High flyer: Strong outlook on the back of sound policies and increasing openness

Forecast to be one of the world’s fastest-growing marketplaces over the next two decades, Mongolia’s economy is developing rapidly. The country’s resource wealth and open, liberalised market are attracting increasing interest from international investors and putting it in the global spotlight.

MAIN FOCUSES: The two big stories of 2011 are Oyu Tolgoi (OT) and Tavan Tolgoi (TT). The former is a copper and gold mine expected to commence extraction in 2013 and containing an estimated 37m tonnes of copper and 1300 tonnes of gold, making it the world’s largest undeveloped copper and gold project. The latter is a coal mine now ramping up production after years of below-capacity operation. TT holds approximately 7.5bn tonnes of coal, making it by some estimates the world’s second-largest deposit.

These projects, and other mines which are already producing, are at the core of Mongolia’s rapidly growing economy. Exports are flowing strongly from the country to its resource-hungry neighbour, China.

While it is no exaggeration to say mineral exports are transforming Mongolia, they are far from the only dynamic aspect of its economy. Public investment is rising quickly as the government looks to strengthen infrastructure and social services while spreading the benefits of wealth across the country. Ongoing fiscal reforms should also help underpin macroeconomic stability. Diversification efforts are gaining momentum, and trading and investment relations with a range of countries are continuing to deepen.

UP AND AWAY: The government expects real growth of 25.6% in 2012, while the IMF is forecasting 11.8% for this figure. The first three quarters of 2011 brought a record 16.7% expansion, according to the Bank of Mongolia (BOM), making the country one of the world’s fastest-growing economies.

Mongolia’s GDP reached MNT8.25trn ($6.44bn) in 2010 at current prices, up MNT1.66trn ($1.29bn), or 25.3%, on the previous year, according to the Mongolian Statistical Yearbook 2010, published by the National Statistical Office (NSO). However, growth in 2005 constant price terms (a more accurate indicator of true changes in the economy) was considerably lower, at 6.1%. According to the NSO, GDP per capita at current prices reached MNT2.99m ($2330).

The economy is dominated by the private sector, which accounted for 73.4% in 2010, up 0.4 percentage points on 2009. Together, the three biggest sectors account for more than half of GDP: mining and quarrying (22.7%); agriculture, forestry and fishing (15.9%); and retail and wholesale trade, including auto repairs (15%). Other major sectors include manufacturing (8.5%), transportation and storage (8.3%), real estate (6.3%) and education (4.2%).

A sign of the country’s growing economic power and stability, Mongolia’s international reserves have grown strongly in recent years, reaching $2.09bn by the end of 2010, up 82.6% on 2009, having risen 79.7% that year. The crisis of 2008 saw reserves drop to $637m by year-end, at which point they would have covered 9.2 weeks of imports. By the end of 2010, they were equal to 33.3 weeks of imports (which had also risen rapidly, making the gain more impressive).

TOP PERFORMER: A 2011 report by economists Willem Buiter and Ebrahim Rahbari forecast that Mongolia would have the world’s highest growth rate over the next two decades. The study, published by financial firm Citigroup, predicts an annual average rate of 8.7% at purchasing power parity (PPP) to 2030, outstripping even India, China and Brazil. The “global growth generators” (3G) index developed by Buiter and Rahbari identified 11 countries with particularly strong growth and investment potential that could supersede the group known as “BRIC plus South Africa” (Brazil, Russia, India, China and South Africa) Citigroup identified three major factors that support its forecast of Mongolian growth: a relatively low starting point, favourable demographics and high levels of investment. The report estimated that the country’s per-capita income at PPP was $3674, qualifying it as a low middle-income country. But with Mongolia experiencing a surge in GDP, and relatively few people to share domestic production, the potential for per capita income growth is considerable.

ALPHA WOLF: “These days investors are flocking to Ulaanbaatar for alpha returns to be made in Mongolian projects,” said H. Ganhuyag, the vice-minister of finance. “The country is destined to become the alpha wolf economy of Asia and the world.”

