Economic Outlook

Mongolia has made strong development progress in recent years, retains enormous longrun economic potential, but faces challenges in ensuring sustained and stable growth in the short to medium-term. Economic growth of Mongolia remained at 7.8 percent and per capita income reached $4,000 in 2014, but growth is expected to slow in the next few years. The economy remains vulnerable to boom-bust cycles and has faced sharp declines in FDI over the past few years.

Mongolia faced a severe balance of payment shock in late 2012 throughout 2013 and 2014 though measures were taken to achieve a soft landing. Commodities super cycle turned down, capital flows toward emerging markets and developing economies reversed, and net foreign direct investment to GDP ratio substantially declined from 45 percent to only 5 percent over the last three years. The balance of payment shock was particularly intense in 2013 though authorities consider the impacts on trade, the current account, and economic activity were significantly lessened in 2014 as a result of policy adjustments. Real GDP growth gradually slowed down from 12.3 percent in 2012 to 11.6 percent in 2013 and 7.8 percent in 2014.

Inflation has decreased gradually in past years and appears broadly under control, and actions have been taken to slow credit and money growth. Annual CPI inflation decreased from 14.0 percent in 2012 to 9.3 percent as of February 2015. Supply-driven inflationary pressure has been substantially decreased. The Bank of Mongolia (BOM) has gradually tightened its monetary policy stance by increasing the policy interest rate twice, 1.5 percentage points in July 2014 and 1.0 percentage point to 13 percent in January 2015. Real interest rates are now strongly positive and money and credit growth have slowed significantly. These decisions have reduced aggregate demand and the current account deficit, curbed inflationary pressure, and promoted macroeconomic and financial stability.

Uncertainty in the balance of payment outlook still remains a concern, and the authorities are pursuing a range of options to reduce risks on this front. The baseline forecast indicates that overall balance of payment could face a 1.4 billion dollars financing deterioration in 2015 due to mainly unfavorable external environment for the mineral exports and a sharp fall of the FDI inflows in the past two years. We note that recent import data has been weaker than the assumptions of this baseline which, if this weakness persists, may assist in ameliorating financing needs. However, authorities accept that a range of actions must be explored to deal with this challenge. They are working closely with a range of international financial organizations and bilateral partners on the possible options for external financing to fill this gap, including the extension of the local currency swap facility between the BOM and PBOC that has been playing a crucial role in mitigating the impacts of the shocks. The authorities have indicated that the PBOC has reaffirmed that it is fully committed to continuing the facility and willing to extend the swap line. Ongoing close consultation with the IMF and responsiveness to its recommendations will assist in this process of engagement with other financing partners. Furthermore, efforts are ongoing to advance negotiations on major projects with a significant potential impact on development and FDI flows. Finally, authorities stand ready to take additional corrective action, if required, to deal with unfolding risks, by adjusting import-intensive spending or fiscal policy.

Fiscal Policy

The authorities are committed to significant reductions in structural deficit targets, including limiting off-budget and reducing quasi-fiscal operations and integrating them into the Budget. In order to strengthen Mongolia’s fiscal position, the authorities have secured Parliamentary approval of the Amendment to the Fiscal Stability Law (FSL), Debt Management Law (DML), and the Comprehensive Macroeconomic Adjustment Program (CMAP). As a result, the authorities will achieve a 2015 fiscal deficit of 5 percent of GDP, including non-commercial Development Bank of Mongolia (DBM) investment, decreasing the deficit by 1 percentage point for each year to reach the deficit target of 2 percent of GDP by 2018 and implement a cost-saving regime in the budget through prioritizing spending.

Concrete measures have been introduced to cut budget expenditures and increase the revenue in line with these fiscal objectives. Budget resources earmarked for civil servants’ wage increase have been decreased by 60 percent and targeted at maintaining real wages of low wage earners, equivalent to a reduction in spending by 0.6 percent of GDP. Authorities are considering ways of targeting non-social welfare related subsidies. On the revenue side, the authorities increased the customs duties and excise tax rates on imported oil, in response to the recent declines of oil prices.

