Mongolia Economic Brief September 2016 http://www.worldbank.org/mongolia Budget expenditures jumped by 33 percent The budget deficit sharply rose in the first (yoy) in Jan-July, largely due to unbudgeted seven months of 2016 amid spending spending programs and loose spending increases and revenue shortfalls. The deficit controls. New government programs were reached MNT 1,974 billion in Jan-July, a launched in the first half. These programs threefold increase from MNT 638 billion in included three policy loan programs (Good the same period last year. The budget deficit Herder/Student/Fence Programs) and a over the first seven months is estimated to buyback program of the ETT shares owned by have reached over 8 percent of annual GDP, Mongolian citizens (Good Share Program). In far exceeding the budgeted annual deficit Mar-July, over MNT 500 billion was spent for target (MNT 940 billion or 4 percent of GDP). the four Good Programs. These programs Budget revenues fell by 3.3 percent (yoy) in were not recorded in the budget execution the same period, reflecting weaker report until July, and have been funded by commodity prices and import contraction. the BoM. Many of the on-budget Mining revenues sharply dropped, with expenditures also exceeded the original royalties almost halving from one year ago. budget plan, including the Child Money Customs duties declined by over 10 percent Program, interest payments, and public due to weaker imports. Non-tax revenues investment spending. In addition, the also declined by 4.3 percent, reflecting a 33 government spent over MNT 400 billion in percent drop in oil revenues, and minimal Mar-July for the Housing Mortgage Program collection of dividends and privatization that was previously undertaken by the BoM. revenues. The mortgage program spending, however, is yet to be recorded in the budget execution report. This Economic Brief was prepared by MFM Mongolia Team, composed of Taehyun Lee (Senior Country Economist), Altantsetseg Shiilegmaa (Economist), Davaadalai Batsuuri (Economist), under the guidance of Mathew A. Verghis (Practice Manager). Corrective measures have been taken by the to the government’s definition—is expected government. The new government to reach over 19 percent of GDP by end- announced on August 9, that the 2016. Nominal value of general government consolidated budget deficit would reach 21 debt, including the sovereign-guaranteed percent of GDP under the current trend, TDB debt and the outstanding debt of the including all unbudgeted programs such as Build-Transfer (BT) projects, is projected to Good Programs and Housing Mortgage reach over 90 percent of GDP due to the high Program. The government terminated Good deficit and exchange rate depreciation, a Programs, and submitted a supplementary sharp rise from 66 percent of GDP in 2015. budget for 2016 to include unbudgeted expenditures, aiming to contain the budget The recent measures taken by the new deficit at 18.2 percent of GDP. The proposed government are welcome, but further actions budget, however, excluded the Housing are urgently needed. The immediate Mortgage Program that was transferred to challenge facing the new government was to the government in March. The commercial contain the sharp rise in budget deficit and portfolio of the DBM still remains off the consolidate unbudgeted expenditures. The budget. A revised Medium Term Fiscal recent announcement of the accurate fiscal Framework for 2016-18 was also submitted situation was a significant step toward a to the parliament. The revised MTFF was credible fiscal consolidation. The revised proposed to aim to reduce the budget deficit revenue projections of the government seem to 15 percent of GDP by 2018, and 9 percent largely realistic, based on conservative of GDP by 2020. assumptions. Projected high budget deficit and rapidly rising government debt, however, Fiscal consolidation measures were proposed urgently call for a comprehensive and strong to adjust spending and mobilize revenues. The fiscal consolidation plan, including spending government proposed to mobilize revenues adjustment based on priorities and revenue by raising tax rates on personal income tax, mobilization measures. The fiscal alcohol and tobacco tax, and vehicle tax in consolidation plan should also include all of 2017. The Child Money Program was also the remaining off-budget programs such as proposed