Mongolia: Fourth Review Under the Extended Fund Facility Arrangement and Request for Modification of Performance Criteria—Press Release; Staff Report; Staff Statement; and Statement by the Executive Director for Mongolia
A three-year arrangement for Mongolia under the Extended Fund Facility (EFF) was approved on May 24, 2017, in an amount equivalent to SDR 314.5054 million.
A three-year arrangement for Mongolia under the Extended Fund Facility (EFF) was approved on May 24, 2017, in an amount equivalent to SDR 314.5054 million.
1. One year into the program, macro performance continues to be strong though vulnerabilities remain high. The authorities have used the benign external environment and strong growth at home to over-perform on fiscal targets, refinance outstanding debt at lower interest rates and build foreign exchange reserves. That said, more progress is needed to durably reduce Mongolia’s core vulnerabilities. In addition to high commodity dependence, public debt remains high, reserves are not yet at adequate levels, and the banking system needs additional capital and tighter supervision. The outlook for continued strong growth – buoyed by high commodity prices and mining-related investments – will provide a critical window to address these vulnerabilities. A key concern is that rising pressures to stimulate the economy in the run-up to the next parliamentary election in 2020, may result in premature easing in policies and delayed structural reforms.
2. The economy continues to post strong growth. Real GDP grew 5.1 percent in 2017, up from 1.2 percent the year before, due to a sharp recovery in FDI, household credit growth and mineral exports. Despite weak coal exports in January and February, the economy accelerated further in the first quarter of 2018, rising 6.1 percent y.o.y., helped by strong output in the construction sector.
3. After strong capital inflows in 2017, the balance of payments has moderated in recent months. The current account deficit rose to over 10 percent of GDP in 2017 (up from 4 percent in 2015), reflecting strong investment-driven import demand and rising dividend repatriation from the mining sector. Large Oyu Tolgoi (OT)-related FDI, donor inflows, and other foreign currency inflows more than offset this deterioration, allowing reserves to rise by $1.7 billion (15 percent of GDP) over the course of the year. In recent months, however, progress in building reserve buffers has slowed due to an acceleration in consumer- and investment-related imports, a decline in scheduled donor flows, temporary border bottlenecks for coal exports, and portfolio outflows related to maturities on public debt.
4. The fiscal accounts continue to be strong. The primary balance in 2017 improved by 15 percentage points to reach a surplus of 2 percent of GDP. Two-thirds of this adjustment was expenditure contraction from excessive 2016 levels. Revenues also improved, due to a boom in both commodity exports (corporate income tax, royalties) and mining related-imports (VAT, customs). The robust fiscal performance has continued in the first quarter of 2018 with a 2.1 percent of GDP primary surplus, due largely to a 23 percent rise y.o.y. in revenues and large loan repayments to the Development Bank of Mongolia (DBM).
5. After a sharp rise in 2017, inflation has stabilized in recent months. A mixture of one-off factors (changes to the CPI basket, higher tax rates), higher imported fuel prices, and a recovery in demand raised inflation to 7.2 percent in 2017, up from less than one percent the year before. This acceleration has moderated in the first 4 months of 2018 with inflation remaining below the 8 percent target. On this basis, the Bank of Mongolia cut the policy rate by 100 basis points in March, bringing the cumulative cuts to 500 basis points and completing the reversal of the 2016 emergency hike.
6. The AQR has been completed and banks have begun to address the outstanding capital shortfall. The identified capital shortfall in the AQR as of the third quarter of 2017 was 1.9 percent of GDP. To determine capital needs for end-2018, BOM analyzed banks’ business plans and updated the AQR results accordingly. In May, BOM communicated the final capital shortfalls to banks that must be met by end-December 2018. In addition, BoM informed banks in May (prior action for this review) that they must formally book the provisioning gap identified by the AQR results by end-June. Meanwhile, to provide an important backstop for financial stability, Parliament will pass a Recapitalization Law which outlines when and how public-sector funds can be used to support systemic banks in the event of a capital shortfall (prior action for this review).
7. Bank lending accelerated throughout the last year. Despite high interest rates (17 percent in nominal terms on average) and the uncertainty during the AQR, credit growth rose from 7 percent in 2016 to 11 percent last year, driven by non-mortgage lending to households who borrowed to maintain purchasing power after the 25-percent depreciation of the Togrog in 2016. While credit to corporates remained largely flat in 2017, in part due to relatively weaker quality of credit exposures, there are some signs of recovery in recent months.