GDP expansion is also likely to be driven by the small, young and growing population, which is expected to rise from 2.7m in 2010 to 3.5m over the next four decades, boosting the working-age population by 18.7%. Finally, the Mongolian economy will benefit from a domestic investment surge. From 2006 to 2009 its investment rate was 38.5% and its saving rate 39.1%, among the highest in the world. As long as these rates stay relatively stable, Mongolia’s labour productivity should increase rapidly – just like that of its frugal neighbour China over the past 30 years.

While the 3G index also highlights weak institutional capacity and policymaking in Mongolia, these are outweighed by positive factors, and the country’s robust democracy, which has insulated it from the “resource curse” seen elsewhere in the region. Press coverage on the report highlighted the potential for investment in Mongolia, suggesting that the country might become “the next emerging market superstar”.

RECOVERING FROM TROUBLE: Such has been Mongolia’s stellar rise on the world economic stage that it seems remarkable how recently the economy was in dire straits. The country was hit hard by the global economic crisis. The price of its main exports, particularly copper, plunged, affecting both its fiscal and external accounts. With government revenue, export earnings and foreign direct investment (FDI) falling from previously buoyant levels, the country faced a domestic economic crisis. Budget income declined so far that the deficit was no longer being financed, and the banking system showed signs of strain.

Those living below the poverty line – around one-third of the population at the time, according to IMF estimates – were particularly vulnerable, with inflation being in double-digit figures.

HONOURING AGREEMENTS: To address the situation, the government, like many others in developed and emerging markets, agreed to a stand-by agreement (SBA) with the IMF in March 2009. The SBA took the form of a $224m loan to support an 18-month expansionist economic programme, combined with extensive reforms to restore economic stability and strengthen the social safety net to protect the poor. The IMF noted that Mongolia had been given “exceptional access to IMF resources” equal to three times the country’s normal quota (its maximum obligatory commitment to the IMF).

The government’s policy under the SBA had four major prongs. First – and by far most important – budgetary changes were required to restore Mongolia’s fiscal position and to enable long-term improvements to the institutional framework to bolster the country’s fiscal stability, thus lowering the chances of another boom-and-bust cycle. Second, an active monetary policy was necessary to protect international reserves, which had been dwindling throughout the crisis. Third, improvements to the country’s social security system were needed to help Mongolia’s poorest. Finally, oversight and regulation in the banking sector had to be strengthened, including the enhancement of deposit guarantees.

TURNAROUND: The funds helped pull the country through a difficult year, with the economy only contracting by 1.3%, according to the IMF – relatively little given the plunge in commodity earnings.

At the conclusion of the agreement’s post-programme monitoring phase in September 2011, the IMF noted the economy’s “remarkable turnaround”, praising the Mongolian authorities’ successful execution of “sound macroeconomic policies”, adding that the recovery of copper prices and the support of the international community had also helped pull the economy back into its growth trajectory. However, the organisation has become increasingly critical of the continuation of expansionary fiscal policy through a period of strong economic growth, warning of the rising risk of overheating and instability.

ECONOMIC POLICY: In his speech introducing the draft 2012 budget, Prime Minister S. Batbold announced that Mongolia had become a middle-income country. The draft budget forecasts real growth of 25.6% in 2012, taking GDP to approximately MNT18trn ($14.04bn) and GDP per capita to MNT6.4m ($4992), according to Frontier Securities, an Ulaanbaatar-based investment firm.

The 2012 budget places an emphasis on four key aims: stabilisation and sharing of revenue from natural resource extraction across the population through taxation and other policy tools; human development, in part through investment in the health and education systems; improving important infrastructure, including railways, roads and power plants; and increasing the availability of lower-cost financing. Continued devolution at the aimag, or province, and municipality levels is also a priority for the country.

FIGURES: The draft budget foresees equalised budget revenues of MNT6.4trn ($4.99bn), or around 36% of GDP. Some MNT2trn ($1.56bn) of this – around 31% of total revenue – will come from the mining sector. This represents a substantial chunk of the exchequer’s earnings, but public spending is still less dependent on mining than some Gulf states are on hydrocarbons, for example. The progress of Mongolia’s diversification efforts will help to determine whether this remains the case in a decade’s time.

