Continued momentum: Despite turbulence, double-digit growth was maintained in 2013

Following a mining-related boom in exports and foreign direct investment (FDI), from mid-2012 Mongolia’s rapid economic growth faced the challenges of trade deterioration and falling commodity prices and demand on the one hand, and global and regional uncertainty on the other. The Oyu Tolgoi (OT) gold and copper mine that had emerged as a beacon for investor appetite in the land-locked yet resource-rich country has become a bellwether for investor confidence.

With an estimated $1.3trn in mineral deposits underground at current market prices, Mongolia holds great promise for investors. GDP was just $10.3bn in 2012, and a single large project in mining, energy or infrastructure has the potential to drive spikes in FDI and growth. Commercialisation of OT’s first phase from July 2013 is helping to diversify Mongolia’s mineral exports away from coal, while the government is working to improve the investment environment by adopting the new Investment Law, among other measures.

Fresh from a 16-month electoral cycle, investors are looking forward to over three years of relative policy stability and implementation of the administration’s new “from big to smart government” policy. Although Mongolia’s balance of payments looked strained by the end of 2013 due to a fall in export revenues and a drop in FDI, authorities maintained overall macro and financial stability and sustained double-digit real economic growth in 2013 – 11.54% in the first three quarters of the year – through economic stability programmes, conducted by unconventional and targeted monetary easing as well as off-budget expenditure in the infrastructure sector. Addressing macroeconomic risks while restoring investor confidence will be key to reaching the economy’s full potential. Already one of the economies most open to trade, the authorities are striving to build an equally open investment regime.

Rapid Pace

Any economy that has doubled in size in four years runs the risk of overheating. Nominal GDP in 2005 constant terms grew from $3.93bn to $8.4bn between 2008 and 2012, according to the World Bank. Regardless of absolute levels, real economic growth ratcheted up from an average of 9.2% annually over 2006-08 to 12.1% in 2010-12, according to the Bank of Mongolia (BOM), the central bank, reaching a world-leading 17.5% in 2011. Although the global financial crisis in 2009 resulted in the economy contracting by 1.3% in real terms – leading the authorities to seek a $224m IMF programme – conclusion of the OT Investment Agreement (OTIA) in October 2009 unleashed unprecedented FDI inflows, contributing to the strong economic growth in subsequent years.

FDI grew from $1.7bn in 2010 to $4.6bn and $4.4bn in 2011 and 2012, respectively, according to the World Bank. Gross capital formation accelerated from 37% of GDP in 2005 to 59% by 2011, while savings rose from 32% to 35% of GDP, according to Standard Chartered. Annual credit growth reaching 73% by the end of 2011 gave rise to concerns over potential overheating. Meanwhile, growing coking coal exports, which rose from 5.1m tonnes in 2008 to a peak of 22.5m in 2011, combined with the commodity super-cycle’s height to provide 54.3% and 64.3% year-on-year (y-o-y) growth in exports in 2010 and 2011, respectively. As coal eclipsed traditionally dominant copper exports for the first time, Mongolia benefitted from rising, albeit more volatile, coal prices. It had become, in the words of ratings agency Moody’s first report on Mongolia’s banking sector in April 2013, “an economy that is increasingly exposed to commodity-driven boom-bust cycles”.

Cooling Enthusiasm

Enthusiasm over Mongolia cooled in the run-up to parliamentary elections in June 2012 and with falling global commodity prices from the second quarter of 2012. Furthermore, enactment of a vague yet restrictive strategic-sector foreign investment law in May 2012 and calls for renegotiating the OTIA raised the spectre of political risk for investors in mining. These factors prompted FDI inflows to drop 17% in 2012, albeit still at a relatively high $4.4bn, and 49.8% y-o-y by November 2013, to $2.1bn. Exports, of which mining accounted for 94%, fell 9% in 2012, and a further 4.1% y-o-y to $3.1bn by October 2013, on the back of a 27% drop in coal export volumes in the first half of2013 and a 53% fall in their value.

In an open economy that is so dependent on mining – which accounted for 22% of GDP and 61% of industrial value-added in 2012, according to the National Statistical Office (NSO) – the impact was significant. Economic growth slowed to 12.4% y-o-y in 2012 and to 11.5% in the first three quarters of 2013, though double-digit growth was sustained through countercyclical and proactive macroeconomic policies. “Anything less than 10% GDP growth would be terrible,” BOM Governor N. Zoljargal said in November 2013.

Stimulus

To bridge the gap in aggregate demand left by slowing FDI and lower exports, the authorities have, since late 2012, engaged in countercyclical monetary easing to prevent a credit crunch and maintain overall economic stability. The Fiscal Stability Law, which was passed in 2009 following the IMF programme, mandates a structural budget deficit below 2% of GDP from 2013. Within this constraint, the BOM was able to employ a range of monetary policy tools including both standard instruments and unconventional tools similar to quantitative easing. Additionally, the government’s investment arm, the Development Bank of Mongolia (DBM), embarked on an off-budget spending programme in the form of new investments in real infrastructure.