Outlook and Risks
8. Despite some deterioration in the external environment for emerging markets, the near-term outlook for Mongolia remains favorable. An increase in OT-related FDI and an acceleration in credit will compensate for moderate real mining exports, higher oil prices and rising global interest rates, allowing growth to remain at 5 percent this year. With this growth, staff estimates that the output gap in the non-mining sector, which is more relevant for policy settings, will be slightly positive in 2018. Nonetheless, inflation is expected to remain around 8 percent, reflecting the cessation of one-off domestic factors. Gross international reserves are expected to remain broadly unchanged due to delays in prior actions for some donor loans and continued strong import growth.
9. Growth and the balance of payments are expected to remain strong in the medium term, helping build reserves and reduce public debt. The growth path is anchored by assumptions related to two large construction projects. First, FDI will be supported by continued OT-related investments and the start of several projects related to the Tavan Tolgoi (TT) coal mine. Second, in 2021-22, the second phase of the OT copper mine will start production, boosting exports. This strong growth, accompanied by continued fiscal consolidation, will help public debt reach about 71 percent of GDP in 2020 (vs. 97 percent projected in the original EFF) and return to 2015 levels of 55 percent by 2023. Although the expectation of sustained strong domestic demand has resulted in a deterioration in the current account deficit, strong FDI and exports will still bring reserves to $4.7 billion, or 7 months of imports by 2020 (vs. $4 billion projected in the original EFF).
10. Downside risks continue to outweigh upside risks. By eliminating the primary deficit, almost tripling foreign exchange reserves, and removing all external sovereign bond maturities between now and 2021, the authorities have substantially reduced the risk of renewed crisis in the next few years. Nonetheless, three key risks persist:
Increasing political pressure could result in premature easing in monetary and fiscal policies, a slowdown in structural reforms, or changes to the investment climate which undermine key growth drivers (e.g. OT).
Several developments in the mining sector could undermine the recovery including a fall in prices due to a slowdown in Chinese or global demand, renewed bottlenecks at the border (that can significantly impact coal exports), or a change in China’s environmental policy which has boosted its reliance on imported coal.
Challenges in the follow up to the AQR process (e.g. liquidity pressures, or banks unable to raise needed capital by end-December) could undermine financial stability and/or slow the economic recovery, underscoring the importance of close monitoring and, if needed, decisive action by the Bank of Mongolia.
A. Fiscal Policy
11. Revenues are on track to over-perform but some risks have emerged on capital spending. The Q1 outturn and current projections for the year suggest revenues are likely to exceed previous estimates on the back of strong trade and high commodity prices. The authorities have indicated that they intend to save all of this revenue over-performance (up from the earlier commitment to save half). On this basis, the fiscal target has been tightened to −1 percent of GDP (from −1.6 percent at the time of the last review and −2.6 percent of GDP in the 2018 budget passed by parliament) while leaving future program targets unchanged. This fiscal stance is appropriately tighter than the debt stabilizing primary balance of −5 percent, implying further progress in reducing Mongolia’s still high public debt (85 percent of GDP). However, commitments on concessional foreign-financed capital spending have exceeded budget ceilings by an estimated 2.2 percent of GDP. The over-run stems from a sharp increase in available concessional financing, a low ceiling on such spending in the 2018 budget, and inadequate coordination during the change in government late last year. Nonetheless, the authorities have committed to implement offsetting measures (e.g. prioritization of other capital spending or lower non-essential current spending) as necessary to meet the agreed deficit target and will strengthen the public financial management to prevent this from happening again.
12. Though headline fiscal performance has been strong under the program, the structure of the budget needs to improve further to support sustained adjustment.
Fuel Price and Tax—The authorities currently fix the retail price of the most widely-used gasoline. However, during periods of particularly high world prices, the retail price is not adequate for importers to make profits, leading to fuel shortages. The authorities have committed to moving away from this system by the start of 2019. Working with Fund staff, the authorities intend to adopt a formula which (i) ensures sufficient corporate profits to prevent shortages, (ii) increases the flexibility of the consumer price, (iii) and gradually re-introduces an excise tax to reach a target level over a three-year period (end-December structural benchmark).