The Government of Mongolia has started implementing recommendations of international financial organizations to limit off-budget and quasi-fiscal operations and integrate them to the budget. The parliament has agreed to the integration of off-budget ‘quasi fiscal’ spending into the central budget. This includes several programs currently operated by the Bank of Mongolia. A comprehensive set of actions are being undertaken to improve the legal environment and governance structure of the DBM to match international principles and standards and to ensure the successful operation of the bank in international financial markets. As a first step, the authorities are planning to transfer non-commercial lending activities in the pipeline of the DBM to the budget after conducting an independent assessment on the portfolio. While commercial DBM spending is not being fully integrated with central budget at this stage controls are being greatly enhanced to ensure these investments are driven by market considerations. The Minister of Finance will now approve financing of projects and activities included in the 2015 budget, to ensure consistency with the budget deficit and macroeconomic conditions (including BOP requirements). Furthermore, the DBM shall now obtain the Finance Minister’s opinion when taking on a direct or contingent liability or any other explicit or implicit financial obligations regarding the consistency of any such liabilities with the FSL. Controls are being put in place to prevent political intervention in decision making processes, and more generally, improve governance and oversight. Another key element regarding control is that the Finance Minister and the Governor of the Bank of Mongolia will jointly approve supervision rules on DBM operations, effectively putting the DBM under the BOM supervision. Amendments along these lines will be introduced to Parliament in the Spring Session. The authorities are also investigating the potential to transfer key social programs currently in the Future Heritage Fund to the central budget.

The authorities will keep fiscal settings under review to ensure public debt is managed appropriately. The Medium-term Debt Management Strategy and the Comprehensive External Debt Servicing Plan have been revised in accordance with the newly adopted Debt Management Law and the CMAP was approved by the Financial Stability Committee on March 13 of this year. Under this approach, the authorities will initiate active debt and liability management operations to ensure further debt is serviced or rolled over in a way that is consistent with macroeconomic stability.

The authorities are taking step to underpin Mongolia’s long time fiscal future through the establishment of a sovereign wealth fund. The draft Law on Future Heritage Fund is expected to be reviewed and passed during the 2015 Spring Session of the Parliament. The fund would be designed consistent with international best practices. The aim is to ‘ring fence’ a certain portion of mining revenues to support future development needs, while also supporting the realization of counter-cyclical policies.

Monetary and Exchange Rate Policy

Supply-driven inflationary pressure has been substantially decreased and inflation appears broadly under control. There has been a positive change in the composition of inflation since 2013, with ‘supply shock inflation’ being significantly reduced. The BOM considers that this positive development is due to the PSP and a range of measures reducing headline inflation. The inflation outlook consistent with the Bank of Mongolia’s medium-term target of 7 percent, and real interest rates are now strongly positive. Monetary policy will continue to be managed in a prudent way to control inflationary pressures.

The BOM considers unconventional monetary policy measures have assisted in achieving a soft landing and is now phasing out programs as planned in the context of the broader macroeconomic adjustment program. The BOM considers its unconventional monetary policy measures, including the price stabilization program (PSP), as instrumental in achieving a soft-landing for the economy, mitigating impacts in the balance of payment shock on the economy and risks of a potential economic crisis, reducing supply-driven pressures on inflation, and ensuring financial sector stability. With the implementation of the CMAP, measures are being taken to normalize unconventional aspects of the monetary policy and the BOM has been intentionally phasing out the program as planned. Remaining PSP loans shall be transferred to the Government by the end of the 1st half of 2015, and this process has already commenced. The Government and the BOM are jointly examining the Sustainable Mortgage Financing Program including how it aligns with long term efforts to boost domestic savings and possible response options.

The Bank of Mongolia remains committed to a flexible exchange rate regime. If necessary, the Bank of Mongolia intends to intervene only for the purpose of smoothing out excessive exchange rate volatility.

The Bank of Mongolia will look for opportunities to enhance monetary policy decision making frameworks at an appropriate time.

Structural Reforms

The authorities are committed to improving the investment climate to assist growth and contribute to the resolution of BOP challenges. The authorities have submitted Parliament draft amendments to simplify tax laws and enhance their contribution to private sector growth, including by reducing inconsistencies and ambiguities. The authorities proposed amendments to the VAT to reduce the informal sector, support small businesses, and simplify the administrative procedures. They have also prepared an amendment to the corporate income tax law to support non-mining business activities.

Financial Sector

The Bank of Mongolia is taking action to strengthen the banking sector, enhance banking system safety, proactively address potential systemic risks, and ensure financial stability. The Bank of Mongolia received IMF technical assistance (TA) on enhancing systemic oversight and crisis preparedness capabilities in February 2015. The Bank of Mongolia has already started implementing the recommended actions provided by the TA by reflecting them in its Medium term strategy on banking supervision, including phasing in measures to ensure better risky loan recognition, improve provisioning and capital buffers, and improve risk weights among other actions. These actions will be implemented progressively.

Conclusion

The Mongolian authorities are committed to taking decisive action to ensure macroeconomic stability, thus laying a sound basis for longer term development. They are implementing measures across a wide range of areas, including those identified by Fund staff, and understand the need to further transition policy if circumstances require. Authorities greatly value ongoing engagement with the Fund and will keep staff recommendations under close review.