World Bank warns that the 2011 budget is risky

Parliament reviews 2011 budget in light of World Bank’s assessment
The World Bank’s economist’s team made an analysis on the 2011 budget Bill of Mongolia and concluded the budget is risky, recommending adjusting to better reflect the lessons from the previous boom and bust. The analysis focused on budget influence into inflation and currency rate. The revised 2011 budget proposal envisages a steep increase in government spending, together with a sharp rise in the fiscal deficit to 8.6 percent of GDP. This budget, if approved, will compound already existing inflationary pressures caused by the sharp economic rebound and the lack of spare capacity in the economy, says the World Bank.
The budget proposal contravenes the Fiscal Management Principles contained in the recently passed Fiscal Stability Law, in particular, the principle to aim to create macroeconomic stability and restrain inflation. The World Bank economic analysis strongly suggest that the current budget proposal makes Mongolia set to witness a replay of the 2006-8 boom years, leaving it vulnerable to a bust similar to the one that occurred in 2008-2009. Under the proposal for 2011, general government spending will reach a whopping 50.5 percent of GDP. This is the second consecutive budget in which current spending is some 30 percent higher than the previous year. The increase is primarily driven by a 22 percent rise in spending on wages and salaries compared to the 2010 budget (reflecting the 30 percent increase in public sector wages and salaries that took place in October 2010) and a nearly 50 percent increase in spending on transfers. This will bring total spending on transfers to account for roughly 40 percent of total government spending in 2011, or 21.4 percent of GDP. The increase is due to a more than doubling in allocations to the Human Development Fund, which is financed by mineral revenues, to Tgs 805 billion (around 10 percent of GDP). “This is a risky budget proposal Inflation will increase significantly if the budget is implemented. The economic rebound in recent quarters has been stronger than expected and the economy is currently operating at close to capacity. We estimate that this budget will add about 15 percent inflation on top of the already existing inflation of around 10 percent. Such a high inflation rate will quickly erode the real value of the cash transfers, making these politically less attractive than they seem today.” noted Rogier van den Brink, World Bank Lead Economist for Mongolia. “Moreover, there is a substantial risk of secondround effects in the form of a wageprice spiral as a direct consequence of the expansionary fiscal policy and if higher inflation expectations become entrenched.”
High domestic inflation also causes the currency to appreciate in real terms, hurting the export sectors. For instance, this would hurt both agricultural exports, on which the rural population depends, and an already small manufacturing sector.
The World Bank economists mentioned that financing of the projected 8.6 percent deficit will be difficult. It depends on the Tavan Tolgoi agreement under negotiation, withdrawals from the newly established stabilization fund and privatization proceeds. The financing of the fiscal deficit comes from the following
sources. First, government estimates that it will receive advance payments equalling to 5.6 percent of GDP (Tgs 442.5 billion) from the Tavan Tolgoi mining deal which is currently under negotiation. “However, entering project negotiations such as TT with demands for large upfront payments reduces government’s negotiation powers considerably, and risk leading to delays in reaching the agreement and/ or unfavorable terms” said Mr Rogier van den Brink. Moreover, if these prepayments do not materialize the government could pursue borrowing on the international markets. However, such markets are increasingly jittery due to the euro zone woes, and could be difficult to access if and when Mongolia needs the financing.
Second, the government will disburse 2.1 percent of GDP (Tgs 164.6 billion) of resources out of the Fiscal Stability Fund which is to be established this year and will start functioning from 2011. However, money saved in the stabilization fund should first be saved for the inevitable downturn, not immediately spent.
“With the 2011 budget proposals, Mongolia would be following a welltrodden path adopted by many other resource rich economies, such as the Netherlands, my home country in the 1960s, after which the infamous “Dutch Disease” is named.” emphasized Rogier van den Brink. These countries provided huge subsidies and transfers to citizens that resulted in upward wage-price spirals that eventually proved difficult to control, fed domestic asset price bubbles (e.g in housing) and severely undermined profitability in the traded sectors. The eventual bust e.g in the case of the Netherlands was severe, requiring comprehensive and painful structural reforms, and the decline in the non-mineral traded sectors proved difficult to reverse.
Again, another bout of extremely high inflation could also undermine confidence in the currency and the financial system. Mongolia’s banking system remains fragile and a number of problems including undercapitalization, high levels of non-performing loans, and systemic problems of poor governance and risk management systems combined with poor oversight remain to be fully addressed.
The World Bank experts also warn that there are significant risks in the global environment. The external risk factors which could set this downturn in motion again include continuing uncertainty in international financial and debt markets, a severe slowdown in growth in developed countries, an external terms of trade shock (commodity prices once again seem to be entering a super cycle and it is hard to ascertain the degree to which commodity price increases over the past year are warranted by fundamentals or not) and a domestic confidence shock to the banking sector that is currently weighed down by high levels of non-performing loans on its books. The World Bank says it sent a letter attached with this analysis on the budget bill to the Finance Minister, the Bank of Mongolia and MPs.
source: The Mongol Messenger newspaper

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