70210 June 2012 Mongolia Quarterly Economic Update The World Bank The World Bank’s Mongolia Quarterly Economic Update assesses recent economic and social developments and policies in Mongolia. It also presents findings of ongoing World Bank activities in Mongolia. The Update is prepared by a team from the World Bank’s Poverty Reduction and Economic Management (PREM) Sector Unit in the East Asia and Pacific Region Vice-Presidency, consisting of Munkhnasan Narmandakh, Tehmina Khan and Altantsetseg Shiilegmaa under the guidance of Zahid Hasnain. This Update also received contributions from Alexander Pankov, Tungalag Chuluun, Trang Van Nguyen and Juan Feng. Copies can be downloaded from http://www.worldbank.org.mn. For further information, comments and questions, please contact Munkhnasan Narmandakh (mnarmandakh@worldbank.org). Mongolia Quarterly Update 2012 Contents Executive Summary....................................................................................................................................... 5 Real sector developments ............................................................................................................................ 7 External sector .............................................................................................................................................. 9 The Exchange Rate, Reserves and Bond Issuance ...................................................................................... 11 Banking sector............................................................................................................................................. 14 Inflation ....................................................................................................................................................... 16 Fiscal developments.................................................................................................................................... 18 Labor Markets and Poverty......................................................................................................................... 25 Economic outlook ....................................................................................................................................... 27 Figures Fig 1 The economy grew by 16.7 percent in the first quarter of 2012 ........................................................ 8 Fig 2 Industrial output continues to grow at a healthy pace ....................................................................... 8 Fig 3 The trade deficit continues to widen ................................................................................................. 10 Fig 4 although imports are growing much more slowly compared to a year ago ..................................... 10 Fig 5 while exports fell in April, the first yoy decline in more than two years.......................................... 10 Fig 6 …as exports to China have fallen back ............................................................................................... 10 Fig 7 Commodity prices have fallen sharply since last year ....................................................................... 11 Fig 8 Although the current account widened, it remained fully funded by FDI inflows ............................ 11 Fig 9 Both the nominal and real exchange rates appreciated in Q1 ........................................................... 11 Fig 10 FX reserves remain high ................................................................................................................... 11 Fig 11 The central bank continues to sterilize its accumulation of reserves but at a much slower pace than last year .......................................................................................................................................... 12 Fig 12 Mongolia also successfully debuted its first international bond offering at relatively favorable yields ....................................................................................................................................................... 12 Fig 13 Both local and foreign currency deposit inflows are tapering off .................................................... 15 Fig 14 while real rates of returns on local currency deposits are sharply negative ................................... 15 Fig 15 Credit growth has decelerated after peaking in November of last year, and is likely to slow down further ..................................................................................................................................................... 15 Fig 16 … But lending remains highly concentrated ..................................................................................... 15 Fig 17 NPLs are the highest and Tier 1 buffer capital ratios among the lowest in the region .................... 16 2 Mongolia Quarterly Update 2012 Fig 18 and the overall volume on NPLs on bank balance sheets remains large ........................................ 16 Fig 19 Inflation is accelerating in Mongolia….............................................................................................. 17 Fig 20 …in marked contrast to the rest of East Asia ................................................................................... 