Despite efforts from 2012 to constrain the previous two years of pro-cyclical fiscal expansion, consistent revenue shortfalls, which fell 12% short of projections in 2012, linked to falling commodity prices and export volumes have kept the core budget in deficit, despite low disbursement of capital expenditure. With around one-third of all tax revenue coming from royalties, dividends and corporate tax on mining companies, budget revenues depend overwhelmingly on the mining sector. The budget shortfall increased sharply from a 0.5%-of-GDP surplus in 2010 to deficits of 4.8% and 8.4% in 2011 and 2012, respectively, according to IMF data.

Although the 2013 budget forecast revenue growth of 47%, including additional revenue of $267m from expected renegotiation of OT royalties from 5% to 20%, the supplemental 2013 budget passed in October formalised the earlier under-allocation of funds by cutting spending to a total of $2.44bn, according to IMF figures. Indeed, capital spending was a mere 32% of budgeted levels in the year to October 2013, and recurrent spending reached 65%. While 2013 spending has remained flat on 2012’s, revenue growth of 13% in the first three quarters remained 55% below original 2013 budget projections, at $2.1bn compared to a budgeted $4.4bn, with the World Bank forecasting a 15-20% revenue shortfall for financial year 2013.

Given prudent expenditure management by the Ministry of Finance (MoF), the core budget deficit fell from $319m in 2012 to $178m in 2013 (equivalent to 1.7% of GDP), while off-budget spending, controlled by the Ministry of Economic Development (MED), was rising. The BOM’s price stabilisation programme (PSP), aimed at constraining supply-driven inflationary pressure, and its mortgage financing scheme resulted in the injection of $2.04bn through the banking system, equivalent to 21% of bank assets and 16% of GDP by October 2013. The resulting acceleration in credit growth, which doubled to 48% from December 2012-September 2013, generated expansion in the construction sector.

The 2014 budget passed in November 2013 aims to contain budget deficit growth, curbing consolidated spending at $3.35bn and forecasting revenues of $2.8bn. The shortfall will be financed through a combination of local bond issues and $174m in project loans from development agencies. While revenue projections appear more realistic than those in the original 2013 budget, key assumptions such as the MNT1368:$1 exchange rate appears less likely to materialise.

Growth Structure

As government off-budget spending worked to offset slumping FDI and export-revenue inflows, the structure of Mongolia’s growth has changed markedly from mid-2012. Though growth in non-minerals continued to outpace that in mining, both slowed significantly. Annualised non-mineral growth fell from a peak of 19.1% in 2011, at the peak of OT phase one’s construction, to 13.3% in 2012 and 12.3% in the first half of 2013, while that in mining slipped from 8.7% and 8.9% to 6.1%, according to the World Bank.

With the first quarter of 2013 the weakest quarter in three years, at 7.1% y-o-y, growth ratcheted up from the second quarter, with 14.3% y-o-y, driven by the construction and agricultural sectors. With a combined MNT420bn ($252m) in BOM credit flowing to the construction and housing sectors in 2013, together with DBM-funded road and housing developments, the construction sector grew by some 150% y-o-y in the first half of 2013, and was on track for 129% growth in the second half of the year, according to the World Bank.

Agriculture, which accounts for 16% of GDP and 40% of employment, benefitted from good climatic conditions and the PSP, and grew 20.6% y-o-y in the first half of 2013, maintaining its above-20% growth rate for six consecutive quarters. With livestock herding accounting for 80% of output, according to the NSO, a clement 2012 winter – following dzuds (harsh winters where livestock are unable to find sufficient food) in 2010 and 2011 – was key to solid growth. Central to the government’s efforts to stimulate growth, banks also shared in the uptick, with bank credit growth doubling from 24% y-o-y in December 2012 to 48% by September 2013. Net of taxes, Resource Investment Capital estimates that construction, agriculture and banking accounted for 8.8% of the 11.3% GDP growth in the first half of 2013. Despite a dip in y-o-y growth to 11.9% in the third quarter of 2013, growth forecasts for financial year 2013 range from BOM’s 11% to the IMF’s 11.8% and the 12% of the Asian Development Bank (ADB).

BOP Strains

While current account deficits are common for resource-rich economies in the build-up stages, and particularly given Mongolia’s limited manufacturing capacity and liberal trade regime. “The Mongolian economy’s vulnerability to external shocks was increased by recent years’ pro-cyclical fiscal policy,” Jan Hansen, the ADB’s senior country economist, told OBG. Additionally, as average disposable incomes have increased, with GDP per capita reaching $4000 in 2013, according to the ADB, ranking Mongolia 155th globally, the trade balance has been squeezed by growing demand for manufactured goods, while demand for Mongolia’s unprocessed mineral exports, which accounted for 91% of the total in 2012, has remained flat.

