Mission Concluding Statement 

February 17, 2011

The 2011 Article IV consultation discussions took place against the backdrop of a strong economic recovery in Mongolia and signs that the economy is overheating. Inflation is already too high and the large increase in fiscal spending underway will make matters worse. Discussions focused on the policies for managing the current business cycle and for ensuring Mongolia’s vast mineral deposits lead to lasting prosperity.

1. Recent developments. Growth rebounded strongly last year to 6.1 percent. This recovery is all the more impressive in light of the severe winter that led to a sharp contraction in agriculture, especially animal husbandry. The shock to food supply, however, helped drive inflation into the double digits for much of the year, led by rising meat prices. Higher copper prices and a rapid increase in coal production are fueling strong export growth that has helped boost international reserves to an all-time high.

2. Outlook. Growth this year is projected to remain strong and is set to accelerate to around 10 percent. The large increase in fiscal spending underway, however, is creating excess demand that will result in higher inflation and surging imports. Inflation could reach some 20 percent by year-end. Over the medium-term growth will be driven by an increase in mining output, with an especially large boost around 2013 when production from Oyu Tolgoi starts.

3. 2011 Budget. With around one-third of Mongolians living below the poverty line and the effects of the economic crisis and last year’s severe winter still lingering, the government’s desire to provide immediate support to the population is understandable. However, the large increase in spending this year will actually do more economic harm than good. Any immediate benefits will be dissipated through higher inflation, crowding out of private sector activity, and faster real exchange rate appreciation. So, in the end, real household purchasing power could actually go down, imports will surge as they become cheaper relative to domestically produced goods, and local business will become less competitive with knock-on effects for investment and employment. International experience also shows that such high inflation—particularly given its concentration in staple food items—will have an especially hard impact on the poor whose consumption basket contains a high share of such foods and who have little means to shield themselves from the impact inflation has in eroding their real incomes. Therefore, the 2011 budget should be amended to reduce spending substantially.

4. Medium-term fiscal framework. A sound fiscal policy is necessary for ensuring that Mongolia’s mineral wealth leads to lasting prosperity for all Mongolians. In practical terms, this means managing public spending growth in a way that (i) helps smooth economic growth (through a counter-cyclical fiscal policy); (ii) leaves room for the private sector to thrive; and (iii) provides buffers to insulate the budget—and the economy—against a downturn in global commodity prices. The adoption of the fiscal stability law last year was a landmark achievement in this regard. However, the 2011 budget is a big step backwards. The fiscal stability law will succeed only if it is strictly adhered to in letter and spirit; failure to do so will undermine its credibility and impact on preventing a recurrence of the policy driven, boom-bust cycles that Mongolia has experienced in the past. This will entail expenditure restraint in the coming years, for example by keeping spending frozen in real terms, to bring the fiscal position in compliance with the numerical rules that start in 2013. Moreover, it is equally important not to circumvent the law by using off-budget vehicles or government guarantees that would, in effect, undo the economic benefits of adhering to the law and come with the additional costs of an increase in fiscal risks and a loss of transparency. The Development Bank, public-private partnerships, and public guarantees are sources of such quasi-fiscal risk and, if such operations are to proceed, need to be managed prudently and in line with international good practices.

5. Structural fiscal reforms. The efforts underway to advance structural fiscal reforms are welcome and should proceed. A top priority is the introduction of a targeted poverty benefit, as part of social transfer reform, that would help Mongolia’s most vulnerable citizens and increase fiscal flexibility. The adoption of an integrated budget law, in line with the government’s plans, would help modernize the framework for intergovernmental fiscal relations, strengthen budget execution, and improve the planning process for public investment and medium-term fiscal policy. Efforts to strengthen the large taxpayer office should continue and will yield dividends in terms of providing better taxpayer services and larger and more efficient revenue collection. In contrast, increasing exemptions or otherwise using the VAT to target preferred sectors would prove to be highly inefficient—as well as ineffective—yet come with the costs of substantially complicating tax administration and risking revenue leakage.