17 Fig 21 Food prices have shot up, notably of meat ..................................................................................... 17 Fig 22 which constitutes nearly a third of the food CPI basket under the revised CPI weights ................. 17 Fig 23 Government spending is rising extremely fast, mostly on capital projects ..................................... 20 Fig 24 while revenue growth has stalled ................................................................................................... 20 Fig 25 Despite revenue growth being the strongest, public balances have deteriorated the most in Mongolia compared to other East Asian economies .............................................................................. 21 Fig 26 and the deficit has risen sharply ...................................................................................................... 21 Fig 27 Real wages in informal labor markets in UB have increased since January despite the acceleration in inflation ............................................................................................................................................... 25 Fig 28 But nearly 60 percent of those surveyed reported that wages were insufficient to meet basic needs ....................................................................................................................................................... 25 Tables Table 1 Mongolia: Key Indicators................................................................................................................ 28 Boxes Box 1 Tapping international financial markets: benefits and risks for Mongolia ....................................... 13 Box 2 Controlling Off-budget Financing for Infrastructure ......................................................................... 22 Box 3 Key Considerations for setting up a targeted social welfare benefit ................................................ 24 Box 4 2011 poverty level dropped to 29.8 percent in Mongolia ............................................................... 26 3 Mongolia Quarterly Update 2012 Abbreviations and acronyms bn Billion BoM Bank of Mongolia CPI Consumer Price Index DBM Development Bank of Mongolia FX Foreign currency FSL Fiscal Stability Law GDP Gross Domestic Product HDF Human Development Fund LC Local currency LHS Left hand side MFA Mongolian Financial Association mn Million MNT Mongolian togrog MoF Ministry of Finance mom Month-on-month mt Metric ton NPL Non-performing loan NSO National Statistics Office OT Oyu Tolgoi RHS Right hand side tn Trillion US$ United States Dollar WPT Windfall Profit Tax yoy Year-on-year YTD Year-to-date 4 Mongolia Quarterly Update 2012 Executive Summary1 The Mongolian economy is continuing to grow at a very rapid pace, expanding by 16.7 percent year- on-year (yoy) in Q1. This high growth however, is also fuelling inflation which touched 16 percent in April, well above the Bank of Mongolia’s (BoM) inflation target of 10 percent. Increasing government spending on wages and salaries, large cash handouts to the general population, and burgeoning capital expenditures are adding to the demand pressures. Meanwhile, the worsening global economic outlook, in particular a faster than expected slowdown in China, Mongolia’s largest trading partner, has negatively impacted export growth, resulting in a deterioration in external balances. Under these circumstances, the advice to Mongolian policy-makers is to “hold your horses” and adopt a more cautious macro-economic stance, tightening both monetary and fiscal policy to prevent further over- heating of the economy. Growth is being led by the service sectors, in particular wholesale and retail trade which expanded by 51 percent yoy in Q1, following an outturn of 70.5 percent in the last quarter of 2011, and transport which grew by 11.7 percent yoy. The development of the Oyu Tolgoi mine is having strong spillovers into the rest of the economy, including through lifting consumer and business sentiment. The first quarter data also revealed that the agriculture sector is finally recovering from the effects of “dzud” (severe weather conditions) suffered in late 2009/early 2010, growing by 13.6 percent in Q1. Government spending growth is outpacing revenue growth, resulting in an increasing fiscal deficit. Spending, in nominal terms, was 32 percent yoy higher in April (year to date, YTD, basis) with capital spending growing by more than 100 percent. Revenues are failing to grow at the same pace, rising only 21 percent in nominal terms on a YTD basis in April, as a result of weaker growth in receipts from taxes on international trade, and negative growth in excise taxes, royalties and dividends from mining sector companies. As a result, the fiscal deficit has climbed considerably, reaching 4.7 percent of GDP in March, its highest level in nearly two years (although it has since eased slightly in April). Although the 2 percent structural deficit ceiling under the Fiscal Stability Law becomes binding only in January 2013, with the structural deficit amounting to 6.1 percent of GDP in April, Mongolia will have to undertake a substantial amount of fiscal tightening in 2013 if it is not to miss the target. In particular, the exponential growth in capital spending is straining the absorptive capacity of the economy, as evidenced