Mongolia Monthly Economic Update
Mongolia has been one of the hardest hit countries in East Asia by the financial crisis, although unlike other countries, the crisis was transmitted via the commodity channel, rather than via the financial sector, World Bank concluded in its Mongolia monthly economic update for August, which was released on September 7. Following is an excerpt from the update.
The price of Mongolia’s main export, copper, fell by as much as 65 percent to US$3000/tonne in March 2009 from US$8700/tonne in April 2008. Prices of other main export commodities—coal, zinc, cashmere, and crude oil also fell significantly.
During the boom years (2003-2007), the government had run modest fiscal surpluses, but these turned out to be insufficient to absorb the fiscal shock caused by the collapse of the mineral prices. Moreover, the fiscal shock was exacerbated because, during the boom years, the government had shifted the fiscal burden away from the non-mining sector, leaving the budget increasingly dependent on revenues from mining. At its peak in 2007, mining-related revenue, i.e. corporate income tax and dividends from mining companies, the windfall profits tax, and royalties, contributed nearly 40 percent to total revenue or 15.3 percent of GDP. The non-mining fiscal deficit increased dramatically from a 7.3 percent of GDP deficit in 2006 to a 15.3 percent deficit in 2008.
Underlying this worsening overall trend were several other unsustainable expenditure trends. For instance, while before the boom years, social transfers had by and large been targeted to the poor, these transfers proliferated and became universalized during the boom years. The most important social transfer program, the Child Money Program, disbursing about Tg140 billion per year (5.6 percent of fiscal expenditure in 2008), was almost exclusively dependent on volatile mining revenues: it received three quarters of its financing from the Mongolian Development Fund (MDF), which in turn was financed by mineral revenue savings. Wages and salaries as a share of GDP increased sharply from 2006 to 2008. Capital expenditure also increased sharply, but projects frequently lacked feasibility studies and insufficient resources were set aside for the proper maintenance of existing infrastructure.
The global downturn also aggravated problems in the financial sector which had been overheating during the boom years. During the boom, very high domestic inflation—33.7 percent in August 2008, the highest in East Asia in 2008—and loose monetary policies led to a credit boom, masking growth in non-performing loans (NPLs). It also led to negative real interest rates on local currency deposits, resulting in flight of local currency (MNT) savings into foreign exchange (FX) deposits, where interest rates were as high as 12 to 18 percent in some banks.
When Anod Bank, the fourth largest private commercial bank, was taken under conservator ship by the Bank of Mongolia (BoM), at the end of 2008, and major shortages of foreign currency emerged—forcing the BoM to ration FX leading to a substantial deviation between the official BoM exchange rate and the parallel market rate—the public started to lose confidence, leading to a generalized flight out of both togrog and FX deposits. To restore public trust in the banking sector, the government issued a blanket deposit guarantee in November, but it left many customers in uncertainty about which deposits were included, and togrog deposits only started to return in February.
This flight out of the local currency was further aggravated by the BoM mopping up local togrog as it sold off its international reserves in an attempt to hold on to an ill-advised de facto currency peg to the USD. Other major commodity exporters let their currencies freely depreciate as a first defense mechanism against falling international prices. While the BoM lost US$500 million of international reserves between July 2008 and February 2009, the currency depreciated anyway, by about 38 percent between the end of October and the middle of March.
Policy actions taken in the beginning of 2009 to address the crisis…
In the absence of sufficient fiscal surpluses from previous years, the government’s fiscal position became difficult once fiscal revenues declined as a result of the sharply lower commodity prices. To keep the fiscal deficit within finance able limits, the government could cut spending or raise revenues, or both. Since raising revenues is inherently difficult during an economic downturn, the government had little choice but to cut spending drastically in its 2009 budget.
The original 2009 budget was approved in November 2008, but when the final 2008 budget outturn and the January and February 2009 figures came in, it became clear that the expected revenue estimate for the full year was unlikely to be realized. Without additional measures, the 2009 budget deficit was heading for 12 percent of GDP.
