in Figure A3, the togrog is currently overvalued and should be allowed to depreciate. Aggressive government investment would lead to overheating, bid up the relative price of nontradables, widen the current account deficit, and impede the pace of the required real depreciation.

13. In sum, a DSGE-model-based analysis confirms earlier findings that frontloaded fiscal consolidation is needed. The analysis in this paper stresses the benefits of adopting a comprehensive approach to enhancing absorptive capacity, managing natural resource wealth in a way that avoids Dutch disease, and sustaining the longer-term diversification of growth. In Mongolia, given the nontrivial role of the natural resources sector, it is particularly important to look beyond traditional metrics of investment pace. While the ambitious scaling up of public investment can generate higher non-mineral growth, it can also pose substantial challenges to debt sustainability and macroeconomic stability.

Figure A3:
Figure A3:

Fiscal and External Variables, and Growth

(Left column: Baseline Scenario; Right column: Adverse Scenario)

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

C. Mongolia—Risks of Rapid Credit Growth5

This paper uses techniques from the literature to conclude that Mongolia experienced a potentially harmful credit boom in 2013.

14. Mongolia has seen strong credit growth in 2011–2013. Credit grew by an average of 50 percent per year during 2011–13. In 2013, the strong growth was driven mostly by construction and real-estate loans, largely as a result of the central bank’s easing programs. This led the banking sector’s loan-to-deposit ratio to rise to 123 percent and the credit-to-GDP ratio to 57 percent in 2013. In 2014, credit growth decelerated, but the credit-GDP ratio rose further to 61 percent.

A01ufig2

Mongolia: Credit to Private Sector

(In percent)

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Sources: Mongolian Authority

15. This paper analyzes whether the strong credit growth constitutes “a bad credit boom” and discusses the risks of such a boom.6 The paper takes a three-step approach. It first assesses the medium-term trend of credit, using various filtering techniques.7 The second step is to calculate the “credit gap” obtaining from the difference between the actual credit and the medium term trend. Finally, it looks at whether the credit could represent a “bad” credit boom by estimating credit gap with respect to certain threshold.8 The paper also uses the direct approach found in Dell’Ariccia and others (2012), where a 20 percent annual increase in the credit-to-GDP ratio is taken as the threshold of natural credit increase.

16. The estimation concludes that Mongolia experienced harmful credit booms in 2011 and 2013. In 2013, credit exceeded its threshold in all methodologies, with equilibrium credit in 2013 estimated at around 50 to 55 percent of GDP. Similarly, Mongolia experienced a credit boom in 2011 of about 3 to 5 percent of GDP higher than the appropriate levels. In 2014, credit (including mortgage-backed securities) remained above the threshold level.

Table A2:

Mongolia’s Credit Gap and the Sign of Bad Boom across Method (% to GDP)

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Boom if credit to GDP ratio increase by more than 20 percent, in Dell’Aricia and others (2012).

The deviation from trend is greater than 1.5 time standard deviation and annual growth credit exceeds 10% in Dell’Aricia and others (2012)

Mendoza and Terrones (2008)

Gourinchas and others (2001) and BIS (2010)

Borio and Lowe (2002)

Relative to its trend, in Gourinchas and others (2001) and Hilbers and others (2005)

Borio and Lowe (2002), Borio and Drehman (2009), Hilbers and others (2006), and BIS (2010)

Gersl and Seidler (2001)

Source: IMF Staff estimate

17. The Mongolian credit boom in 2013 was higher than in other peer countries in the region. Cross country data show that the Mongolian credit gap in 2013 was bigger than those of other countries in the region. The finding remains relevant when the credit gap is compared to historical levels of peer income countries in the region, except Indonesia and Lao PDR (Figure 3).

A01ufig3

Historical Comparison: Credit Gap vs Credit

(In percent to GDP-Gap using HP Filter Rolling method)

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Sources: IMF Staff estimate
A01ufig4

International Comparison: 2013 Credit Gap vs Credit

(In percent to GDP-Gap using HP Filter Rolling method)

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Source: IMF staff estimates

18. Many empirical papers conclude that excessive credit is harmful. Credit booms can propagate excessive demand, generate economic overheating, and trigger asset price bubbles. Such unfavorable developments would reduce domestic competiveness, widen external imbalances, and foster depreciation. Rapid credit growth also raises banking and broader financial-sector vulnerabilities, given the typical deterioration of asset quality. This early warning seems relevant to the FSI data – Mongolia’s credit quality has started to deteriorate since mid of 2013; and liquidity has tightened as reflected in the decreasing liquid asset ratio.