The budget sets out expenditure of MNT7.1trn ($5.54bn), or 39.5% of GDP, which would leave a deficit of MNT740.9bn ($578m), or 4.1% of GDP. This is a sustainable figure in the short term, given the twin factors of Mongolia’s moderate levels of public debt and the likelihood of there being a swing back to budget surpluses at some point in the near future. Some MNT2.4trn ($1.87bn) has been allocated for capital expenditure and a record MNT1.5trn ($1.17bn) for investment, 87.1% of which is going towards construction, 9.2% to equipment purchases and 3.7% to capital repairs. While revenues are expected to be good, there is still an important role for international donors to play. Mongolia expects to receive MNT566.2bn ($442m) in funds from borrowing alone, of which 87%, some MNT494bn ($385m), is planned to go towards investment efforts.

Controversially, the policy of generous universal social transfers through the Human Development Fund (HDF) is set to continue in 2012, with a MNT1.5m ($1170) “bounty” to be given to each citizen. Every Mongolian will receive MNT500,000 ($390) in cash, with seniors and the vulnerable also getting the remaining MNT1m ($780) in the form of a direct payment. Others will have this amount allocated to health payments, tuition fees and housing purchase prepayments, as needed. The majority of citizens (2.2m) will also be given a MNT1m ($780) convertible government bond on a share of the TT project, which they will can hold or sell back to the state.

EXPANSION: The budget has been seen as a continuation of Mongolia’s expansionary fiscal policy and has received a mixed response. While it indicates that necessary improvements in infrastructure and social services will continue to be made, the draft is aggressively pro-cyclical and presupposes a reasonably healthy global economic climate that will guarantee high commodity export earnings.

Indeed, prior to the publication of the draft budget, the IMF had already noted in a statement that “the policies to address both high and rising inflation and to lessen vulnerabilities are clear – restrain fiscal spending and tighten monetary policy... further fiscal spending would only add fuel to this overheating economy at a time when it least needs it”.

Dale Choi, the chief investment strategist at Frontier Securities, called the increase in public spending “highly risky and ill-advised”. He warned that the continued fiscal stimulus could increase the risk of macroeconomic instability at a time of global economic uncertainty, and echoed the IMF’s recommendation that the government keep spending levels at or below those of 2011. This seems unlikely to happen, as public sector employee salaries are already set to increase by 53%, and a variety of investment initiatives and revenue distribution schemes have also been included in the proposed spending plan.

This budget should be understood in the light of the upcoming elections, set to be held in 2012, which are expected to be hotly contested. The government is determined to deliver on its spending promises and ensure that the poorest in Mongolian society receive their share of the country’s soaring resource earnings.

Nonetheless, analysts such as B. Lakshmi, the manager at the Ulaanbaatar-based Economic Policy and Competitiveness Research Centre, a think-tank, argue that the handouts do not do much to help the poor, and indeed may be indirectly damaging for them. The single biggest risk inherent in the new budget is that it will stoke inflation, affecting the livelihoods of those low-income people it seeks to help, and hurting producers and export-oriented industries already feeling the pinch of a strong and rising tugrik.

On the other hand, it would take a sharp and prolonged decline in the international economy – particularly in China – to push the deficit to dangerous levels. Given the long-term outlook for Mongolia, even in uncertain times, the spending increases do not appear to be in any way unaffordable.

SPENDING IT WISELY: Choi and others have, it should be noted, highlighted several positive points in their analyses of the draft budget. One is the move towards better-targeted social transfers, such as subsidised health and education for those who need it. The TT bond issue should be less inflationary than a direct cash grant of the same value, as many recipients are likely to hold onto the bond in the expectation that it will appreciate, rather than choosing the monetising option and spending those funds immediately.

Lee Cashell, the chairman and managing partner of Asia Pacific Investment Partners (APIP), which has a range of interests in Mongolia, also praises the government’s ongoing commitment to investment in infrastructure. The 2012 budget doubles infrastructure spending, allotting about MNT1.5trn ($1.17bn) to road and rail projects alone.

Lack of transportation and utility infrastructure has long held Mongolia’s economy back and has contributed to inflationary bottlenecks. Although investment in roads, railways and power plants feeds into demand, over the longer term it provides a base for sustained growth while easing price pressures.

While overheating certainly contains risks for Mongolia, they should not be over-exaggerated. Inflation, while high, reflects a fast-growing economy starting from a low base, as well as international factors over which Mongolia has little control. Perhaps most importantly, there is little evidence that the economy’s acceleration, and that of government spending, is deterring any significant international investment from flowing into the country.