Faced with the reality of the global downturn and its impact on Mongolia, the government initially considered a variety of possible responses, including signing long-term mineral export contracts in exchange for large up-front payments, and implementing a wide-ranging stimulus package to be funded by a US$1.2 billion sovereign bond. However, as adverse conditions continued to worsen, and access to international capital markets on reasonable terms seemed very difficult, a bi-partisan consensus began to emerge around a more comprehensive policy response, which could be supported by the IMF and other development partners. These policy changes included strong actions on fiscal, monetary, exchange rate, and financial policies.
On fiscal policy, in March 2009 Parliament approved an amended 2009 budget projecting a 5.4 percent of GDP deficit. This was done mainly by (i) cutting expenditures on low-priority new investments, projects for which bidding had not started, and projects for which no feasibility studies had been conducted; (ii) freezing wages and hiring of public servants; (iii) reducing interest payments on foreign loans (effectively a limit on sovereign non-concessional borrowing);6 and targeting social transfers. The level of capital maintenance expenditure was retained. The March amendment would be followed by a second budget amendment in June of 2009 to avoid reducing the existing level of Child Money Program payments, and finance the additional costs of on-going, priority projects caused by unexpected increases in the price of certain inputs. The fiscal deficit of the amended budget was 5.8 percent of 2009 GDP, up from 5.4 percent under the March amendment.
Correcting earlier macroeconomic policies, the BoM raised its policy rate, the 1-week CB bills rate, to 14 percent from 9.75 percent, and allowed a more flexible exchange rate (initially through an auction), while avoiding overshooting and preserving its foreign exchange reserves. This led to a convergence of the official BoM and market exchange rates. Another key action was that the BoM appointed an international reputable auditor to undertake a portfolio audit and develop a restructuring plan for Anod Bank to set standards for dealing with possible future bank failures.
External partners responded by pledging balance of payment and budget support
The Government presented its action plan to the development partners on March 14, 2009. On April 1, 2009, the IMF Board approved an 18-month Stand-By Arrangement (SBA) of US$229 million to help Mongolia adjust to the external shock by stabilizing the macroeconomic situation. The center piece was a substantial fiscal adjustment to deal with the fall in mineral revenues of 10 percent of GDP. Fiscal deficits of 6 and 4 percent of GDP, in 2009 and 2010, respectively, were built into the program, amounting to a total financing gap of US$205 million in 2009 and 2010. Additional reforms focus on monetary and exchange rate policies, rebuilding confidence in the banking system, and protecting the most vulnerable from the downturn and the adjustments.
To fill the financing gap, the World Bank pledged US$60 million (US$40 million for 2009 and US$20 million for 2010) in the form of two single-tranche development policy credits supporting reforms in the policy areas most affected by the downturn: (i) fiscal policy and management, given the budget’s strong dependence on mining revenues; (ii) social protection, given the impact of the economic downturn on the poor; (iii) the financial sector, which was overheating when the global crisis hit, and which experienced a major bank failure in late 2008; and (iv) the mining sector, given the sector’s importance in driving the recovery.
The government obtained equally strong support from the Asian Development Bank (ADB, US$60 million) and Japan (US$50 million), and also received several firm pledges from a number of bilateral partners. As a result, the projected balance of payments and fiscal gaps were filled. So far, the IMF has disbursed about US$118 million under the SBA in balance of payments support for the central bank, and the World Bank, Japan and the ADB disbursed their pledged amounts for budget support in 2009 (US$130 million in total) in July.
Fiscal balance remains under pressure
Total revenue and grants fell by 21 percent in nominal terms and 29 percent in real terms in January-July compared to a year earlier. Corporate income tax, windfall profits tax, VAT, excise tax revenue, import duties, and royalties were lower, due to the slowdown in growth, consumption, imports and commodity prices. Revenue from taxes on wages and salaries and social security contributions were higher in real terms. Dividends were 206.5 percent higher in real terms.