by rapidly increasing cement prices. There has also been an increase in alternative sources of infrastructure financing, through “build-transfer” schemes and project financing by the Development Bank of Mongolia (DBM) that represent significant fiscal liabilities. The DBM is backed by a full sovereign guarantee, and rising debt service payments that fall due in the next few years could constrain fiscal space in the near term. Claims on budgetary resources could also grow with the proposed monetization of Erdenes TT shares. Inflation is being pushed up by rising core inflation, which reflects demand side pressures from higher government spending, and by rising food prices, notably of meat. Recent rate hikes by the BoM are helping to reduce the pace of bank lending, which had been growing over 60 percent at the start of the year. Although there is room to hike further, with the interest rates on central bank paper still 1 The analysis is based on Q1 + April 2012 data from the Bank of Mongolia (monthly bulletin, balance of payments, loan report and monthly consolidated banking system balance sheet), the National Statistical Office (monthly bulletin), relevant government authorities and international databases. 5 Mongolia Quarterly Update 2012 negative in real terms, monetary tightening needs to be complemented by fiscal restraint in order to be effective. On the external front, exports contracted by 2.8 percent yoy in April. This was the first fall in more than two years, and reflected weaker global economic conditions, sliding commodity prices and slowing growth in China which is Mongolia’s largest trading partner. Coal, which is the largest export earner, is barely growing, while copper exports have been performing poorly for some time now. On a four- quarter rolling sum basis, the current account deficit widened to 35 percent of GDP in Q1 2012 from 18 percent in Q1 2011 but was financed by the record levels of FDI inflows of US$ 4.4 bn or roughly half of GDP, and FX reserves remain high. The Togrog has appreciated in recent months, in both nominal and in real terms which will undermine the competitiveness of Mongolia’s non-mineral traded sector. Recent poverty analysis, conducted jointly by the World Bank and the NSO, finds that the national poverty headcount rate declined from 39.2 percent in 2010 to 29.8 percent in 2011. This progress took place against the backdrop of strong economic growth, sizeable social transfers, and large investments to help the recovery from the 2010 dzud. However the recent acceleration in inflation is worrying since it will impact the poor disproportionally, and rising food inflation is particularly worrying since food constitutes 49 percent of expenditures among households in the lowest quintile of the income distribution. The global economic outlook has deteriorated considerably in recent months. Financial conditions in high-income Europe, higher oil prices, and, most importantly, the slowing Chinese economy pose risks for Mongolia. The channels through which these operate include financial and trade linkages – namely volatility in commodity prices and through demand from China for its mineral exports. Indeed, signs of these are already visible as demonstrated by the decline in exports in April. Other financial market linkages should also not be discounted: Mongolia’s banking system, which has shown signs of overheating over the past year, is highly dollarized, with about a third of deposits denominated in dollars and easy convertibility out of the Mongolia Togrog. A sharp economic slowdown and/or an increased macroeconomic instability could expose the liquidity and asset quality vulnerabilities in individual banks and system overall. Given these risks, Mongolian policy-makers need to adopt a cautious macro-economic stance. This will entail limiting the build-up of vulnerabilities in the banking sector, reining in the growth of government expenditures, minimizing off-budget financing activities and ensuring that the lending of the DBM is within the framework of the FSL. Adjusting the policy stance in this manner will address the internal imbalances that are already evident as well as position Mongolia better to deal with the risks to the regional and global economy. It will also ensure that the money spent is well spent, namely on activities that help to build the public and human capital infrastructure of Mongolia and maximize the returns of the country’s mineral wealth to its people. 6 Mongolia Quarterly Update 2012 Real sector developments 2012 started with first quarter growth of 16.7 percent… The economy continues to grow at a furious pace, expanding by 16.7 percent year-on-year (yoy, Fig 1) in the first quarter. This makes Mongolia one of the fastest growing countries in the world. … fuelled by the development of the mining sector as well as highly expansionary fiscal policy Growth is being fuelled by the development of the Oyu Tolgoi mine which has had strong spillovers into the rest of the economy, including through lifting consumer and business sentiment. Government spending is also growing extremely fast, further boosting domestic demand through growing outlays on wages and salaries, large cash handouts to the general population and capital projects. As a result, the service sectors of the economy are booming: wholesale and retail trade expanded by 51 percent yoy in Q1 and added 5 percentage points (pp) to GDP growth, much larger than the growth contribution of any other sector; transport, communication and other services added another 4.2 pp with the transport sector growing by 11.7 percent in Q1 following a contraction of 29 percent in Q4 last year. The mining sector also performed well during the first quarter with a positive contribution to GDP growth of 1.6 pp. After showing signs of strong overheating during the summer of last year, construction sector activity has weakened considerably: the sector contracted for the second quarter in a row, with output falling by 20.5 percent in Q4 and 12.5 percent in Q1. The sector appears to have hit capacity constraints in the form of shortages of skilled labor, construction materials and equipment. Local supply of construction materials was affected by the closure of several companies mining for construction materials (gravel, limestone producers) due to the law regarding mining activities near forests and riverbed areas. Transport delays meanwhile have also worsened, with reports indicating that the amount of time required to import material has increased from 15 days to around 45. Finally, wages are reported to be rising fast in the construction sector (this is also borne out in World Bank surveys of informal labor markets, see next section) with companies struggling to pay higher wages while borrowing costs have increased due to a tightening of monetary policy. Going forward, capacity constraints are likely to prove a significant impediment in implementing the massive road building and social housing plans announced by the government and the private sector housing developments. First quarter data also revealed that the agriculture sector has finally recovered from the effects of “dzud” (severe weather conditions) suffered in late 2009/early 2010. The sector grew by 13.6 percent following barely positive growth during 2011 and a contraction of 16.6 percent in 2010. This bodes well for low-income families in rural areas that had been particularly hard hit by the dzud, many of whom had been forced to migrate to urban areas to look for employment opportunities. Industrial output continues to grow at a healthy pace … Mongolia’s industrial output remains healthy, with total output rising by 12 percent yoy in April (three-month moving average basis. This strong performance is mainly driven by manufacturing sector which makes up almost 30 percent of total output and which rose by 20 percent, supported by manufacturing of basic metals (up 94 percent) and food and beverages (up 16 percent) in April. Mining and quarrying sector accounts for 60 percent of total output and also grew by 10 percent. 7 Mongolia Quarterly Update 2012 Fig 1 The economy grew by 16.7 percent in the first Fig 2 Industrial output continues to grow at a healthy quarter of 2012 pace % point contributions to GDP growth, yoy Industrial output, 3 month moving average % yoy, 2005 constant prices 50 Agriculture Mining Mining and quarrying Other services Manufacturing Construction Wholesale & retail trade 40 Industrial output 25 Electricity, comm. & residual Transportation Manufacturing GDP Utilities 20 30 15 20 10 10 5 0 0 -5 -10 -10 Q3-08 Q1-09 Q3-09 Q1-10 Q3-10 Q1-11 Q3-11 Q1-12 -20 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 Sources: NSO, WB staff estimates.* Preliminary GDP estimates And the development of the Oyu Tolgoi mine remains on track … With the completion of 87 percent of the first phase of the development of the Oyu Tolgoi mine in April, the mining and stockpiling of ore from the open pit has already begun. Meanwhile, commercial production is expected to start in the first half of 2013. Looking ahead, the slowdown in China and deteriorating conditions in the Eurozone may have a strong impact on demand for Mongolia’s mineral output The global economy is facing renewed headwinds. The sovereign debt crisis in the Euro area is intensifying again. Economic activity data from China, to which Mongolia ships the bulk of its coal and copper output, suggest that growth is continuing to moderate and that the investment boom that had underpinned strong Chinese demand for global commodity imports and kept commodity prices high is coming to an end2. Turbulence in international financial markets could also affect financing needed to develop Mongolia’s mineral wealth while delays in building railway networks to transport mineral output (due to capacity constraints in the construction sector) could affect revenues from the mineral sector. The continued demand softening for commodity imports by China and lower prices will impact negatively demand for Mongolia’ mineral output and revenues. Indeed, as discussed in the trade section, growth in Mongolia’s exports has been weakening since the start of the year and turned negative for the first time in more than two years in April. 