The country’s trade deficit expanded from $291m in 2010 to $1.75bn in 2011 and $2.35bn in 2012, receding slightly to $1.9bn in the year to November 2013. Compared to compound annual growth of 15.2% from 2008-12, exports in the year to October 2013 fell 4.1% y-o-y, with imports down 8% as construction activity slowed at key mining projects and the weakening tugrik reduced imports of food and consumer products. Though the value of coal exports dropped 45.3% y-o-y to $783m, that of copper rose 8.4%, spurred by first exports from OT. Non-mineral exports – mainly textiles – grew 32.3% from higher cashmere sales buoyed by the lower currency. Though imports of machinery and equipment, linked to subdued mining activity, fell 18% y-o-y, imports of food and construction materials grew 11.4% and 7.3% y-o-y, respectively, in the first eight months; despite the PSP helping constrain food import growth by stimulating domestic production. Current account deficit thus remained at $2.4bn in the year to August, around 2012 levels and accounting for 24% of GDP, according to the World Bank.

Amid lower FDI inflows unable to compensate for the current account deficit and the increasing money supply, the currency’s fall accelerated throughout 2013. The tugrik lost 25% of its value by October 2013, reaching MNT1740:$1, its lowest level in a decade compared to an average of MNT1200-1400:$1. However, despite traditional weakness during the winter months, the tugrik had recovered somewhat by the start of January 2014, when the currency was valued at MNT1625:$1.

Monetary Buffers

With double-digit inflation falling to 8.3% in the first half of 2013, contained through the PSP and down from a 34% peak in August 2008 and 14% in 2012, BOM actively cut interest rates from 13.25% to 10.5% in the six months to June 2013 and embarked on unconventional policies that injected liquidity equivalent to 21% of banking assets. With BOM also expecting inflation to remain within striking distance of its 8% target in 2014, it plans to continue the PSP while withdrawing some direct liquidity support from banks (see analysis). Although inflation has since picked up to 12% in November and 12.5% in December, according to BMO data, broad money continued to grow at roughly 22% y-o-y, despite 48% credit growth, given significant recycling of bank liquidity into the local-currency government bond market.

Mongolia has a managed floating exchange rate and the BOM has a flexible exchange rate policy. The BOM does intervene at times through open market operations; however, this is only done to smooth short-term volatility, meaning that the rate largely fluctuates in line with evolving market conditions and macroeconomic fundamentals. A sovereign bond disbursement and the BOM’s interventions in the foreign exchange market had reduced foreign reserves from a historical high of $4.1bn (including Chinggis bond proceeds) in December 2012 to $2.4bn by December 2013. However, the BOM maintains that international reserves are still adequate for precautionary purposes. Mongolian authorities are conscious of the need for FDI inflows to increase in order to bolster foreign reserves, but there is still a portion of recently raised bond proceeds and development agency funding to call upon in 2014.

Funding Constraints

Another key challenge stems from fiscal funding constraints imposed by a debt ceiling capping foreign debt at 40% of GDP from 2014.

Although the MoF had formulated a medium-term debt strategy prior to the $580m DBM and $1.5bn sovereign Eurobond issues in 2012, the MED-backed floats altered Mongolia’s debt profile significantly. The $1.5bn issue was the first tranche of a $5bn medium-term note programme. While domestic debt, multilateral loans and bilateral credit lines accounted for 28%, 40% and 24% of all public debt, respectively, in 2011, commercial debt (the two Eurobonds) accounted for the lion’s share of debt (33%) in 2012, while the other three accounted for only 23%, 19% and 19%, respectively. Total foreign currency government debt rose from 35% of GDP in 2010 to 42% in 2012, and 49.5% by the end of 2013, according to the MoF, although it is expected to drop to 40% by the end of 2014, based on 17% GDP growth projections.

The cost of serving the country’s foreign debt rose in 2013. Amid sharp rises in emerging-market bonds and concerns over looming tapering of the US’s quantitative easing, ratings agency Standard & Poor’s downgraded Mongolia’s “BB-” sovereign rating outlook to negative (Fitch and Moody’s maintained stable outlooks on their “B+” and “B1” ratings, respectively), leading to 250 basis-point yield increases on the Chinggis bond to 8.171% by September. While yields have normalised slightly since, the local currency cost of servicing Eurobonds rose as the MNT fell. Though DBM and Chinggis bonds are “bullet bonds”, which require only twice-yearly coupon payments with principal provisioned at maturity, raising new funds may be more challenging. In early 2014, however, the DBM had successfully raised funds through the issue of a Samurai bond, with the Japan Bank for International Cooperation guaranteeing 90% of all coupon payments, highlighting that the Mongolian authorities do still have funding options.