Once the election rush is over, many expect Mongolian officials to begin tightening fiscal policy. While this will partly be determined by the eventual victor and the pledges made on the campaign trail, the new Fiscal Stability Law (FSL), if implemented and adhered to, should help lock-in fiscal responsibility.

STABILITY LEGISLATION: Described as a “landmark” law by the IMF, the FSL, also sometimes referred to as the Fiscal Responsibility Law, was passed in June 2010 and sets out clear budgetary regulations. The law limits the structural fiscal deficit to 2% of GDP, imposes an effective ceiling on public expenditure growth, and introduces a new, transparent formula for projecting copper prices (one of the most important fiscal variables in Mongolia). It also sees the creation of a fund for surplus commodity revenues that could be channelled into the HDF as well as into the country’s new development bank.

The FSL was supported by a large parliamentary majority, indicating widespread understanding among the country’s political leadership that responsible fiscal policy will be necessary to underpin Mongolia’s long-term economic prospects.

Choi asserts that the FSL “will assist Mongolia in avoiding the typical pitfalls of growth for resource-rich countries, especially Dutch disease”, noting that the Netherlands successfully adopted a similar programme of fiscal restraint when it tackled its own resource-related problems.

INTEGRATED BUDGET: The FSL will be used in conjunction with the Integrated Budget Law (IBL), which has been designed to strengthen budgetary oversight and is expected to help tighten fiscal policy. The IBL requires feasibility studies for proposed government-funded projects, limits scope for budgetary amendments and enhances long-term planning. It also clarifies local and municipal government responsibilities and contains measures to unify the budget and prevent off-balance sheet spending. The IBL was still under discussion by parliament at the time of research, but could prove to be an influential reform, both in fiscal and administrative terms.

REGIONAL DEVELOPMENT: Decentralisation and devolution is another central theme in Mongolia’s fiscal policy. Recent reforms are meant to give substantial new funds and powers to governments at both regional and municipal levels.

For instance, each soum, or municipality, has been allotted a Soum Development Fund (SDF), the size of which depends on the municipality’s population and level of economic development; in 2011, the average size of the funds was MNT50m ($39,000). The SDFs will lend money at favourable terms to local businesses and organisations, within certain parameters.

To help ensure local oversight of funds, citizens are able to attend meetings and committee gatherings at which the funds’ activities are to be determined. A “negative list” of activities which the SDFs cannot support includes any and all celebrations or activities that can be deemed political.

BOOST TO SMALLER BUSINESSES: Small and medium-sized enterprises (SMEs) are expected to receive a significant boost from the SDFs’ lending programmes. “The government is trying to address the challenges faced by SMEs, particularly in agriculture,” O. Adiya, the head of the secretariat at Consultative Council on Investment Climate and Private Sector Development (CCIC-PSD), a government-run think-tank, told OBG. “Financing is a major issue. But there are now substantial resources that can be allocated to SMEs, for example through the SDFs.”

The expansion of the SDFs is a radical departure from Mongolia’s Communist-era system, in which power was concentrated in Ulaanbaatar, where almost all decisions were made. Lakshmi told OBG that the funds will provide an impetus for regional development and help to strengthen democratic control of Mongolia’s investment resources.

CURRENCY: The tugrik was the world’s best performing currency in 2010, rising 14.8% against the dollar, according to the BOM, from MNT1443 to MNT1257. The value has grown as foreign investment and export earnings have soared, and traders have taken an increasing interest in the currency.

According to the BOM’s deputy governor, N. Zoljargal, Mongolia’s monthly flows in the currency market reached $1.5bn by the end of 2010, having started the year valued at around $400m. The central bank maintains a flexible exchange rate regime that has earned much praise from the IMF, which noted that it has acted as a useful shock absorber over the past few tumultuous years. Thus the BOM tends to avoid money market interventions that Zoljargal says may spook investors. Currency appreciation in 2010 helped moderate imported inflation, just as the drop in 2009 helped support economic recovery.

Despite a continued surge in exports and ongoing investments, the tugrik fell somewhat in 2011, declining in value by 11% over the course of the year. Possible reasons for the decline are a mild correction after the 2010 rise; a shift to the dollar, the traditional safe-haven currency, during the global economic uncertainty in the final months of 2011; Mongolia’s rising inflation rate; and the slow rate of progress on the TT and OT projects.

