Price pressure: With expansion throughout the economy comes rising inflation

While Mongolia’s double-digit GDP growth is helping transform the country and makes it an emerging market star, it also contributes to double-digit inflation. High inflation is probably the single-biggest macroeconomic concern for the country since the end of the global economic crisis. While this is a sign of the economy’s success, rising prices are a serious issue for ordinary Mongolians, investors and policymakers.

PRICES ON THE RISE: The National Statistical Office estimates that the consumer price index (CPI) rose by 13% in 2010, following a 4.2% increase during the slowdown of 2009. This drove overall inflation to 10.1%. Ulaanbaatar, the economy’s centre and home to almost half the population, was particularly subject to inflationary pressures from increases in the money supply and population growth, with CPI rising 14.3% in 2010.

Foodstuffs are an important component in CPI, and price increases of 18.6% in 2010 helped drive overall inflation. Other key CPI components include housing, water, electricity and fuels, which rose 12.7% in 2010; clothing and footwear (10.5%); alcoholic beverages, tobacco and miscellaneous goods and services (4.2%); transport (1.3%) and education (18.8%).

The Bank of Mongolia (BOM) estimated in November 2011 that inflation would reach 13% by year-end. It identified pressures including expansionary fiscal policy, real interest rates at or below zero and subsequent rapid increases in credit, and high spending by individuals and businesses. It estimated around three percentage points of inflation came from meat prices, and that the government could shave those off the overall rate by increasing the meat supply.

INDICATORS: The rapid rise of the money supply is indicative of Mongolia’s inflationary issues. In 2010 the broad (M2) money supply, the main indicator used in inflation, grew by 63.1% to MNT4.68trn ($3.65bn). M2 rose 26.9% in 2009, having contracted by 5.5% the previous year. M1 (roughly M2 minus time deposits) rose 77.8% to MNT1.16trn ($1.23bn) in 2010, growing rapidly after increasing just 0.6% in 2009 and 9.6% in 2008. Broad money supply continued to grow quickly in 2011, rising 29.6% in the first three quarters, to reach MNT6trn ($4.68bn). Well-known Mongolian economist and blogger D. Jargalsaikhan told OBG that one reason inflation is so high is that rapid increases in the money supply are not corresponding to growth in productivity.

CAUSE & EFFECT: Frontier Securities, a Mongolian investment firm, sees expansionary fiscal policy as the single most important factor behind inflation. It suggests rising public expenditure could see inflation hit somewhere between 14% and 27% in 2012 unless the BOM acts to suppress prices. The IMF forecasts 14%, but may revise upwards if pressure keeps building.

Other factors should also be taken into account. The rapid expansion of Mongolia’s mineral industry has cash flooding into the country, both as investment in developing its mines (and related sectors) and as payment for growing amounts of coal, copper and other commodities being shipped out. “Inflation is certainly connected with government cash,” Jargalsaikhan, who is also a member of the board of the Mongolia Economic Forum, told OBG. “There is also the effect of artificial inflation in real estate through speculation that values will continue to rise.”

Mongolia is also particularly vulnerable to climate-related supply shocks to its domestic food supply. The notorious dzud, a phenomenon occurring during very cold and prolonged winters when snow cover prevents animals from grazing, can drastically affect livestock numbers – the UN estimates 17% of Mongolia’s herds died in the particularly harsh 2009-10 dzud.

There are also international dynamics at play. As of late-2011 analysts were predicting a continued rise in global inflation, driven by a number of factors. Global food prices are high and rising due to growing demand, changing dietary habits (mainly the consumption of more expensive and resource-intensive meat products in emerging markets) and supply shocks caused by climatic and social factors. Oil prices through 2011 were also quite high by historic comparisons, and likely to remain so in 2012, due again to high demand in emerging markets and a number of supply factors. While energy prices tend to be discounted from top-line inflation figures, they have a significant impact on the costs of transportation and thus most goods.