2 It is important to bear in mind that while Chinese demand for commodities related to export manufacturing and investment will likely turn weaker, private consumption growth remains strong. This will support prices for imports such as palm oil, vegetables, fish and meat, rubber for the production of tires, and other consumption-related commodities 8 Mongolia Quarterly Update 2012 External sector The trade deficit continues to widen although imports are growing at a much slower pace compared to last year Trade data show a further widening of the trade deficit in April, as import growth outpaced that of exports (Fig 3). The latest data show a deficit of almost US$ 2.1 bn in March 2012 (on a 12 month rolling sum basis3), up from US$ 0.7 bn a year ago. Imports reached US$ 7.0 bn in April, a 74 percent increase from a year ago, while exports climbed to US$ 4.9 bn from US $3.3 bn a year ago. However, import growth has slowed considerably from last year as mining transport and machinery equipment and fuel imports related to the development of the OT mine (these accounted for 70 percent of total imports in 2011) have fallen back (Fig 4). April data show an increase of 25 percent yoy in total imports. In part this likely reflects base effects, namely the surge in equipment, fuel and transport imports last year as the development of the OT mine gathered pace, and also the effect of growing lead times to import goods, which have increased from around 15 days to 45. On an annual basis, exports fell for the first time in April compared to year ago Exports fell by 2.8 percent yoy in April, the first negative number in more than 2 years and further weakness is likely as more rapid than expected slowdown in China pose the largest risks to the outlook (Fig 5). Mongolia’s exports over the past year have been supported almost entirely by large coal shipments to China, where Mongolia sells 93 percent of its exports. Total exports to China fell slightly by 0.2 percent yoy in April, with overall coal exports, the largest export earner for Mongolia, barely increasing (Fig 6) on a monthly basis. On a year-to-date basis, coal is up 51 percent with unit prices still strong at 32.2 percent increase. Exports of copper fell for the fourth consecutive month in April, down by 19 percent yoy, due to 18 percent drop in unit price. Copper prices have been falling since January and registered a 10 percent fall between the end of April and the middle of May (Fig 7).Exports of gold also performed poorly but due to 47 percent drop in volume while unit prices increased by 12 percent in April. Cashmere season started in March with herders and traders attempting to push up prices of greasy cashmere by limiting the volume of greasy cashmere being sold on the market and available for export. As a result, export earnings from greasy cashmere were down by 57 percent yoy on YTD basis in Q1 while export volumes were 36 percent lower. Chinese buyers currently dominate buyers for cashmere, with local dehairers and spinners remaining on the sidelines. However, combed goat down increased in volume terms by 4 times since Q1 2011, outperforming greasy cashmere. With global economic prospects looking dim as the euro area crisis drags on, global commodity prices are becoming increasingly volatile. Meanwhile the momentum of global trade is slowing, and with China trying to engineer a soft landing for its housing market and its economy, the risks only lie to the downside. Renewed volatility in global financial markets or any shift in risk appetite, in both domestic and overseas investors, suggests that demand for Mongolia’s commodity exports is unlikely to remain robust. Indeed this is already being borne out in the export data. 3 Monthly trade data tends to be highly volatile and also is affected by seasonal factors. For this reason, 12-month rolling sums are illustrated. 9 Mongolia Quarterly Update 2012 On a four-quarter rolling sum basis, the current account deficit widened to 35 percent of GDP4 in March 2012 from 18 percent the previous year (Fig 8), but was financed by the record levels of FDI inflows of US$ 4.4 bn or roughly half of GDP. Net remittances declined to US$ 60.5 mn in Q1 2012 from US$ 121.6 mn in Q1 2011 mainly due to rising outflows from the private sector. Fig 3 The trade deficit continues to widen Fig 4 although imports are growing much more slowly compared to a year ago US$ mn, 12-month rolling sum* Percentage point contributions to year-on-year growth 8,000 500 Mineral products 200% Transport equipment 7,000 0 Machinery and equipment 6,000 150% Food products -500 Base metals 5,000 Other 100% Total imports 4,000 -1000 3,000 -1500 50% 2,000 Exports Imports -2000 1,000 0% Trade balance (right axis) 0 -2500 Mar-06Mar-07Mar-08Mar-09Mar-10Mar-11Mar-12 -50% Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Fig 5 while exports fell in April, the first yoy decline in Fig 6 …as exports to China have fallen back more than two years Exports, percentage point contributions to year-on-year growth Exports, percentage point contributions to year-on-year growth 190% Other Other Greasy cashmere 160% China Coal 140% 120% Russia Gold Copper concentrate 80% Total 90% Total 40% 40% 0% -40% -10% -80% Aug-09 Aug-10 Aug-11 Dec-09 Dec-10 Dec-11 Oct-09 Oct-10 Oct-11 Feb-10 Apr-10 Feb-11 Apr-11 Feb-12 Apr-12 Jun-09 Jun-10 Jun-11 -60% Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 4 Monthly and quarterly trade data tends to be highly volatile and also is affected by seasonal factors. For this reason, 4- quarter rolling sums are illustrated 10 Mongolia Quarterly Update 2012 Fig 7 Commodity prices have fallen sharply since last Fig 8 Although the current account widened, it