to target the lower income Housing Mortgage Program and DBM’s off- households. Salaries for high ranking officials budget corporate lending programs that were proposed to be cut by 30 percent and would likely increase fiscal burden. the royalty rate for gold sales to the BoM was raised back to 5 percent. There is a strong need for prioritizing expenditures to protect the vulnerable and The World Bank expects the budget deficit to improving public expenditure efficiency. reach 18 percent of GDP, close to the Weakening growth and declining household projections of the supplementary budget. The consumption, despite the large increase in primary budget deficit, which excludes government spending this year, suggests that interest payments, is projected to reach 14 public expenditures may not be productive percent of GDP due to interest expenses enough to support growth and jobs, reaching over 4 percent of GDP. The underscoring the need for proper consolidated overall budget deficit—which assessment of public expenditure efficiency adds DBM’s off-budget commercial portfolio and effectiveness. Particularly, the most 2 recent poverty analysis showed that poverty growth. Strengthening the social safety net, closely tracks growth and consumption. The particularly targeting the vulnerable groups recent high unemployment rate and a sharp near or below the poverty line, would help drop in household consumption indicate that mitigate the social costs of fiscal adjustment many households near the poverty line may and support growth. be sliding back to poverty, putting a drag on Figure 1. Budget expenditures sharply rose in Jan-July despite Figure 2. The budget deficit is projected to reach over 18% of GDP, the declining revenues. pushing the government debt to over 90% of GDP in 2016. Budget revenues and expenditures (billion MNT): Jan-July Consolidated budget deficit and government debt (% to GDP) Revenue Expenditure Fiscal deficit DBM's corporate loans: LHS DBM's social program: LHS 6,000 On-budget deficit: LHS Gov't definition of deficit 5,014 General government debt: RHS 5,000 0 120 3,781 4,000 3,466 3,074 3,186 3,328 3,145 3,040 -5 100 3,000 2,000 -10 80 1,000 -15 60 0 -1,000 (112) (138) -20 40 (638) -2,000 -25 20 (1,974) 2011 2012 2013 2014 2015 2016f -3,000 2013 (I-VII) 2014 (I-VII) 2015 (I-VII) 2016 (I-VII) Source: MoF, WB Staff estimates Note: The government’s definition of budget deficit includes social programs of the DBM in 2015-16. Before 2015, the government excluded all DBM programs from the budget. The consolidated deficit definition (used by the World Bank) include all DBM programs. Monetary policy also loosened in recent Exchange rate volatility increased in July and months. With no government securities August. After gradual appreciation in May- auctions held in Apr-Aug, the government June with the influx of a $750 million relied on the BoM in funding the growing sovereign borrowing, the togrog depreciated budget deficit. The BoM has provided over by almost 15 percent against the USD in one MNT 900 billion in Mar-July to the and a half months from end-June to mid- government, most of which was injected to August. The recent depreciation largely commercial banks for the new Good reflected a $400 million outflow for the Programs and the Housing Mortgage purchase of Erdenet mine shares, elevated Program. As a result, the monetary base and excess togrog liquidity, and weak market M2 increased by 40 percent and 13 percent, sentiment. respectively between March and July. Bank loan growth, however, remained subdued at The swift policy rate hike of the BoM helped 0.8 percent (yoy) in July, reflecting weak ease the exchange volatility. Facing the economic conditions. The lack of government intensified pressure on the exchange rate bond issuances, the large liquidity injection and signs of currency speculation, the BoM and slow loan growth have substantially raised the policy rate by 450 bps to 15 increased excess liquidity in the banking percent on August 19. The central bank also system since March, reflected in a large announced that it would strengthen togrog increase in the central bank bill (CBB) liquidity management by introducing a three- holdings of the banks in July. month CBB which carries a premium over the current seven-day CBBs. The central bank 3 also stressed the need for complementary policy rates alone, however, will likely