Most expect the tugrik to resume its appreciation in the medium term, due to rising exports and investment. While closely monitoring its rise, the BOM will likely continue to see the exchange rate as a useful safety valve to help keep the economy in line.

FIGHTING DUTCH DISEASE: The tugrik’s inflation in 2010 was widely interpreted as a warning sign of the so-called Dutch disease, one of the current leading concerns among Mongolian businesspeople and policymakers. The "disease" draws its names from the consequences suffered by the Dutch economy as a result of growth in its oil industry during the 1960s. It refers to the negative impact of resource exploitation on other sectors of a country's economy.

The primary concern is that the development of the resource leads to inflows of revenues which drive increases in the real exchange rate. This in turn makes other export-oriented sectors, particularly manufacturing, less competitive as their goods become more expensive overseas. In the case of Mongolia, there has clearly been a rise in the value of the tugrik largely caused by the growth of the mining industry, which has made life more difficult for exporters of other goods, such as those working with cashmere and agricultural produce, as well as the tourism industry, for which the country has great hopes.

The broader definition of the disease that is now accepted also directly applies to Mongolia – the “crowding out” of other sectors due to growth in the exploitation of the country’s natural resources. Mongolian non-mining companies complain that they are finding it harder to attract and retain skilled staff, as competition from mining companies offering higher wages and better conditions has grown.

Some also say that public resources are too focused on supporting mining development, though it is understandable that the government is keen to encourage the growth of its major earner, the revenue from which is already being used to support initiatives under way in other sectors.

The claim that mining crowds FDI out of other areas is more spurious – it is mining-driven growth that is encouraging FDI, and there are increasingly significant levels of FDI going to other sectors as well. Overdependence on mineral exports, however, is already beginning to become a serious challenge.

A MATTER OF CONCERN: Curtailing Mongolia’s most important industry would undoubtedly be an unhelpful response for the economy, but the symptoms remain a matter of concern. “We already have the Dutch disease, as we are too dependent on coal and copper,” prominent Mongolian economist and blogger D. Jargalsaikhan told OBG. “We have been late with using mining revenue to diversify.”

The government and private sector bodies are now working together to address the situation, and substantive steps are already being made, as seen in the SDFs and the FSL. Diversification programmes that support other sectors are gaining momentum.

As Jargalsaikhan noted, increases in productivity will also be important in tackling the disease, and could be gained from more competition in the non-mining sector as well as investments in infrastructure, especially in the industrial sector.

Education is also an important factor in increasing the availability of skilled labour for all sectors, particularly high-value ones. The new Development Bank of Mongolia (DBM) could be key in tackling the Dutch disease, largely through infrastructure finance and funding of the country’s non-mining companies.

DEVELOPMENT BANK: One of the biggest challenges faced by the Mongolian private sector is the cost of financing. Commercial banks’ rates are high, both due to the BOM base and their own deposit rates, which have increased as they look to draw in long-term deposits in a period of high inflation.

“Such is the demand for money that banks can keep lending even at an unusually high policy rate of around 20%,” Jargalsaikhan, who is also a member of the board of the Mongolia Economic Forum, said. “But the interest combined with the rising currency make it very hard for Mongolian firms to be competitive.”

While some firms are able to turn to foreign banks to secure lower-cost financing, this is not possible for most Mongolian companies, due to risk aversion on the part of the lenders, who require high levels of underlying assets, as well as transparency and auditing that most local firms do not have.

The launch of DBM has been widely welcomed in the business community, and expectations are high. “There is a real need for low-cost capital, and creating a development bank is the very best thing that Mongolia can do,” APIP’s Cashell told OBG. “The development bank can provide long-term funding at a low cost and it can be specifically used to help alleviate inflationary bottlenecks.”

In its September 2011 report on Mongolia, the IMF sounded a note of caution on the development bank, warning that it “should not be used as a means to circumvent the FSL or as a vehicle for off-budget government spending”. The IMF asserted that to do so would undermine both fiscal stability and the credibility of the legislation governing it.