Social Spending—The level of social assistance spending in Mongolia is relatively high at over 2 percent of GDP and has been successfully protected under the program, as intended, amid substantial fiscal adjustment. However, the composition of that spending has deviated from the original program which had intended to change the Child Money assistance from universal coverage to the poorest 40 percent of children and use the resulting savings to scale up spending on programs targeted at the poorest households. Instead, the authorities have reduced coverage to the poorest 80 percent of children and reversed much of the planned increase in other targeted programs to finance this higher coverage. Moreover, there is ongoing pressure to reverse even this modest narrowing of the Child Money program and return to universal coverage. While this mix of policies will not undermine macroeconomic stability, it will reduce assistance to the most vulnerable and it departs from key commitments in the Asian Development Bank and World Bank programs. Going forward, if the authorities wish to have universal or near universal programs, it is important to ensure that the budget more broadly continues to address inequality concerns, such as through progressive income taxation.
Infrastructure Concessions—In recent years, previous governments signed a series of non-transparent “build-transfer agreements” to invest in infrastructure. The unpaid fiscal commitments in the associated projects, which are in varying degrees of completion, total roughly 5 percent of GDP. To limit fiscal risks, the authorities are in the process of auditing the completed concessions to assess the precise cost and legality of the projects. Once the audit is complete and a payment schedule finalized, the authorities will include these obligations in the 2019 budget and the next Medium-Term Budget Framework (end-August structural benchmark). No new build-transfer agreements have been signed since early 2017 and the authorities have confirmed that the practice is now forbidden.
Mortgage Program—Between 2013 and 2016, there was a surge in subsidized mortgages financed by the Bank of Mongolia which dominated the market, accounting for 80 percent of outstanding mortgages. Since 2016, the Ministry of Finance has been solely responsible for all net new subsidized mortgage lending but has limited the aggregate size of the subsidy it will provide to 0.4 percent of GDP per year; as a result, mortgage growth overall has slowed and the stock is falling relative to GDP. Going forward, the authorities have committed in a Memorandum of Understanding signed in late 2017 to transfer the stock of subsidized mortgages on the BOM balance sheet to the government. Staff will also work with the authorities to find ways to better target subsidies to the most vulnerable.
Development Bank of Mongolia (DBM)—Before the program, DBM was a key source of off-budget fiscal spending with net lending of 3 percent of GDP per year. To address this, the program took two steps. First, it expanded the fiscal coverage of the general government to include DBM net lending. Thus far, this approach has successfully curtailed fiscal risks and DBM had net repayments of 0.5 percent of GDP in 2017. Second, the program called for an audit of its activities since 2012 to assess the degree to which DBM has operated largely as an extension of fiscal spending or rather as a more commercial enterprise. The board of DBM has now approved this audit and it is expected to be completed by mid-November 2018. Once done, more work will be necessary to assess the proper role for DBM going forward, balancing fiscal and governance risks against genuine development needs.
B. Monetary and Exchange Rate Policy
13. The next move in the policy rate should await clear evidence on the direction of inflation and the balance of payments. While inflation has stabilized just below the 8 percent target in recent months, upside risks remain as credit growth is strong and the output gap has turned positive. Also, while gross reserves are significantly higher than expected at the time of program approval, they remain at only 80 percent of the IMF ARA metric (a ratio between 100–150 percent is considered adequate). Therefore, the authorities should keep monetary policy on hold and stand ready to hike if inflation surprises negatively or the balance of payments fail to strengthen. The authorities’ plan to tighten macroprudential measures in coming months; while mainly aimed at financial stability concerns, this may also help tighten the stance and reduce domestic absorption (see para 17 below).
14. The external position remains broadly in line with fundamentals. In 2016, the Togrog (in nominal and real and nominal effective terms) depreciated by nearly 25 percent. Since then, it has been broadly stable amid substantial reserve accumulation. This large change in relative prices has not generated a correction in the current account deficit (indeed it has widened) due to a surge in FDI-related capital goods imports and dividend repayments. In addition, households reacted to the loss of foreign currency purchasing power by sharply increasing borrowing, which has led to an acceleration of consumer imports. To some degree, large current account deficits are inevitable during this capital-intensive phase of Mongolia’s development. At the same time, overall external debt is now very high at 240 percent of GDP (see external DSA) while foreign assets are still low. To maintain external stability going forward, it will be important to rein in consumer credit and ensure that the investment climate is sufficiently strong to increase Mongolia’s export potential.