be less and comprehensive monetary and fiscal effective, if the government continues to run policy adjustment. The market has stabilized a large deficit and rely on central bank since these measures were implemented. funding. The most pressing challenge for the central Underlying pressure on the exchange rate bank is to delink monetary policy from fiscal would likely remain without significant policy activities and safeguard international adjustment. While the recent policy rate hike reserves. Continued monetization of reduced exchange rate volatility, flexible government programs would weaken the exchange rate movement reflecting the credibility and effectiveness of monetary market fundamentals would help absorb policy, undermine fiscal discipline, and external shocks and necessary adjustment of exacerbate macroeconomic vulnerability by the economy. Intervention would be escalating pressure on the exchange rate and ineffective against underlying pressure from inflation. The monetary authorities have loose economic policies and external been signaling tighter policy stance since the imbalances, while also reducing foreign appointment of the new Governor. Higher exchange buffers. Figure 3. Monetary policy became loose amid significant Figure 4. The exchange rate stabilized after a policy rate hike, monetization since March. following a sharp depreciation between July and mid-Aug. Key liquidity indicators (trillion MNT, %) Daily exchange rate (USD/MNT): Mar-Aug 5.0 Bank excess reserves (trillion MNT): LHS 100% 2,320 August 18 BoM's gross claim on govt (trillion MNT): LHS Policy rate hike Bank loan growth (%, yoy): RHS 2,270 4.0 M2 growth (%, yoy): RHS 75% 2,220 2,170 3.0 50% 2,120 2.0 25% 2,070 2,020 1.0 0% 1,970 1,920 18-Aug-16 28-Aug-16 11-Mar-16 21-Mar-16 31-Mar-16 9-Jun-16 10-May-16 20-May-16 30-May-16 19-Jun-16 29-Jun-16 9-Jul-16 8-Aug-16 10-Apr-16 20-Apr-16 30-Apr-16 19-Jul-16 29-Jul-16 1-Mar-16 0.0 -25% Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Apr-12 Oct-12 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Source: BoM Private consumption sharply dropped in the Growth dropped to 1.4 percent (yoy) in the same period while recovery in investment first half of the year. Mining GDP growth supported growth. Weak growth in key labor- slowed to 9.1 percent, largely reflecting the intensive sectors such as construction and lower grade concentrates produced by the services translated into deteriorating labor Oyu Tolgoi (OT) mine. Non-mining market and household welfare conditions. The production declined by 0.8 percent, with unemployment rate climbed to 11 percent in contraction in manufacturing by 12 percent the second quarter, the highest since 2010. and construction by 0.1 percent. Service Nominal average household income declined by 10 percent, reflected in an 11 percent drop sector growth remained stagnant at 0.6 (yoy) in real household consumption in the percent. Agriculture growth dropped to 3.5 first six months. Gross capital investment, percent in the aftermath of the harsh winter. meanwhile, increased by 7.1 percent (yoy), 4 possibly reflecting increased government (yoy) in the first seven months, led by a large investment by over 20 percent (yoy) in the first drop in imports of investment goods and oil half. products. Consumption goods imports showed signs of recovery, increasing by 0.1 percent in Weak commodity prices continued to dampen Jan-July and by 6.6 percent in May-July from a exports despite growing export volumes in key year ago. Imports of capital goods, however, commodities. Export volumes increased for dropped by 25 percent (yoy) in the first seven most of the key commodities in the first seven months, due to falling imports of machinery months on a year-on-year basis. Copper and construction goods. Oil product imports concentrate volume increased by 21%, due to also declined by 38 percent (yoy), reflecting stronger-than-expected production of OT. lower prices. Coal export volume rose by 35%, as Mongolia coal replaced the reduced supply to China Nation-wide headline inflation and UB-city from Chinese coal mines and some of the coal inflation remained low at 0.9 percent and 0.1 exporting countries. However, lower prices of percent (yoy) respectively in July. A 13 coal (-30%), copper (-37%), and oil (-25%) percent drop in meat prices and a 6.4 percent reduced total export earnings by 9.7 percent drop in