Mongolia Economic Brief April 2016 http://www.worldbank.org/mongolia The budget deficit sharply widened in the first social welfare transfer spending including the three months of 2016. The deficit reached MNT Child Money Program transfers. Capital 618 billion in Jan-Mar, a fourfold increase from expenditures almost doubled in the first three MNT 145 billion in the same period last year. months compared with the same period last The budget deficit over the first three months year. reached 2.6% of annual GDP, two-thirds of the annual deficit target (MNT 940 billion or 4% of Spending control measures are likely to be GDP). needed to contain the deficit within target. The expected OT-2 investment is expected to Revenue collections fell by 11% (year-on-year gradually support import-related taxes in the [y/y]), following a 3% annual decline in 2015. second half. Nevertheless, overall revenue Mining revenues were severely hit by the weak collections are likely to remain far weaker than commodity market, with royalties plummeting the annual budget plan unless the commodity by 73% from a year ago. Personal income tax market significantly improves in the near revenues remained close to last year’s level, future. Spending increases at the current rate but corporate income tax (CIT) collections would make it difficult to contain the deficit more than halved, likely due to falling CIT within the 4% of GDP ceiling of the Fiscal collections from mining companies. Most of Stability Law without abrupt spending cuts in the consumption and import-related taxes the latter half of the year. exhibited sluggish growth, reflecting subdued economic activity. Significant external financing has been mobilized. The government announced that a Budget expenditures increased by 24.4% y/y in $250 million five-year syndicated loan was the same period. Recurrent expenditures rose mobilized at Libor + 625 basis points, the by 15% from last year’s first quarter, with proceeds of which were received in March. In strong increases in interest payments on addition, the government issued a $500 million government debt, purchases of goods, and five-year sovereign international bond at a 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). coupon rate of 10.875 percent in April. The debt repayments. Increasing reliance on effect of the new external borrowings on external debt, however, demands high projected gross government debt in 2016-17 vigilance on the rising exposure of the debt could be ameliorated, if used to substitute portfolio to exchange rate risks. domestic bond issuances or saved for future Figure 1. Budget deficit sharply widened in Jan-Mar as Figure 2. Large external borrowing was mobilized to finance the expenditures rose by 24% and revenues dropped 11 percent. growing budget deficit. Budget revenues and expenditures (billion MNT): Jan-Mar Monthly composition of deficit financing sources (billion MNT) 7,000 Foreign financing Revenue Expenditure 6,000 Domestic financing 1,800 1,711 5,000 Total net financing needs 1,600 4,000 1,373 1,400 1,287 1,231 3,000 1,118 1,141 1,095 1,200 1,020 2,000 1,000 1,000 800 0 600 -1,000 400 -2,000 200 -3,000 Aug-15 Jan-15 Mar-15 May-15 Jan-16 Mar-16 Feb-15 Jul-15 Sep-15 Dec-15 Feb-16 Apr-15 Oct-15 Nov-15 Jun-15 0 2013 (I-III) 2014 (I-III) 2015 (I-III) 2016 (I-III) Source: MoF The balance of payments deficit reached $125 financing could provide substantial liquidity million in Jan-Feb. Despite an $85 million buffers for the remainder of the year, current account surplus and a $152 million mitigating the underlying BoP pressures from a drawdown on the currency swap facility with projected deterioration in the current account the PBoC, the balance of payments remained balance and continued private sector financial under strain from substantial net financial outflows. outflows via currency and deposit accounts ($216 million) of the private sector and The pressure on the balance of payments is corporate loan repayments ($126 million). expected to remain high for 2017. Falling Foreign direct investment (FDI) remained mineral exports and increasing imports are weak, at $11 million net inflow in Jan-Feb. expected to widen the current account deficit Gross international reserves declined to $1,197 in 2017, elevating the pressures on balance of million in Feb, from $1,323 million at end-2015. payments, despite an expected recovery in FDI. Further straining the external accounts are the New government external borrowings are concentrated debt repayments scheduled in expected to ease the pressures on the balance Mar 2017 ($580 million) and Jan 2018 ($500 of payments (BoP). A moderate BoP surplus is million). Repayment of these debts would expected in Mar due to the inflow of the $250 substantially erode foreign exchange buffers million syndicated loan. Gross international unless substantial amount of the maturing debt reserves moderately