6. Monetary policy. Inflation is already too high, and the substantial increase in fiscal spending underway will push it up further. There are limits to what monetary policy can achieve if budget spending this year is not scaled back. Nonetheless, the central bank should be more proactive in fighting inflation and promptly initiate a tightening cycle, starting with an up-front hike in interest rates. The central bank policy rate is already very negative in real terms and will become even more so as inflation rises. Higher interest rates will be essential in tempering the rise in inflation. Inevitably, such a tighter monetary policy stance will lessen the availability of credit to the private sector and slow private activity. This crowding out of the private sector, while undesirable, is better than the alternative of allowing inflation pressures to build-up further. However, responsibility for such crowding out lies firmly in the decision to put in place a very loose fiscal policy that the monetary authorities now need to offset with the tools at their disposal. This ongoing fight against inflation would be greatly helped by giving the central bank a more explicit mandate to make inflation the primary objective of monetary policy.

7. Macroeconomic policy mix. The expansionary fiscal policy and concomitant need for a tighter monetary policy is an inefficient policy mix. It results in macroeconomic volatility and higher inflation. The higher inflation also carries large social costs and it takes an especially hard toll on those already living in poverty, as the spike in prices reduces their purchasing power significantly. It also erodes the real value of savings and hurts those on a fixed income, such as retirees. A better macroeconomic mix would significantly scale back the increase in government spending this year and thereby reduce the amount of monetary tightening needed. This mix would result in lower inflation this year and next, a smoother growth path, lower interest rates, and less real exchange rate appreciation. Outcomes that would help improve the competitiveness of the local economy and create a better environment for the private sector.

8. Exchange rate policy. The flexible exchange rate regime has been working well over the past 1½ years. International reserves are at an all time high, and the nominal exchange rate has evolved in line with market conditions. The central bank has succeeded in dampening excess volatility in the exchange rate stemming from large and lumpy foreign exchange flows, and this intervention strategy remains fully appropriate for the period ahead. Moreover, the nominal appreciation that took place last year helped to tighten monetary conditions and reduced the increase in inflation. Looking forward, the flexible exchange rate regime will continue to be well suited for the Mongolian economy. Specifically, it will help control inflation, provide a shock absorber against external shocks, and facilitate the real exchange rate adjustment that is likely to take place over the medium-term with the rapid growth in the mineral sector.

9. Banking system. A healthy banking system is important for promoting the development of the private sector. This includes ensuring that entrepreneurs, farmers, and businesses all have access to credit on reasonable terms while safeguarding depositors’ money through effective supervision and regulation. The recent progress, therefore, in strengthening the framework for banking supervision is welcome. Now, it is critical to strictly enforce existing regulations and replace supervisory forbearance with resolute action against any banks that are not in compliance. At the same time, implementation of the Empowering the Banking Sector and Capital Support Program would offer a transparent and fair means of providing temporary financial support to any bank that needs time to come into full compliance. Prompt passage of this legislation should be a top priority. In addition, all existing and future costs of bank restructuring should be promptly covered by the budget and not borne by the central bank.

10. Medium-term outlook. The Mongolian economy has a bright economic future, as development of the mineral sector will lead to a substantial growth and an opportunity to spread prosperity to all Mongolian citizens. Such prosperity, however, is not guaranteed. Many countries have experienced the “resource curse” which underscores that the risk of failure is real, and Mongolia’s recent crisis illustrates that the cost of failure is high. Success will require disciplined macroeconomic policies, including (i) containing fiscal spending pressures and strictly adhering to the fiscal stability law; (ii) gearing monetary policy toward containing inflation, including by timely adjusting interest rates in line with the evolving price pressures; (iii) maintaining a flexible exchange rate regime; and (iv) safeguarding the banking system through prudential regulation and supervision. Pursuing such a combination of policies would leave Mongolia well poised to ensure that its mineral wealth translates into strong, sustained, and equitable growth.

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The mission would like to express its sincere appreciation to the Mongolian authorities for their gracious hospitality and for the frank and candid nature of our discussions.