Public Sector Reform

To improve fiscal management and public-sector efficiency, the Mongolian authorities have committed to a programme of public sector reform that ranges from creating a sovereign wealth fund (SWF) to privatising certain state-owned enterprises (SOEs) and attracting private investment to public-private partnerships (PPPs).

Although Mongolia established the Human Development Fund in 2008, this was used mainly as a vehicle to distribute mining proceeds rather than to make productive investments. In 2013 the MoF drafted a bill to establish a bona fide SWF, with World Bank and ADB support, with parliamentary debate expected in 2014. The fund would invest partly offshore to offset upward pressure on the currency and build up fiscal buffers.

Following passage of the new Investment Law, the government announced plans in November 2013 to relaunch a privatisation process largely stalled since 2005, with the first sales expected for the state-owned Shivee Ovoo and Baganuur coalminers, though a timeframe was not announced at time of press. The aim is to reduce the number of SOEs by one-third through mergers or privatisations, although Invest Mongolia’s acting director-general S. Javkhlanbaatar said that this would be “a long process”. Parliamentary approval of the October 2013 Investment Law is likely to improve investment conditions over the long term by providing a more stable climate for both foreign and domestic investments; however, resolution of outstanding conflicts with key investors such as Rio Tinto will be key to boosting FDI in the short term. “While the new Investment Law is a positive development, it will take time for it to impact FDI inflows, which are lower during the winter season,” Howard Lambert, ING’s head of corporate and investment banking in Mongolia, told OBG.

Meanwhile, although a Concession Law was enacted in 2010, planned projects have still suffered repeated delays, with only one independent power plant, the 52-MW Salkhit wind farm, inaugurated in June 2013. The planned build-operate-transfer coal-fired CHP5 power plant in the capital, Ulaanbaatar, has suffered delays linked to project location changes, and should be tendered in 2014. “Seeing more PPP projects come to fruition will depend on the overall outcome of these pioneering projects,” the prime minister, N. Altankhuyag, told OBG. The government was preparing a list of PPPs, including projects in the infrastructure, power, mineral processing and industry sectors, to present to parliament in December 2013, with approval expected in early 2014. “We are expecting $60bn of projects in the coming decade, so the government is eager to attract investment through PPPs,” B. Byambasaikhan, managing partner at NovaTerra, told OBG.

Development partners such as the World Bank and the ADB have called for more rigorous preparation of projects and more transparent budget provisioning to maximise socio-economic returns from the government’s infrastructure plans. “Local banks lack the financial capacity to support large-scale infrastructure development, as funding costs are much higher than for global banks,” Norihiko Kato, CEO of Khan Bank, told OBG.

Uneven Dividends

The rapid expansion since 2010 has yielded dividends by driving down aggregate unemployment and poverty, though income inequality remains high by global standards. Government cash hand-outs and public sector pay increases played a role, as did the stimulus to employment from construction on mining and real estate projects. According to the NSO, the poverty rate declined from 38.7% in 2010 to 27.4% in 2012, albeit still shy of the 18% targeted by 2015 under the Millennium Development Goals.

Unemployment fell from 11% in 2010 to 8% in 2012 and 7.3% by June 2013. Given unemployment’s definition as “registered unemployed”, or active formal jobseekers, the lion’s share of employment is informal – some 66%, according to the World Bank-supported NSO “Labour Force Survey”. Despite the major economic contribution of mining, employment creation at production stages is relatively small. “Mining accounts for only 4% of employment in Mongolia, excluding construction workers linked to the development phase,” Hansen told OBG. “While agriculture should drive job creation, there is very little investment in processing.”

Although challenges in the mining sector continued, with lay-offs of 1700 of OT’s 10,000 workers in August 2013, the World Bank reported in November a sustained shift away from agriculture and mining towards other sectors, particularly services.

Mongolia’s largest employer, agriculture and herding, is particularly exposed to dzuds, as in 2010 and 2011, which prompted large migrations towards Ulaanbaatar and secondary towns, and a declining share of employment from 42% in 2007 to 29% by June 2013.

The 6% of the workforce employed in public administration benefitted from an average 60% pay rise in 2012, while employment in manufacturing (6% of the total), wholesale and retail trade (13%), and transport (5%) remained relatively flat.

Outlook

With political stability ensured until 2016, the government is striving to improve the coherence of Mongolia’s legal framework. “Our investment climate is already more predictable and stable than it was six months ago,” Altankhuyag told OBG. In 2013, authorities’ quasi-fiscal stimulus and aggressive monetary easing sustained double-digit growth for the year, yet these measures are ultimately unsustainable and future economic growth will depend on the success of a range of measures aimed at improving economic conditions.

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The Report: Mongolia 2014

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