Between January 2009 and July 2009, there were some tentative improvements in corporate income tax, windfall tax, royalties, dividend that can probably be attributed to copper prices rising from their December 2008 low of US$2700/tonne. But VAT and import duties remained at a constant level below the corresponding periods in 2008, reflecting a drop in consumption and import demand.
Total expenditure and net lending rose by four percent in nominal terms, but fell by seven percent in real terms in January-July compared to a year earlier. There were real cuts in purchases of goods and services, domestic investment and expenditure on maintenance. Subsidies to energy companies increased, but the amount of the subsidies is very small. Wages and salaries fell slightly in real terms. Transfers from the social security fund (e.g, pensions) and from the social assistance fund (e.g., Child Money Program) rose only by a small amount in nominal terms, and fell in real terms.
Net lending mostly consisted of a one-off on-lending operation to gold producers (the “gold bond”). However, this is supposed to be repaid in 2009 and should therefore not impact the final outturn of the fiscal deficit. Total expenditure alone, excluding net lending, was 11.4 percent lower in real terms. Looking at trends between January 2009 and July 2009 only, expenditure on maintenance is gradually picking up, though still 67 percent lower in real terms than in 2008. Investment is also gradually increasing, as a result of the June budget amendment.
The 12-month rolling fiscal balance continued to deteriorate in 2009 up to July
On a 12-month rolling basis the same trends are shown: revenue has fallen, while expenditure was relatively stable as a share of GDP. The fiscal deficit in the 12 months to July amounts to 9.8 percent of GDP, after a protracted decline since early 2008 and a brief slowdown around April. Stripping out net lending, this adjusted deficit would be 7.5 percent of GDP in the 12 months to July.
The goods trade deficit narrowed
The goods trade deficit narrowed to US$0.6 billion on a 12-month rolling basis by July from a recent peak of US$1.1 billion in February, as imports contracted much more sharply than exports in line with the slowdown in domestic spending.
Goods exports are down 37.4 percent in dollar terms from a year earlier in January-July, driven by declines in shipments abroad of most commodities
Exports of copper were down 56 percent in dollar terms due to the decline in copper prices, while export volume hardly changed since 2008. Similarly, zinc exports fell mostly in line with prices, rather than due to volume drops. Exports of crude oil and combed goat down (a cashmere-related product) were down as well, with price declines exceeding volume declines in. Gold exports stagnated, with no shipments in June and July. Gold production has fallen by about 50 percent compared to the same period last year. Gold producers were said to be short of liquidity to finance their operations, but a special gold bond was issued to alleviate this financing constraint. However, some observers argue that this special credit window came too late and was not sufficiently targeted to gold producers to be effective. Another reason for the drop in gold export volumes was that a major gold producer shut down due to a labor dispute and a revoked mining license. However, news sources suggest that the actual volume of exports may be higher, as gold exporters tried to evade the windfall profits tax by smuggling gold out of the country.
By contrast, exports of coal and greasy cashmere were up due to large increases in export volumes. In the case of greasy cashmere, this more than offset the large price drop.
January to July exports (in dollar terms) to all destinations fell compared to a year earlier
Exports to China (accounting for about 70 percent of exports) fell 31 percent. Exports to the EU fell 26 percent. Exports to the U.S. are now 89 percent lower than in 2008. Exports to Canada and Russia also fell substantially.
Goods imports fell by 40 percent in dollar terms from a year earlier in January-July
Imports of industrial goods, such as base metals, mineral products, machinery and equipment, fell the most, reflecting the slowdown in industrial production in Mongolia. Imports of food products fell by less, because food import demand is less dependent on the domestic slowdown and exchange rate depreciation than the other types of imports.
The narrowing of the goods trade deficit led to a narrowing of the current account deficit
The current account of the balance of payments—recording the balance of goods and services trade, net investment income, remittances and grants to the government—came in at US$720 million deficit in the second quarter of 2009 (15.2 percent of GDP). The deficit has started to narrow, after it peaked in the first quarter of 2009.