C. Financial Sector Policy
15. The next 6 months is a critical period in the follow-up to the AQR. Banks are now expected to address the capital shortfall identified by BOM. By end-December, the banking system should be fully capitalized and well-positioned to support the ongoing economic recovery. If any bank is unable to raise the needed capital by end-December, the authorities now have the powers to intervene in a manner that safeguards financial stability (end January-2019 structural benchmark). Specifically, in the case of systemic banks that are unable to fully meet the shortfall with private capital, the authorities can use the soon-to-be passed recapitalization law to inject public funds under strict conditions. In the case of a non-systemic institution, BOM can use the revised banking and DICOM laws to resolve the bank and protect depositors as appropriate. That said, even though BOM now has such powers, additional contingency planning and scenario analysis is still needed to ensure that, if needed, BOM can effectively and safely intervene. In particular, BOM, in cooperation with MOF, should map out hypothetical transaction details and identify the needed public resources.
16. The authorities are starting to focus on improving the legal and regulatory framework for NPL resolution, while strengthening prudential regulation. Mongolian banks’ inability to efficiently resolve non-performing loans – through restructuring or enforcement of collateral – hurts economic growth because it impairs their balance sheet and puts upward pressure on interest spreads. To address this, the authorities had planned to draft and publish a detailed NPL resolution strategy (end-May structural benchmark) but this has taken longer than expected and will be completed in coming months. Implementation of this strategy - including reforms related to collateral enforcement (end-November structural benchmark), reformed corporate bankruptcy law (end-March 2019 structural benchmark), taxation, judicial process (end-April 2019 structural benchmark), and real estate data (end-April 2019 structural benchmark)—is expected to start in the Fall. Meanwhile, the authorities are still considering whether creating an Asset Management Company could help resolve the current large stock of NPLs which is a legacy of the previous downturn. Due to governance and fiscal concerns, the authorities have confirmed that in the event an AMC is established, the Mongolian public stake would be limited to a small minority stake, and no public entity will lend or issue guarantees to the AMC. In addition, the authorities aim to adopt new prudential regulations by revising the structure of risk weights, introducing a definition of capital and capital buffers aligned with international standards, and detailing the criteria for restricting dividend and coupon payments when needed (end-December structural benchmark).
17. Adoption of macro-prudential measures aimed at household loans would support financial stability and consumer protection. Though reported non-performing loans remain low, more than 40 percent of household loans now have debt service-to-income ratios above 60 percent. For the most part, the loans are “collateralized” by household wages or pensions which notionally reduces the risk to lenders. However, such high debt levels increase the risk to growth and public welfare if households are using disproportionate shares of their income to repay debts on which they cannot default. To prevent this risk from materializing, it is important to broaden the coverage of macro-prudential measures on lending to households from only mortgages to also include consumer loans (given recent strong growth in non-mortgage consumer credit). The authorities aim to put in place a limit on the debt service to income ratio on new household lending in coming months to address financial stability risks (end-September structural benchmark). Going forward, it will be important to improve the institutional framework regarding macro-prudential measures to clarify the analytical framework and decision-making process of the macro-prudential toolkit.
18. The authorities have strengthened their AML/CFT framework but further work remains. In 2017, the Asia Pacific Group (APG) released a critical assessment of Mongolia’s AML/CFT regime, finding deficiencies in both the underlying legal framework and enforcement of existing laws. This finding has resulted in closer international scrutiny and a reduction in correspondent banking relationships. In April, Mongolia took concrete steps to address some of the deficiencies identified by the APG, amending both the AML/CFT law and the Law on Infringements. Going forward, it is critical that the authorities demonstrate progress with respect to the implementation of AML/CFT regulations and targeted financial sanctions on financing of proliferation of weapons of mass destruction. In addition, it will be important to step up risk-based offsite and onsite supervision of banks, non-bank financial institutions, and other high-risk entities. The Financial Action Task Force may consider Mongolia’s status (i.e. potential “grey listing”) in June and the APG will assess Mongolia’s progress with respect to the AML/CFT framework in July.
19. Progress has been made in implementing safeguards assessment recommendations. The BOM has drafted a new charter for the Internal Audit Department, established a quarterly reporting mechanism of the function to the Supervisory Board, and discussions are underway with another central bank on conducting a peer review of internal audit and aspects of controls. The new central bank law provides for an independent oversight body to oversee the audit and control mechanisms.