A01ufig5

Mongolia: NPL and Liquid Asset to Total Asset Ratio

(In percent)

Citation: IMF Staff Country Reports 2015, 109; 10.5089/9781484346341.002.A001

Sources: Mongolian Authority

19. Various country experiences also show that prolonged credit booms can lead to banking crises and substantial output losses. Laeven and Valencia (2013) documented the impact of banking crises on output, debt, and asset quality. Hilbers and others (2005) pointed out that the cost of a credit boom to the economy will depend on the nature of credit, the rate of credit growth, the main providers of credit, the main borrowers, the sectoral loan composition, the currency composition of loans, and the maturity of loans.

Table A3:

Banking Crises’ Outcomes, 1970–2011

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Source: Hilbers, Otker-Robe, Pazarbabosioglu, and Johnsen (2005)

20. The policy implications are clear: credit should be managed properly to sustain the economy without risking a crisis. Among others, Dell’Ariccia and others (2012) summarize the major policy recommendations to deal with credit booms. These include fiscal, monetary, and macroprudential tools. Policy coordination across different authorities and across borders may also need to be strengthened.

Annex VII. Policy Agenda for Strengthening the Banking Sector

Important legal and regulatory reforms have been passed, but bank supervision needs further upgrading. A recent TA mission outlined priority actions, as follows:

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1

The Fiscal Stability Law, which went into effect in 2013, required that the structural on-budget fiscal deficit be kept below 2 percent of GDP, but the government created the Development Bank of Mongolia (DBM), run by a new Ministry of Economic Development, and channeled an extra 8 percent of GDP in capital spending through it.

2

Project and borrower selection criteria are difficult for staff to evaluate, and given the DBM’s track record, a cautious approach is desirable. Moreover, standard statistical principles do not allow for a portion of an agency’s spending to be carved out and treated differently.

3

Even without OT-2—and thus with lower growth—debt would be on a declining path from 2018, as shown in an alternate scenario in the accompanying DSA.

4

Mineral wealth—most of which, of course, has not been converted to financial wealth—has been estimated at up to $3 trillion, which would be nearly 150 times Mongolia’s total external debt and more than 300 times its gross public debt.

5

Because of the weakness of monetary transmission through the interest-rate channel, care should be taken in interpreting a Taylor rule for Mongolia.

6

The loans under the BOM easing programs were exempted from capital charges (zero-risk weighted) and from limits on large exposures and industry concentrations.

7

To be precise, the FSL amendments and new DML implement the following: (1) non-commercial DBM spending is brought onto the budget and thus included in the calculation of the structural fiscal deficit; (2) structural fiscal deficit limits are temporarily raised (5 percent of GDP in 2015, 4 percent of GDP in 2016, and 3 percent of GDP in 2017) but kept at 2 percent of GDP for 2018 and beyond; (3) the definition of debt is narrowed from public to general government debt (with the new definition, SOE debt and government guarantees that are fully secured by government securities are excluded); and (4) debt limits are temporarily raised (58.3 percent in 2015, 55 percent in 2016 and 50 percent in 2017) but remain at 40 percent for 2018 and beyond.

8

The scenario also assumes that banking, structural, and social protection reforms are also undertaken—see below.

9

The current account deficit narrows in dollar terms relative to the baseline scenario; but since the adjustment lowers GDP, the CAD in percent of GDP rises. Also, the CAD still worsens for a few years within the adjustment scenario, on account of OT’s geological conditions and the start of OT-2 construction.

10

For further background, see IMF Departmental Paper No. 13/2 (August 28, 2013), “Boom, Bust, or Prosperity? Managing Sub-Saharan Africa’s Natural Resources Wealth.”

1

For Mongolia, one should arguably focus only on non-mining imports (half the total), as mining imports come with their own FDI financing. From this perspective, the optimal range would be 2¼ to 3½ months of total imports, but being high in that range is advisable given the volatility of the mining sector, the extent of deposit dollarization, and the need to boost market confidence to facilitate debt rollovers in 2017/18

1

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize, in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually-exclusive risks may interact and materialize jointly.

1

Summarizes a paper under preparation by Baoping Shang (FAD) and Koshy Mathai (APD).

