The mineral-rich country’s prospects were so bright only a few years ago, until the government went on an ill-advised spending spree.
That Mongolia could face an external debt crisis seemed inconceivable just a few years ago. The country of three million people is so rich in copper, gold, coal, iron and other mineral resources that some dubbed it the Kuwait of Asia. Yet today Mongolia faces a real risk of becoming the first mineral-rich country to fall prey to the “resource curse” before it even develops its resources.
The crisis traces back to 2012, when a new Mongolian coalition government took office facing extremely favorable economic conditions, including high mineral prices and strong demand from China. Gross domestic product had grown by 17.3% in 2011 and by another 12.3% in 2012, making the country a global leader.
Investment flowed into Mongolia as a result of an agreement with Rio Tinto to develop the massive Oyu Tolgoi copper-and-gold resource in the Gobi Desert. There was also strong interest in the equally massive Tavan Tolgoi coal deposit in that region, along with other coal, iron and copper deposits.But the new government had won election by making highly populist promises, and this led to a contradictory agenda. On the one hand, the government attempted to renegotiate the already signed Oyu Tolgoi agreement, and in general started seeking better terms from foreign mining firms. This led to a quick drop in investment, growth and revenues. At the same time, the government rapidly expanded spending on housing, government salaries, social welfare and pensions.
The only way the government could finance the resulting large budget deficit was by borrowing. For the first time, Mongolia became a significant global issuer of commercial paper. Between 2012 and June 2016, the government raised $3.6 billion, roughly one-third of GDP, on global bond markets, paying high interest rates. Adding in the swap arrangements with the Chinese central bank and other loan guarantees, Mongolia’s external debt position by 2015 became highly precarious, with total debt of more than 70% of GDP.
There was also a massive buildup of domestic debt. In a throwback to the planned-economy era, the banking sector once again became a major financier of government programs. Total loans in the economy doubled in the first two years of the 2012 government’s term, and the money supply expanded at an extraordinarily rapid pace. Nonperforming loans began to build up.
The state-owned Development Bank of Mongolia, established in 2011, tapped international bond markets to finance infrastructure projects and other programs whose capacity to generate an adequate financial return was far from clear. At the same time, the central bank launched two large direct-lending initiatives through the commercial banks. A “price support program” offered low-interest loans to businesses, while a subsidized mortgage-lending program propped up Mongolia’s real-estate and construction sectors.
As a result, direct central bank claims on commercial banks, which had long been near zero, soared to more than four trillion Mongolian togrog, or more almost $2 billion, by the end of 2013. These programs have been kept off the government’s budget, another throwback to the planned-economy days.
By 2014, international financial institutions expressed measured but clear concern about the deteriorating economic situation. The central bank slowed monetary expansion and budgets were tightened somewhat. This coincided with a continued collapse in foreign investment and a steady decline in global mineral prices due to China’s slowdown. As a result, Mongolia’s growth slowed sharply to 2.3% in 2015 and is likely to be zero or negative in 2016.
But the current economic downturn isn’t primarily due to a decline in global commodity prices. It is the result of the government borrowing heavily against future export earnings while taking actions that deferred the day when those exports would materialize. Instead of preparing for an inevitable cyclical downturn in commodity prices, the government took steps that magnified that downturn’s impact.
One alarm bell sounded in May when the Mongolian Mining Corporation, a 100% private company with a large stake in the Tavan Tolgoi coal mine, defaulted on the $500 million bond it issued in 2012. Although not unexpected, this default is a harbinger of more trouble to come. In the next two years, Mongolia’s cash-strapped government must repay $1.2 billion in commercial debt.
Just two years ago there was still active discussion in Mongolia about creating a sovereign-wealth fund to manage the big foreign-currency surpluses mining would generate. Now the country faces the real possibility of an external debt crisis and sovereign default.
Having borrowed irresponsibly and enjoyed an unsustainable increase in its standard of living, Mongolia has no choice now but to tighten its fiscal belt for the next few years, while encouraging a rebound in sustainable sources of growth. The country must rebuild trust with foreign investors by creating fair and transparent bidding procedures and honoring past contracts, while avoiding the well-known environmental and economic traps that commodity exporters face.
Mongolians elected a new government in June, with a clear mandate to turn the economic situation around. The opportunity is still there, but time is running out. Everyone in the country should be clear that tough steps are needed and the cost of failure could be years of lost growth.