D. Program Modalities
20. Performance on program conditionality has been strong. The authorities have met all quantitative performance criteria (QPCs) for end-March. With respect to structural reforms, the authorities have submitted two tax administration laws which were originally due last February. With respect to structural benchmarks due since the last board date (end-March to end-May) the authorities passed amendments to the Bank of Mongolia law, and will pass a Recapitalization Law, while approval and publication of the NPL resolution strategy has been delayed.
21. Looking forward, QPCs have been updated to reflect revisions in the macro-framework while new structural benchmarks have been added. For 2018, the primary balance was tightened to reflect revenue over-performance and the end-year NIR target has been revised downward, primarily to reflect delays in donor funding. Monetary targets were adjusted accordingly. Several new structural benchmarks have been added in fiscal policy (fuel price mechanisms and taxation, tax administration compliance) and banking (booking AQR results, new macro-prudential limit on household lending, and several measures related to strengthening the NPL resolution framework).
22. The program remains fully financed despite some envisioned delays in donor funding. The size and phasing of program funding at the time of board approval was designed to both ensure public debt sustainability and restore external balance. While donor funds have largely disbursed as expected, the program has overperformed on its two goals, primarily reflecting better than expected external conditions. Public debt at end-2017 was ten percentage points of GDP lower than originally projected and this over-performance is expected to become 20 percentage points by end-year. Meanwhile, NIR as of end-March 2018 was $1.5 billion higher than the initial targets but the margin will moderate somewhat by year end due to delays in donor funding. The delays in donor funding are largely because the authorities need more time to complete several prior actions—which are expected to be done by early 2019. However, given the over-performance to date, the delay in NIR accumulation can be accommodated within the program. Nonetheless, with public debt still high and reserves not yet at adequate levels, significant risks remain as noted in para 10 above.
23. The authorities have successfully averted a debt crisis, but challenges remain. Driven by strong external demand combined with expenditure restraint, macroeconomic outcomes have exceeded expectations. The fiscal and reserve targets under the program have been met with considerable margins. While compliance with structural conditionality has been mixed, important progress has been made and going forward the authorities have committed to implementing key structural reforms in banking and fiscal areas. However, risks to the program remain, including from lower external demand for commodities, rising domestic pressures, adverse changes to the investment climate, and resistance from vested interests.
24. A key challenge is continued fiscal discipline while improving the structure of the budget to support sustained adjustment. As the 2020 elections near, spending pressures are rising. With public debt still high at around 85 percent of GDP and the economy exposed to global commodity developments, it is crucial that the authorities maintain the strong commitment to the program. On fiscal policy, priority should be given to continued expenditure restraint and strengthening of the tax administration, while protecting social spending. In addition, efforts to improve public financial management—particularly with respect to concessions, public investment, and the operations of the DBM—are needed.
25. Maintaining policies to support buildup of international reserves will be critical to help insulate the economy from external shocks. The authorities are committed to maintaining a monetary policy stance that is vigilant against inflation and supporting further improvement in the balance of payments. While gross reserves are significantly higher than expected, they remain at only 80 percent of the ARA metric—and are expected to remain flat in 2018. It will be important that the authorities keep monetary policy on hold and stand ready to raise rates if the balance of payments fails to strengthen or if inflation surprises negatively. In this context, sustained replacement of costly domestic-financed capital spending with concessional foreign-financed lending, and curbing the rapid increase in non-mortgage consumer credit, will also help.
26. Another key challenge will be the successful completion of the bank recapitalization process. The authorities are moving ahead with strengthening the banking system in line with the planned follow-up to the recently completed Asset Quality Review. Banks that are undercapitalized will have until end-December to raise capital. Ensuring that the banks are fully capitalized, will be crucial to restore confidence in the financial sector. This will need to be supported by enhancing banking supervision, making legislative and regulatory changes to address non-performing loans, and strengthening the AML framework.
27. On the basis of progress to date and the authorities’ continuing commitment to the program, staff supports the request for modification of performance criteria and recommends completion of the fourth review.
Mongolia: Selected Economic and Financial Indicators, 2015-23
Sources: Mongolian authorities; and Fund staff projections.
Includes DBM spending.
Excludes privatization receipts; includes DBM commercial spending and from 2017 onwards mortgage interest financed mortgage spending.
Gross official reserves includes drawings from
General government debt data excludes SOEs debt and central bank’s liabilities from PBOC swap line.
December 2014 =100
Mongolia: Selected Economic and Financial Indicators, 2015-23