remained year fully funded by FDI inflows Jan 2010=100 US$ mn, 4-quarter rolling sums 180 Copper 5000 Q1 2011 Gold 4000 170 NewCastle Coal 3000 2000 Q1 2012 160 1000 150 0 -1000 140 -2000 -3000 130 -4000 120 Remittances CA balance Other net inflows Net FDI inflows Net portfolio inflows 110 100 90 80 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Sources: BoM, MoF, NSO and WB staff estimates. The Exchange Rate, Reserves and Bond Issuance The Togrog has appreciated in recent months, in both nominal and real terms, and this undermines the competitiveness of Mongolia’s non-mineral traded sector The Mongolian Togrog has appreciated slightly in recent months after losing value towards the end of last year. At the beginning of May, the exchange rate had appreciated by nearly 6 percent compared to the start of the year. The real exchange rate – which essentially measures the price of a basket of Mongolian goods against the similar basket of goods in its main trading partners and hence is a key indicator of competitiveness in international markets – has also resumed its upward trends, appreciating by 11 percent in Q1 compared to the end of last year (Fig 9). This reflects significantly higher inflation pressures within Mongolia even as inflation has fallen in its main trading partners, and will take a toll on the already small manufacturing and agricultural sectors’ exports. Fig 9 Both the nominal and real exchange rates Fig 10 FX reserves remain high appreciated in Q1 Index=100 in Jan 2006 US$ mn, stock US$ mn, mom change 140 2,900 Stock of BoM international reserves 500 130 month on month change, RHS 400 2,400 120 appreciation 300 110 1,900 200 100 1,400 100 90 REER 0 80 USD vs MNT, Jan 2006=100 900 70 -100 60 400 -200 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 11 Mongolia Quarterly Update 2012 Fig 11 The central bank continues to sterilize its Fig 12 Mongolia also successfully debuted its first accumulation of reserves but at a much slower pace than international bond offering at relatively favorable yields last year MNT mn % Selected Debt Issuances, YTD March 2012, East Asia, Left axis shows issuer with announcement date and maturity in brackets 1400 Central Bank bills (net) 16 Issuer (announcement date *, maturity in years) 5.00 1200 7-day CBBs rate, RHS 14 EXIM Bank Korea (1/4,10) 1.00 DBS Bank Ltd/ Sing (2/21,5) 2.35 12 1.00 Coupon (%) 1000 Overseas Ch. Banking (3/6,3) 1.63 US $ bn 10 1.00 800 Korea Nat. Oil Co. (3/26,5) 3.13 8 1.00 EXIM Bank Korea (1/4,5) 4.00 600 1.25 6 5.00 Rep of Ph (1/4,25) 400 1.50 4 5.20 Rep. of Ind (1/9,30) 1.75 200 2 5.75 Dev. Bank of Mong (3/15,5) 0.58 0 0 0 1 2 3 4 5 6 7 09/08 03/09 09/09 03/10 09/10 03/11 09/11 03/12 Sources: BOM, Bloomberg, World Bank.* month/day Foreign exchange reserves have risen in recent months, in part reflecting the deposit of the proceeds from DBM’s bond issuance Meanwhile the Bank of Mongolia had accumulated some US$ 440 mn of foreign exchange reserves by April, following a sale of some US$ 245 mn in the first quarter to stem volatility in currency markets at the end of last year. Net international reserves (NIRs) -- excluding commercial banks’ NIR -- have consequently hit new highs at US$ 2.63 bn in April, up from US$ 2.3 bn in December (Fig 10). However it should be noted that in March 2012, the DBM deposited the US$ 580 million proceeds of its successful bond issuance with the BoM which helped to raise NIRs. Excluding this amount (as per the definition of NIRs by the IMF used in the 2009-10 IMF program), reserves amounted to US$ 1.8 billion at the end of April 2012. This is roughly the same as the level first achieved in January 2011 and is down from about US$ 2.2 billion in mid-2011, presumably reflecting domestic demand pressures and the BoM’s relative preference for exchange rate stability. Finally, the outstanding stock of central bank paper has fallen considerably compared to the start of 2011. As a result, the BoM has been injecting liquidity into the financial system through the net redemption of central bank paper (Fig 11). Bond offerings in international markets attracted strong investor interest, but with global uncertainty mounting once again, Mongolia should maintain a cautious approach The DBM, backed by a full sovereign guarantee, debuted its first foreign currency bond offering on international financial markets in March, worth US$ 580 mn (Fig 12). The bonds are rated B1 by Moody's and BB- by S&P, which is the same rating as the Mongolian sovereign. Along with an earlier US$ 20 m in a private placement at the end of 2011, the DBMs latest offering completes its US$ 600 mn program of issuance to fund infrastructure projects. This has been followed by the sale of US$ 600 mn 5 year bonds by the Mongolian Mining Corporation, which is Mongolia’s largest coking coal producer, in late March 12 Mongolia Quarterly Update 2012 which marked the country’s largest international corporate bond issuance so far.5 The bulk of the money is intended to be used to upgrade transport links, notably to finance a railway link to the Chinese border to substitute for road networks currently used to transport the company’s coal to China. Mongolia is expected to continue tapping international financial markets in the near future. In this context the DBM is expected to return to the markets and