rose to $1,265 million in is rolled-over or refinanced. March, reflecting the inflow of the syndicated loan proceeds. A $500 million portfolio The nominal exchange rate appreciated fast investment inflow from the recent sovereign against the USD in April, following a moderate bond issuance will further support the BoP in depreciation by 2.7% in the first three months Apr. The proceeds of the new external debt- of 2016. After the limited movement in the last 2 four months of 2015, the central bank allowed main trade partners, the real effective gradual depreciation of the exchange rate exchange rate is still stronger compared with against the USD in Jan-Mar on the back of low one year ago. In the first three weeks of April, inflation, while curbing the pace of the togrog appreciated by 3.3%, along with a depreciation through intervention. Due to recent weakening of the USD against most limited exchange rate flexibility compared with other currencies. Figure 3. The BoP recorded a $125 million deficit in Jan-Feb. Figure 4. The exchange rate depreciated in Jan-Mar only moderately, with increased BoM intervention. Monthly BoP trend (million US$) Exchange rate and BoM’s Net US$ Injection (million US$) Errors and omissions Currency/Deposits (excl. BoM) Debt-financing FDI CA Balance Change in gross FX reserves The BoM's net sales of foreign exchange: LHS USD/MNT: RHS 600 300 2,100 250 2,000 400 200 1,900 200 Miilions of USD 150 1,800 0 100 1,700 50 1,600 -200 - 1,500 -400 (50) 1,400 (100) 1,300 -600 Oct-12 Oct-13 Oct-14 Oct-15 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Apr-12 Jul-12 Apr-13 Jul-13 Apr-14 Jul-14 Apr-15 Jul-15 Apr-16 Oct-13 Oct-14 Oct-15 Feb-13 Feb-14 Feb-15 Feb-16 Apr-13 Jun-13 Apr-14 Jun-14 Apr-15 Jun-15 Aug-13 Dec-13 Aug-14 Dec-14 Aug-15 Dec-15 Source: BoM Mining production remained strong in the first March after a 19.8% contraction in the quarter, but weaker terms of trade in key export previous three months. Electricity supply commodities dampened export earnings. including domestic production and imports Mining industrial production increased by rose by 3%, indicating slow economic activities. 36.7% y/y in the first quarter despite the weak In agriculture, the natural losses of adult commodity market conditions, driven by livestock in the first quarter reached 1.5% (830 double digit growth in copper production (48%) thousand animals) of total livestock at end-215 and crude oil (19%). The sales value of (55,979 thousand animals), a significant commodity exports, meanwhile, declined by increase from a 0.1% natural loss ratio in the 13.5% due to a fall in key commodity prices, same period last year. Gross nominal value of reducing total export earnings by 11% in the construction, meanwhile, increased by 29.8% first quarter. Despite strong y/y increases in y/y over the same period, a significant rebound export volumes of copper (33%) and crude oil from 3.6% growth in the previous quarter, with (16%), sharp drops in the prices of copper (- strong residential construction off-setting a 29.5%) and crude oil (-31%) reduced export contraction in public construction. values of copper by 6% and crude oil by 20%. Coal export earnings also dropped by 29.8% in Imports fell by 15.3% Jan-Mar reflecting weak Jan-Mar, with a stagnant export volume growth domestic demand, a slower pace than last year. (0.8%) and the falling sales price (-30.4%). Gold Consumption goods imports fell by 8.8% y/y in exports, meanwhile, increased by 13.6% y/y. Jan-Mar, a slower contraction than a 24.5% drop in the previous three months. Contraction Non-mining economic activities remained in imports of capital goods also softened to subdued in the first quarter. Manufacturing 11.7% in the same period, from a 16% drop of industrial production fell by 14.8% y/y in Jan- the previous quarter. Oil product imports, 3 meanwhile, continued to drop sharply by 44% respectively in Mar. A 5.5% drop in energy and reflecting weaker oil prices. fuel prices and a 9.6% drop in meat price significantly contributed to lower inflation. The nation-wide headline inflation and the UB- Core inflation in the capital city also remained city inflation remained low at 1.7% and 1.1% y/y stable at 3.1%. Figure 5. Mining production remained strong, but weak Figure 6. Imports dropped 15.3% in Q1 amid weak domestic commodity prices reduced export earnings by 13.5% in Q1. demand, but import contraction is gradually softening. Growth in mining production and exports of key commodities (y/y, Growth in manufacturing industrial production and imports (y/y, %, 3 %, 3 month rolling sum) month rolling sum) Mining industrial production: RHS Manufacturing IP Total imports Copper concentrate exports Capital goods Fuels 45% Coal exports Consumption goods Oil exports 250% Total exports 100% 30% 200% 80% 15% 150% 60% 0% 100% 40% -15% 50% 20% -30% 0% 0% -45% -50% -20% -60% -100% -40% Jan-14 