The most important driver of the narrowing of the current account deficit was the goods trade deficit. However, the services balance, another key driver, deteriorated further, as incoming tourism revenues disappointed. Inflows of remittances from Mongolians working abroad net of outflows of foreigners working in Mongolia dropped due to the global downturn. However, this was offset by grants to the government, resulting in stable current transfers. Throughout, net income flows were negative, due to dividends paid to foreigners.
The current account deficit was mainly financed by net foreign direct investment inflows and the IMF loan disbursement
The current account deficit was primarily financed by net capital inflows in the financial account, which amounted to US$644 million (13.6 percent of GDP) in the second quarter of 2009. Direct investment by foreign companies (FDI), mainly in the mining sector, fell from the peak in the third quarter of 2008. Net borrowing from abroad by government jumped in the second quarter of 2009, due to the issuing of the gold bond. Other capital inflows, such as trade credit, and short- and long-term lending to the private sector fell from their peaks in the fourth quarter of 2008.
The remaining portion of the current account deficit was financed by a disbursement from the IMF under the SBA ($118 million), FX purchases through the BoM’s auction, and gold purchases from domestic producers. This also allowed the BoM to rebuild its net international reserves to US$684 million at the end of July 2009 (Figure 6b). The depreciation against the USD partly restored Mongolia’s export competitiveness
The exchange rate against the USD has been very stable since April, as the BoM started selling and buying FX to and from commercial banks by auction, after the sharp depreciation against the USD from October 2008 to mid-March 2009, and the partial recovery. The trade-weighted exchange rate (NEER) has closely followed the exchange rate with the US dollar. The reason is that China carries a large weight, and its currency closely followed the US dollar.
This depreciation partly restored Mongolia’s export competitiveness, which is approximated by the inflation-adjusted, trade-weighted exchange rate (REER). However, the REER is still about 10 percent higher than in 2003-06, at the onset of the copper prices boom. Exports in sectors other than minerals may therefore lag once global demand picks up. The REER had steadily eroded during the first three quarters of 2008, when Mongolia’s prices rose much faster than those of its trading partners, while its exchange rate did not depreciate in line
CPI inflation has fallen rapidly to 2.9 percent yoy, allowing the BoM to cut its policy rate
CPI inflation has fallen rapidly to 2.9 percent yoy at the end of July 2009, from its peak of 33.7 percent yoy in August 2008, when it was the highest in East Asia. This was caused mostly by overheating due to strong domestic growth (evidenced by the large contribution of core inflation), although increases in global food and fuel prices also contributed. The BoM tried to fight the high inflation by focusing on exchange rate appreciation to reduce the cost of imports, rather than by increasing the policy rate, the 1-week central bank bills rate, to reduce core inflation. As this was ineffective, borrowing and lending rates became more and more negative, leading to a surge in credit growth and a fall in togrog deposits.
In March, the BoM hiked its rate by 425 basis points to 14 percent from 9.75 percent to signal a policy change. It then lowered it in two steps as inflation fell, as global food and fuel prices eased, and the domestic economy slowed down.
In the financial sector, MNT and FX deposits have recovered, although there has been structural shift of MNT towards FX deposits
Togrog deposits reached Tg985 billion in July 2009. This is Tg98 billion higher than the level at the height of the deposit outflow crisis in January 2009, but lower (by Tg164 billion) than in March 2008, when togrog deposits peaked. FX deposits reached Tg617 billion, higher than the pre-crisis level.
But non-performing loans are increasing sharply
Loan quality continues to deteriorate, as the portfolio is exposed to the sectors that are experiencing a strong slowdown.
Non-performing loans (NPLs) to residents reached Tg353 billion or 13.7 percent of outstanding loans in July, as they continued to increase strongly from Tg87 billion in November. The discrete jump in NPLs from November to December was caused by the failure of Anod Bank, the fourth largest bank.