2

“Macroeconomic Policy Frameworks in Resource-Rich Developing Countries,” IMF Policy Paper, Aug 24, 2012. Also, “Fiscal Regimes for Extractive Industries: Design and Implementation,” IMF Policy Paper, Aug 15, 2012.

3

Summarizes “From Natural Resource Boom to Sustainable Economic Growth: Lessons for Mongolia,” forthcoming IMF working paper, prepared by Pranav Gupta, Grace Bin Li (both RES), and Jiangyan Yu (APD).

4

The model includes only real variables and cannot be used to analyze monetary policy or inflation.

5

Prepared by Firman Mochtar (APD).

6

Given cross country data availability, the panel estimation employs the 2000–13 data series.

7

One method is to use a rolling Hodrick-Prescott (HP) filter to find the potential and long-term credit-GDP trend (as applied by BIS (2010), Borio and Lowe (2002), Borio and Drehman (2009) as well as Hilbers and others (2006)). A second method follows Mendoza and Terrones (2008), who also applied the HP filter, but using the whole sample period rather than a rolling sample period. The third method (backward-looking, rolling, and cubic trend) is taken from Dell’Ariccia and others (2012). Finally, Gersl and Seidler (2011) use economic fundamentals to estimate the equilibrium credit-GDP ratio.

8

Gersl and Seidler (2001) and BIS (2010) use the absolute credit gap about 2 percent of GDP as threshold, while Borio and Lowe (2002) use 4 percent of GDP. Others use relative credit gap to its long term trend and set 5 percent as the threshold credit gap (see Gourinchas and others, 2001 and Hilbers and others, 2005).

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Cover IMF Staff Country Reports
Mongolia: 2015 Article IV Consultation—Staff Report; Press Release; and Statement by the Executive Director for Mongolia
Author:
International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2015: Issue 109
Publisher:
International Monetary Fund
ISBN:
9781484346341
ISSN:
1934-7685
Pages:
89
DOI:
https://doi.org/10.5089/9781484346341.002
  • Figure 1.
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    Figure 1.

    Real Sector Developments

  • Figure 2.
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    Figure 2.

    Fiscal and Monetary Sector Developments

  • Figure 3.
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    Figure 3.

    External Sector Developments

  • Figure 4.
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    Figure 4.

    Inclusive Growth Indicators

  • Figure 5.
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    Figure 5.

    Key Indicators in Baseline and Policy Adjustment Scenarios

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    Reserves Adequacy Under Different Approaches

    (In months of imports)

  • Figure A1.
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    Figure A1.

    Mongolia: Sustainability Assessment Indicators

  • Figure A2:
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    Figure A2:

    Resource Output, Revenues, and Fiscal Variables

    Left column: Baseline Scenario; Right column: Adverse Scenario)

  • Figure A3:
    View in gallery
    Figure A3:

    Fiscal and External Variables, and Growth

    (Left column: Baseline Scenario; Right column: Adverse Scenario)

  • View in gallery

    Mongolia: Credit to Private Sector

    (In percent)

  • View in gallery

    Historical Comparison: Credit Gap vs Credit

    (In percent to GDP-Gap using HP Filter Rolling method)

  • View in gallery

    International Comparison: 2013 Credit Gap vs Credit

    (In percent to GDP-Gap using HP Filter Rolling method)

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    Mongolia: NPL and Liquid Asset to Total Asset Ratio

    (In percent)

Figure 1.

Real Sector Developments
Figure 2.

Fiscal and Monetary Sector Developments
Figure 3.

External Sector Developments
Figure 4.

Inclusive Growth Indicators
Figure 5.

Key Indicators in Baseline and Policy Adjustment Scenarios

Reserves Adequacy Under Different Approaches

(In months of imports)
Figure A1.

Mongolia: Sustainability Assessment Indicators
Figure A2:

Resource Output, Revenues, and Fiscal Variables

Left column: Baseline Scenario; Right column: Adverse Scenario)
Figure A3:

Fiscal and External Variables, and Growth

(Left column: Baseline Scenario; Right column: Adverse Scenario)

Mongolia: Credit to Private Sector

(In percent)

Historical Comparison: Credit Gap vs Credit

(In percent to GDP-Gap using HP Filter Rolling method)

International Comparison: 2013 Credit Gap vs Credit

(In percent to GDP-Gap using HP Filter Rolling method)

Mongolia: NPL and Liquid Asset to Total Asset Ratio

(In percent)