Finally, the expansionist monetary policy undertaken by Western economies such as the US, EU and UK, particularly quantitative easing, are helping fuel an international glut in liquidity, much of which is making its way to emerging markets. Analysts such as Dale Choi, Frontier’s chief investment strategist, and Jargalsaikhan point out that inflation is affecting the poorest particularly hard. The rise in food prices (which makes up a larger proportion of their household spending) and other staples erodes disposable income levels at a time when wages for low-skilled workers are rising more slowly than those of better-qualified jobs.

MONETARY TIGHTENING: In October 2011 the BOM increased the policy rate by 50 basis points to 12.25%. According to a statement from the central bank, it acted to dampen a “sharp increase in demand” that occurred during a period when economic capacity was more limited, thus driving core inflation. It cited a number of factors stimulating demand, including the “rapid expansion” of budget expenditure, the cash handouts given as part of the Human Development Fund and the rapid growth in lending, with total loans rising 64% in the first three quarters of 2011. This increase came after a 25-point increase to 11.75% in August 2011, and a 50-point hike in April, with the latter marking the first rate rise in nearly a year. Prior to that, the policy rate had fluctuated as the BOM contended with high inflation and the effects of Mongolia’s economic crisis, rising from 9.75% to 14% in March 2009.

By 2011 it had become clear that inflation was a considerably bigger threat than an economic slowdown, with the bank estimating a year-on-year rate of 11.3% in October. In conjunction with increasing rates, the BOM sought monetary tightening through a number of other mechanisms. In February 2011, for example, it increased the minimum reserve requirement (MRR) from 5% to 9%. The MRR increase was intended to help mop up some excess liquidity in the market, though its effects appear to have been limited. The BOM aims to keep inflation at or below 10% in 2012, but with so many inflationary pressures, this will be a tough task. Thus, further rises seem likely. This could push up borrowing costs for a private sector already squeezed by high rates and increased competition.

LIMITED EFFECT: Interest rate increases can only have a limited effect on inflation in Mongolia. First, inflation is, to a considerable degree, imported. Also, relatively low levels of private debt mean that higher rates do not reduce disposable income as much as they do in mature markets with higher debt levels. Low mortgage penetration (under 4% of GDP, according to the BOM) means that few households have to redirect earnings to higher interest payments when the BOM raises rates.

Another factor is that rates are already so high most increases are proportionately smaller than they would be if they were at a normalised rate of 5% or less. For example, the BOM’s October increase of 50 basis points from 11.75% raised the base rate by less than one-twentieth; from 5% it would have risen a tenth.

While the BOM has little choice but to keep rates high to attempt to control the money supply, the policy creates a problem for policymakers looking to tackle the root causes of inflation. The high cost of borrowing makes it difficult for companies to invest in expanding output capacity to ease supply bottlenecks. Cashell points to a shortage of investment in cement as an example of high borrowing costs deterring investment.

Therefore, while recommending a further increase in the base rate, the IMF argued this would not be enough to bring down the rate of credit growth and inflation. It therefore urged the deployment of a “range of macro-prudential measures”, including higher capital adequacy and reserve requirements, new lending provisions and tighter liquidity ratios.

LOOKING FORWARD: Inflation is certainly a challenge for Mongolia. Perhaps the biggest issue is the effect it has on those with low incomes, still a substantial proportion of the population. High public spending, particularly on social transfers and public sector salaries, while designed to counteract the effect of rising prices, may actually be exacerbating them, creating a risk of a wage-price spiral in the future.

The BOM is likely to step up its efforts to tighten monetary policy by mopping up excess liquidity, which should affect inflation. Fiscal policy looks set to relax in 2012, which will be an election year. Furthermore, unless there is a serious global downturn, capital should continue to flow into the country.

If, in the short term, Mongolia has accepted a higher rate of inflation as the price of growth and investment, pressures should abate over the medium and long term. The Fiscal Stability Law passed in June 2010 promises to restrain inflationary public spending from 2013 onward, while investments now under way should ease infrastructure bottlenecks making Mongolia less susceptible to pressures of supply and demand.