market reports suggest that major banks including Xacbank, Khan Bank and Golomt Bank are also planning to issue debt in international markets in the next few years. However, while international capital markets are undoubtedly an important source of financing for Mongolia with regard to developing its infrastructure, policy makers should remain cognizant of risks and returns. These are discussed in Box 1. Box 1 Tapping international financial markets: benefits and risks for Mongolia As international financial market strains dissipated in Q1, a number of countries across East Asia took advantage of extremely low yields and continued investor appetite to issue large volumes of debt. In Mongolia’s case the five year US$ 580 mn bond offering by its Development Bank in March drew orders of US$ 6.25 bn with a yield of 5.75 percent, much lower than the initial guidance of 6-6.25 percent reflecting investor interest in the fast growing economy. Mongolia has some of the world’s largest untapp ed mineral deposits, including copper, uranium, coal and gold. Close proximity to fast-growing China means that there is a ready market for these commodities. However, significant investment is required to get these mineral resources out of the ground and to market. For example, an estimated US$ 5 bn is required in the Southern Mongolia region by 2015 for investment in railways, electricity, 6 towns, and water. The largest investment needs are in electricity generation to meet the energy needs of the population and mining projects. Considerable investment is expected in railways and road transportation links and for urban development around mining centers to house workers and their families as well as associated service providers. Domestic capital markets are nascent and thus international financial markets are an important source of funding given the scale of financing required. However it is crucial that money raised by the DBM, which is backed by a full sovereign guarantee, is used to finance projects with high rates of return. These returns should accrue to the government in the form of higher revenues associated with developing potential mining sites and infrastructure projects and higher mineral exports. Although some 40 percent of the funding raised by the DBM is to be used for setting up much needed mining related railway links and corridors, the remainder is targeted towards projects that may have high social returns but limited economic ones. These include the construction of new aimag roads that are not part of any major transport network, housing construction and mortgage loans as discussed later in Box 2. Although Mongolia’s debt sustainability is enhanced by the strong growth prospects of the country and it has accumulated a large buffer of FX reserves, debt issued by the DBM (and the Mongolian Mining Corporation) is of relatively short duration, raising exposure to external shocks or to unexpected delays in major mining projects that impact commodity revenues. The international financial climate continues to be clouded by uncertainty and with the eurozone crisis flaring up again there remains the potential that international commodity prices may fall 5 The Trade & Development Bank of Mongolia, the country’s third largest bank was the first Mongolian bank to tap international debt markets with US$ 75 mn bond placement in 2007. This was followed by a placement of US$ 150 mn senior 3- year debt and a US$ 25 mn subordinated 5-year bonds issuance in December 2010. 6 World Bank (2009) Southern Mongolia Infrastructure Strategy. World Bank Report 13 Mongolia Quarterly Update 2012 sharply in the near term, hurting government receipts. Added to this, a bunching of repayments on public sector 7 debt fall due in the near term. In this climate of global financial uncertainty, Mongolia would be wise to manage its revenues in a prudent manner by saving more in the Fiscal Stability Fund, and on the expenditure side, ensure that money is spent well in order to maximize the returns to the government and ultimately to the Mongolian people. Source: World Bank Staff Banking sector Both domestic and foreign currency deposit inflows into the banking system show signs of leveling off The total volume of deposits in the banking system appears to have peaked in February, as net inflows of both domestic and foreign currency deposits have tapered off in recent months (Fig 13). Interest rates offered on these deposits tend to be highly sticky, but have edged up since the start of the year. The average weighted interest rate on local currency deposits has for instance increased from 10.7 during 2011 to percent to 11 percent in April. The weighted average rate on FX deposits, meanwhile, has risen from an average of 4.7 percent in 2011 to 5.6 percent in April, with the maximum rate on offer rising from 14 percent to 15.2 percent. Domestic lending rates have correspondingly increased, from about 15-16 percent at the end of last year to 18.4 percent in April. However with inflation accelerating, real deposit and lending rates have trended lower – the former are now sharply in negative territory at minus 6.7 percent and the latter are barely positive at 0.6 percent (Fig 14). Lending growth has slowed With growth in deposit funding sharply down compared to the middle of last year, lending growth