In August 2011 the state-run Korea Development Bank (KDB) announced that it had signed a contract to manage DBM for its initial four years of operation. KDB will build a business operating system and take charge of its development financing.

The deal allows the new Mongolian bank to tap into KDB’s expertise and is expected to increase the number of opportunities for Korean firms to participate in DBM projects. While the partnership with KDB is important, the Mongolian government has been keen to emphasise that at least 90% of the DBM’s employees and half the management will be required to be from the Mongolian population.

SOVEREIGN WEALTH FUND: DBM’s founding has led to increased interest in Mongolia’s long-term proposal to create a sovereign wealth fund (SWF) to manage its mining revenues. Many resource-rich countries, most notably those of the Gulf, have successful SWFs that invest earnings internationally with a view to long-term economic security.

SWFs have a number of benefits, which include diversifying the country’s economic interests geographically and sectorally, providing funds during periods of economic difficulty, maintaining a savings pool for citizens, and providing a long-term hedge against the consequences of resource depletion.

A fully-fledged Mongolian SWF is likely to emerge over the next few years on these principles, though it will probably be some time before it becomes internationally active to the degree that, for example, the Abu Dhabi Investment Authority is.

Cashell points out that Mongolia already has considerable expertise in handling portfolios in copper trading, but that it will need to ensure it builds a skilled and experienced team to manage its SWF before venturing into large investments overseas.

“Mongolia will need a conservative and careful investment strategy, as national wealth will be at stake,” he told OBG in an interview.

GLOBAL RISKS: The IMF commented in September 2011 that “with coal output rapidly increasing and two massive mining projects in the pipeline, Mongolia has a bright economic future and an opportunity to spread prosperity to all of its citizens”.

Certainly the outlook is excellent, even allowing for the usual fluctuations in the world economy. Nonetheless, there are some short- and medium-term downside risks that could affect growth.

One of these is Mongolia’s reliance on its two huge and powerful neighbours, China and Russia. China buys around 80% of Mongolia’s exports and the country’s recent economic success is very much founded on strong Chinese demand, while Russia’s supplies of energy help keep the machine oiled.

Mongolia is fortunate to be largely decoupled from the direct effects of the slowdown in Western economies and the eurozone crisis in particular, but the country could be affected by the aftershocks of another serious global slowdown. As a November 2011 research note by Frontier Securities said, “China’s response to any possible global weakness and recession will be decisive for Mongolia.”

Therefore, concerns of a slowdown in China in late-2011 are being taken seriously in Ulaanbaatar. A hard landing could compromise heady growth projections and cause Mongolia to have its own rough ride, particularly given the economy’s current state.

It would, however, take a crisis of unforeseen proportions to cut Chinese demand for copper and coal so much as to induce an overall economic contraction for Mongolia. With its export volumes rising, Mongolia should soon be better insulated from fluctuations in commodity prices that are likely to be the main consequence of another international shakeout.

Geographical diversification of exports is a challenge for landlocked Mongolia, although long-term work is under way to improve transportation links that will facilitate worldwide export and to cement trade deals with a range of partners (see analysis).

In any case, Mongolia is an open, strongly export-oriented economy, with a relatively small domestic market and therefore cannot be immune to international economic cycles. For this reason, it is in the process of amassing a revenue chest that can be used for stimulus and to strengthen the safety net in difficult times – a fortunate position to be in.

OUTLOOK: Mongolia has emerged rapidly onto the global economic stage in recent years. While the country and its resources are no longer well-kept secrets, its economic potential is still largely untapped. The country is at the beginning of what should be a long-term growth path that will deliver higher standards of living to its entire population.

Having recovered quickly from a brief but difficult period at the end of the last decade, Mongolia is enjoying one of the world’s highest growth rates. The maintenance of an expansionary fiscal policy has its critics and risks, but it is supporting much-needed investment, as well as fulfilling political promises in one of Asia’s most robust democracies.

Once the election push is over, Mongolia has the opportunity to implement landmark legislation that will help secure the fiscal balance in the longer term, supporting macroeconomic stability in the future. Other initiatives that show a great deal of promise include DBM and projects that will attract the private sector, strengthening the business climate and supporting the government’s diversification efforts. While risks and shortcomings still exist, Mongolia is showing an increasing capacity to tackle the issues that it currently faces in an efficient and effective manner.