Jan-15 Jan-16 Mar-13 Mar-14 Mar-15 Mar-16 May-13 May-14 May-15 Sep-13 Sep-14 Sep-15 Jul-13 Nov-13 Jul-14 Nov-14 Jul-15 Nov-15 Nov-12 Apr-13 Mar-11 Jan-12 May-15 Mar-16 Sep-13 Feb-14 Jul-14 Dec-14 Aug-11 Jun-12 Oct-15 Source: NSO, BoM Credit conditions remain tight, with signs of The BoM injected substantial liquidity to banks gradual improvement in recent months. in Feb. Following the policy rate cut by 100 Outstanding bank loans continued to decline basis points in Jan, the outstanding claims of by 2.9% y/y in Mar, but at a slowing pace from the BoM on banks increased from MNT 1,235 a 7.5% drop in Dec 2015. Adjusted bank loan billion in Jan to MNT 1,705 billion in Feb, growth, which includes the off-balance-sheet despite a continued withdrawal of the Price securitized mortgages, picked up to 4.2% from Stabilization Program loans. 1.7% y/y over the same period. Non- A subsidized herder loan program was performing loans (NPLs) increased by 17% in launched by the government in March. The the first three months, compared with end- program intends to support herders and 2015, reaching MNT 968 billion in Mar. The NPL farmers, by providing cheaper financing via the ratio rose from 7.1% to 8.2% over the same state-owned State Bank at a 10 percent period. interest rate, much lower than the market rate of around 30% available to herders. The State Bank issued MNT 30 billion to 8,083 herders under the new policy lending program over one month since Mar 15. Given the limited funding capacity of the State Bank, the central bank will likely be the key financiers for the program, together with the Development Bank of Mongolia. 4 In March, the BoM transferred assets related to the subsidized Housing Mortgage Program to the Government. Approximately MNT 2.5 trillion of mortgage assets was transferred from the BoM to the new Future Pension Reserve Fund (FPRF) of the government established in Feb. The transferred assets included the outstanding Residential Mortgage Backed Securities (RMBSs) and BoM loans to banks that were extended under the subsidized mortgage program over the last three years. The transfer of these assets from the BoM to the government, however, was not compensated by the government, resulting in a substantial loss in the BoM’s balance sheet. The mortgage program now belongs to the government budget, but will be implemented by the BoM. The cash flows generated from the FPRF’s mortgage assets are to finance new subsidized mortgages originated by banks, and ultimately support future pension payment from 2030. The BoM will manage the FPRF, as an agent of the government, setting the size and terms of subsidized mortgages. BoM would also likely continue to fund the mortgage program by providing loans to the government, using the mortgage assets of the FPRF as a collateral. The interest rate of subsidized mortgages was further lowered from 8% to 5% in March. The cheaper mortgage loans are available for apartment purchases in specific areas, including: (i) new settlement areas decided by the Ulaanbaatar Municipality; (ii) Ger districts for re-development plans; (iii) three sub-urban districts in UB; and (iv) the rural areas of 21 aimags. The maturity of the subsidized mortgages was also extended from 20 years to 30 years to ease the repayment burden of borrowers. The intention to transfer the mortgage program to the Government is welcome, but we would like to reiterate the following points for further consideration by the authorities:  Mixing the pension and mortgage functions is complicated and nontransparent. The name of the new fund is misleading as the FPRF is mainly to serve as a new financing vehicle for subsidized mortgages, while supporting future pension payments remains only as its long- term objective. Furthermore, strengthening financial sustainability of the pension system requires budget resources beyond the cash flows generated from the mortgage program.  New policy loans issued by the FPRF to commercial banks should be properly recorded as budget spending and compete with other spending priorities, with legislative oversight.  Further BoM financing to the Housing Mortgage Program needs to be terminated. New BoM financing to the mortgage program, if any, should be recorded as government’s borrowing, and controlled under the FSL’s debt limit.  Targeting of mortgage eligibility is needed to reduce the fiscal burden while effectively supporting affordable housing for low and middle-income families. Proper compensation is needed by the government for the transferred mortgage assets to cover the capital loss in the BoM’s balance sheet. The government could issue treasury securities at market rates to the BOM in exchange for the assets. A large loss in the BOM’s balance sheet would result in potential recapitalization costs for the government, possibly compromising the BOM’s independence and ability to conduct monetary policy. 5