NPLs to non-residents amount to Tg37 billion at the end of July (96 percent of loans outstanding to non-residents). Most of these loans were already non-performing before July, but were classified as performing loans. At the request of the BoM, this was corrected in July.
Loans with principal in arrears reached MNT 143 billion in July (5.6 percent of outstanding loans). Although this is down from its peak in May, it means that although some loans in arrears have become non-performing, formerly performing loans are going into in arrears. Total NPLs (to residents and non-residents) and loans with principal in arrears amounted to Tg534 billion at the end of July or 20.4 percent of loans outstanding to residents and non-residents. This is a large deterioration in the health of the loan portfolio compared to July 2008, when total loans outstanding were about the same, Tg2.9 trillion, but NPLs and loans in arrears only made up 5.2 percent.
Especially in key sectors of the economy
Comparing the sectoral composition of the changes in NPLs and loans with principal in arrears between the first quarter of 2009 and the second quarter of 2009, we find that the largest increases were recorded in the construction (Tg20 billion), wholesale and retail (Tg19 billion), and mining and quarrying sectors (Tg11 billion). These three sectors also account for 59 percent of the total NPLs (to residents) and loans with principal in arrears at the end of the second quarter of 2009, with construction amounting to Tg112 billion, wholesale and retail Tg94 billion and mining and quarrying Tg56 billion
The construction sector has the highest ratio of NPLs and loans in arrears to total loans in the sector at 28.7 percent, with mining and quarrying a close second at 27.4 percent. Between the second quarter of 2008 and the second quarter of 2009, NPLs and loans in arrears increased by 274.1 percent. The construction sector accounted for 87.4 percentage points of this increase, with wholesale and retail a distant second at 48.9pp.
As banks became more risk-averse, they slowed down lending to the private sector and started to purchase safe central bank bills
Banks have reduced lending and are buying less risky central bank bills instead, making it very difficult for companies and individuals to obtain loans.
Total loan growth has come to a standstill, with loans outstanding to individuals contracting by 15.6 percent yoy in July 2009, and loans to the private sector slowing down to 11 percent yoy. This slowdown occurred as macroeconomic and financial conditions worsened in late-2008. Growth in loans outstanding had peaked between mid-2007 and mid-2008 as commodity prices boomed.
Instead, banks have started to buy central bank bills from the BoM, which currently provide a high risk-free return of 11.5 percent and are an attractive investment with inflation on a downward trend (currently 2.9 percent yoy). The BoM recently lowered its policy rate to reduce this bias. Newly issued loans continued to decline in major segments of the private sector Newly issued loans dropped 43 percent to Tg593 billion in the second quarter of 2009 from Tg1,041 billion in the second quarter of 2008, when the economy was still booming. The largest decreases in newly issued loans occurred in the wholesale and retail sector at Tg211 billion, with the construction sector a distant second at Tg61 billion. However, the loan portfolio is still exposed for 38 percent to the wholesale and retail, and construction sectors, the two sectors which recorded the highest increases in NPLs from the first to the second quarter of 2009.
Industrial production contracted, and GDP growth slowed down Industrial production (on a three-month moving average basis to smooth fluctuations) contracted by 11.2 percent yoy in July 2009. Manufacturing activity was hit especially hard, with two key activities (manufacturing of textiles and basic metals) contracting by 30 to 60 percent yoy. After a brief rebound, mining and quarrying also turned to contraction, mainly due to decrease in the mining of gold.
Detailed firm-level data confirms this trend. Comparing the first quarters of 2008 and 2009 for a large sample of firms, sales revenue declined by 15.7 percent, and expenses fell by 8.3 percent. This caused income before tax to drop by 64.4 percent, and taxes paid by 60.7 percent. Construction, mining, and gas, fuel and coal wholesale firms also suffered large drops in revenue.
