The development of the Oyu Tolgoi mine is having strong spillovers into the rest of the economy, including through lifting consumer and business sentiment. The first quarter data also revealed that the agriculture sector is finally recovering from the effects of “dzud” (severe weather conditions) suffered in late 2009/early 2010, growing by 13.6 percent in Q1.
Government spending growth is outpacing revenue growth, resulting in an increasing fiscal deficit. Spending, in nominal terms, was 32 percent yoy higher in April (year to date, YTD, basis) with capital spending growing by more than 100 percent. Revenues are failing to grow at the same pace, rising only 21 percent in nominal terms on a YTD basis in April, as a result of weaker growth in receipts from taxes on international trade, and negative growth in excise taxes, royalties and dividends from mining sector companies. As a result, the fiscal deficit has climbed considerably, reaching 4.7 percent of GDP in March, its highest level in nearly two years (although it has since eased slightly in April).
Although the 2 percent structural deficit ceiling under the Fiscal Stability Law becomes binding only in January 2013, with the structural deficit amounting to 6.1 percent of GDP in April, Mongolia will have to undertake a substantial amount of fiscal tightening in 2013 if it is not to miss the target. In particular, the exponential growth in capital spending is straining the absorptive capacity of the economy, as evidenced by rapidly increasing cement prices. There has also been an increase in alternative sources of infrastructure financing, through “build-transfer” schemes and project financing by the Development Bank of Mongolia (DBM) that represent significant fiscal liabilities. The DBM is backed by a full sovereign guarantee, and rising debt service payments that fall due in the next few years could constrain fiscal space in the near term. Claims on budgetary resources could also grow with the proposed monetization of Erdenes TT shares.
Inflation is being pushed up by rising core inflation, which reflects demand side pressures from higher government spending, and by rising food prices, notably of meat. Recent rate hikes by the BoM are helping to reduce the pace of bank lending, which had been growing over 60 percent at the start of the year. Although there is room to hike further, with the interest rates on central bank paper still Mongolia negative in real terms, monetary tightening needs to be complemented by fiscal restraint in order to be effective.
On the external front, exports contracted by 2.8 percent yoy in April. This was the first fall in more than two years, and reflected weaker global economic conditions, sliding commodity prices and slowing growth in China which is Mongolia’s largest trading partner. Coal, which is the largest export earner, is barely growing, while copper exports have been performing poorly for some time now. On a four-quarter rolling sum basis, the current account deficit widened to 35 percent of GDP in Q1 2012 from 18 percent in Q1 2011 but was financed by the record levels of FDI inflows of US$ 4.4 bn or roughly half of GDP, and FX reserves remain high. The Togrog has appreciated in recent months, in both nominal and in real terms which will undermine the competitiveness of Mongolia’s non-mineral traded sector.
Recent poverty analysis, conducted jointly by the World Bank and the NSO, finds that the national poverty headcount rate declined from 39.2 percent in 2010 to 29.8 percent in 2011. This progress took place against the backdrop of strong economic growth, sizeable social transfers, and large investments to help the recovery from the 2010 dzud. However the recent acceleration in inflation is worrying since it will impact the poor disproportionally, and rising food inflation is particularly worrying since food constitutes 49 percent of expenditures among households in the lowest quintile of the income distribution.
The global economic outlook has deteriorated considerably in recent months. Financial conditions in high-income Europe, higher oil prices, and, most importantly, the slowing Chinese economy pose risks for Mongolia. The channels through which these operate include financial and trade linkages – namely volatility in commodity prices and through demand from China for its mineral exports. Indeed, signs of these are already visible as demonstrated by the decline in exports in April. Other financial market linkages should also not be discounted: Mongolia’s banking system, which has shown signs of overheating over the past year, is highly dollarized, with about a third of deposits denominated in dollars and easy convertibility out of the Mongolia Togrog. A sharp economic slowdown and/or an increased macroeconomic instability could expose the liquidity and asset quality vulnerabilities in individual banks and system overall.
Given these risks, Mongolian policy-makers need to adopt a cautious macro-economic stance. This will entail limiting the build-up of vulnerabilities in the banking sector, reining in the growth of government expenditures, minimizing off-budget financing activities and ensuring that the lending of the DBM is within the framework of the FSL. Adjusting the policy stance in this manner will address the internal imbalances that are already evident as well as position Mongolia better to deal with the risks to the regional and global economy. It will also ensure that the money spent is well spent, namely on activities that help to build the public and human capital infrastructure of Mongolia and maximize the returns of the country’s mineral wealth to its people.
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