energy prices contributed to lower (yoy) in the first seven months. inflation in UB, with core inflation also remaining moderate at 2.9 percent (y/y) in Continued import compression kept the trade July. Inflation would likely come under balance in a $708 million surplus in Jan-July. growing pressure in the coming months, Total imports (C.I.F. terms) fell by 17 percent reflecting the recent depreciation. Figure 3. Growth dropped to 1.4% in the first half, with a sharp Figure 4. Trade balance remained in surplus despite export drops drop in private consumption amid rising unemployment rate. due to continued import compression. Quarterly expenditure growth trend and unemployment rate (%) Exports and imports (3 months rolling sum, yoy, %) Final consumption Gross capital formation 90% Trade balance (million $): RHS 300 40 14.0 Net exports GDP Exports (%, yoy): LHS Unemployment rate: RHS Imports (C.I.F. yoy, %): LHS 30 12.0 60% 200 20 10.0 30% 100 10 8.0 0% 0 0 6.0 -30% -100 -10 4.0 -60% -200 -20 2.0 -30 0.0 -90% -300 Oct-12 Oct-13 Oct-14 Oct-15 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Source: BoM, NSO and income balances. In the financial The underlying pressure on the balance of account, a $1,022 million net capital outflow payments continued, recording a $244 million was recorded in Jan-July, in the currency and deficit in May-July. The current account deposit component and the net errors and turned into a $192 million deficit in May-July, omissions component. The overall balance of from a $26 million surplus in the first four payments displayed a moderate $41 million months, due to growing deficit in the services deficit in the first seven months despite the 5 growing deficit in May-July, on the back of a due to weak mineral exports and increasing $750 million sovereign debt-financing in imports of goods and services associated March and April. Inward foreign direct with large mining projects. While increased investment (FDI) recorded a slight net FDI inflows for OT-2 investment would outflow in Jan-July, excluding the offsetting provide some buffers to the external transactions of the $4.3 billion proceeds of accounts, the large external debt repayments due in March 2017 ($580 million) and in the OT-2 project financing which appeared in January 2018 ($500 million) would pose loan disbursements (drawdown of project additional challenges to the fiscal account financing loans) and an FDI outflow and the balance of payments. (shareholder loan repayments). Mongolia’s external financing conditions have Gross international reserves (GIR) declined to tightened. The 2022 Chinggis bond yield rose $1,275 million in July from $1,546 million in to over 8 percent and the sovereign credit April. GIR rose from $1,197 million in February ratings were downgraded by major credit to $1,546 million in April, replenished by the rating agencies in August, reflecting growing proceeds from a $250 million syndicated loan concerns on increasing fiscal and external (March) and a $500 million international bond vulnerability. Mongolia’s external financing (April). Growing current account deficit and conditions will likely remain vulnerable to capital outflows, however, reduced GIR by global financial volatility and Mongolia’s $271 million in May-July, to a level equivalent further economic and policy developments. to approximately three months’ imports. Strong policy adjustment to restore sustainable fiscal and macroeconomic The balance of payments is expected to management would be crucial to improve remain under pressure in 2016-17. The the external refinancing environments for current account deficit would likely widen future debt repayments. Figure 5. The BoP recorded a $248 million deficit in May-June Figure 6. Mongolia’s external financing conditions have tightened and international reserves fell to $1,275 million in July. in August. Monthly BoP trend (million US$) Sovereign bond market yields (%) Errors and omissions Currency/Deposits (excl. BoM) Chinggis 22 Chinggis 18 Debt-financing FDI 14 CA Balance Change in gross FX reserves 600 13 12 400 11 200 10 9 0 8 -200 7 6 -400 5 -600 4 Jan-13 Jan-14 Jan-15 Jan-16 Jul-13 Jul-14 Jul-15 Jul-16 Apr-13 Oct-13 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Source: BoM, Bloomberg Note: Net FDI and loan inflows in May-June 2016 were adjusted to exclude the offsetting transactions of OT-2 project financing. 6