Real GDP grew 0.7 percent yoy in the second quarter of 2009, a rebound from a 4.2 percent yoy contraction in the first quarter of 2009. This followed a period of strong growth of between 7 and 10 percent yoy from 2003 to 2008. The main causes of the rapid slowdown of growth after the third quarter of 2008 were declines in the wholesale and retail, mining, manufacturing, and construction sectors. Agriculture continued to exhibit positive growth.
For 2009, Mongolia is facing a major slowdown in growth to an estimated 2.7 percent in 2009 from 8.9 percent in 2008. This reflects developments in key sectors which have driven growth in recent years: agriculture, due to falling prices of cashmere and other livestock related products; transportation, storage and communication, due to weakening in the mining sector; and other services sectors (including retail and banking), which had been driven by large public expenditure increases on social transfers, and wages and salaries. Contributions to growth from the mining sector steadily declined since 2004.
Recently, Parliament voted to approve four draft law amendments necessary for the conclusion of the Oyu Tolgoi (OT) Investment Agreement between the government and Ivanhoe Mines/Rio Tinto. These amendments will invalidate the windfall profits tax with effect from January 1, 2011, introduce changes to the corporate income tax (extending loss-carried-forward provision from two to 8 years), and permit private sector construction and management of roads and water supply facilities. The agreement will also include a pre-payment of taxes of US$250 million at an interest rate of 5 percent. If the deal is concluded, the Oyu Tolgoi copper and gold mine (together with the Tavan Tolgoi coal mine) will make a substantial contribution to the economic growth of Mongolia in the near future.
Unemployment has been steadily increasing since the beginning of the year as a result of the contraction in the real sector
Registered unemployment reached 3.8 percent of labor force in July 2009, with the number of registered unemployed increasing by 29 percent compared to July 2008. Unemployment had been falling during the boom years, but as the effects of the economic downturn moved towards the real sector, employment conditions have been worsening. This underestimates actual unemployment, which according to plausible, unofficial estimates could be as high as 21-26 percent of labor force.
The latest poverty profile of Mongolia published by the government shows, that even during the recent years of high economic growth, poverty was not reduced substantially. The poverty headcount declined little to 35.5 percent in the 2007/08 survey, down from 36.1 percent in the 2002/03 survey, with large regional differences between the Ulaanbaatar and the rural populations. As average incomes rose, this means that inequality has increased significantly. Furthermore, economic growth in 2009 has been revised downward from 8 to 2.7 percent. Based on the historic correlation between economic growth and poverty estimated by Bank staff, this implies that between 20,000 and 40,000 thousands fewer Mongolians (0.7 percent and 1.4 percent of the population respectively) would be lifted out of poverty in 2009.
A recent survey of the informal urban sector and a recently commissioned study on the crisis implications for household in the informal sector found that the effects of the economic slowdown have a widespread social and poverty impact in Mongolia. Real effective income has fallen by about 60 percent in some informal urban labor markets, due to high inflation eroding real wages and due to reduced job availability. Employment conditions are also becoming less favorable for informal workers in the rural regions, and herders and informal mining workers are barely able to cope with the decreasing job availability, falling wages and increasing living expenses.
The Mongolian government deserves credit for the tough reforms it implemented in early 2009, which has led to support from its external partners. These have led to a stabilization of the external sector. The attention is now shifting to the strains in the financial sector and effects of the downturn on the real economy, unemployment, and poverty.
World Bank thinks it is important that the Government focuses on implementing a tight fiscal policy to avoid a repeat of the boom-and-bust spending pattern that Mongolia experienced. It is also important to improve the planning and budgeting for public investments, and to prioritize the protection of infrastructure maintenance—critical during the downturn. Protecting the poor during this downturn is a challenge, but can be achieved by starting to target the currently untargeted social grants (in particular, the Child Money Program).
In the financial sector, it should ensure stability by intensifying supervision and taking decisive action in case of bank failures in order to retain confidence in the financial sector. In addition, a restructuring of the banking sector is envisaged, after the completion of a series of loan portfolio audits. In the mining sector, the government can now use the recent experience gained during the negotiations of the OT investment agreement to improve the overall policy environment.