has also decelerated to 50 percent yoy in April from 75 percent in November last year. A further deceleration looks likely given the recent tightening of interest rates and reserve requirements by the BOM, and given that growth in deposits, which leads lending growth by some three months or so, is also slowing ((Fig 15). Lending however continues to be highly concentrated with the 50 largest borrowers in the banking system accounting for more than a quarter of all loans (Fig 16). Continued vigilance on financial sector risks remains important Compared to other countries in the region, Mongolia has some of the lowest Tier 1 capital buffers in the East Asia region and also some of the highest NPL ratios that date back to the banking sector crisis from 2008-09 when 2 large banks failed (Fig 17). Admittedly, the ratio of NPLs to gross loans has fallen to 4 percent (excluding the NPLs of the two failed banks) in April from 8 percent a year ago. But this improvement is mainly due to the rapid growth of loan portfolios: the total stock of outstanding NPLs amounted to MNT 235 bn at the end of April 2012, only slightly lower than MNT 303 bn in April 2011 (Fig 18). 7 IMF-World Bank 2011 Debt Sustainability Analysis for Mongolia 14 Mongolia Quarterly Update 2012 Meanwhile high rates of lending growth over the past year have raised concerns about the quality of bank assets, with exposure to real estate which is showing signs of overheating and construction sectors (which contracted for the second quarter in a row in Q1) of particular concern. Although there have been improvements in the risk supervision regime, it remains weak as are internal risk management procedures and corporate governance. Fig 13 Both local and foreign currency deposit inflows are Fig 14 while real rates of returns on local currency deposits tapering off are sharply negative MNT bn, month-on-month change MNT bn, stock Percent (annual rate) FX deposits, stock RHS MNT deposits, stock RHS CPI inflation FX deposits, change MNT deposits, change 400 4,500 Maximum rate on LC time deposits, real 4,000 40 Weighted av. rate on LC time deposits, real 300 Real LC short term loan rate 3,500 200 3,000 20 100 2,500 0 2,000 0 1,500 -100 1,000 -200 500 -20 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Jun-08 Jun-09 Jun-10 Jun-11 -300 0 04/10 10/10 04/11 10/11 04/12 Fig 15 Credit growth has decelerated after peaking in Fig 16 … But lending remains highly concentrated November of last year, and is likely to slow down further % year-on-year change MNT bn lending to 50 largest borrowers as % of total 100 Loans outstanding MNT billion 80 Deposits, 3 months ahead 1,800 Share of total loans outstanding RHS 35% 60 1,600 30% 1,400 25% 40 1,200 1,000 20% 20 800 15% 600 10% 0 400 200 5% -20 0 0% Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 15 Mongolia Quarterly Update 2012 Fig 17 NPLs are the highest and Tier 1 buffer capital ratios Fig 18 and the overall volume on NPLs on bank balance among the lowest in the region sheets remains large % MNT bn Tier 1 Capital Ratios 1,000 Loans with principal in arrears Regulatory Capital to Risk-Weighted Assets 900 NPLs to non-residents Non-performing Loans to Total Gross Loans NPLs to residents 18 800 NPLs of failed banks 16 700 14 12 600 10 500 8 6 400 4 300 2 0 200 ECA China* Indon. Kor Ph. Sg HK (SAR) EAP Av. LAC Mal. Mong 100 0 Mar-09 Mar-10 Mar-11 Mar-12 Sources: BoM, MoF, NSO, WB staff estimates, Finstats. Notes for Figure 27: Data is from Q2 and Q3 2011, with the exception of China for which data is from 2010. Inflation In marked contrast with the rest of East Asia, inflation continues to rise in Mongolia The headline inflation rate in Ulaanbaatar8 climbed to 17.8 percent yoy in April from 9.4 percent rate in December (Fig 19). The national inflation rate meanwhile is 16 percent yoy, much higher than the Bank of Mongolia’s inflation target of 10 percent. Overall the trend is in marked contrast to the rest of East Asia where inflation has been falling since the final quarter of last year. Indeed, in much of the region, inflation is in the low single digits (Fig 20), allowing central banks considerable room to support growth and for policy easing in case the euro area crisis intensifies and global economic growth deteriorates. Higher inflation is being driven by both core inflation (which excludes all food and energy) and higher food prices. Core market prices - excluding all food items and those goods whose prices are administered9 - rose by nearly 13 percent yoy in April contributing roughly half the increase in the headline index and reflecting generalized wage and price pressures in the economy. Food prices meanwhile have been pushed up on the back of a steep increase in meat prices. The overall food index rose by 31 percent yoy in April, up from 7.6 percent in December. Meat inflation soared to 80.6 percent in April, up from 17 percent in December (Fig 21). 8 CPI weights were recently revised for both Ulaanbaatar and the national CPI index. In the absence of complete data for the national index, changes in the UB CPI index, for which breakdowns are available are discussed in the text. 9 Education, communication, passenger transport by rail and bus, water and electricity 16 Mongolia Quarterly Update 2012 Fig 19 Inflation is accelerating in Mongolia… Fig 20 …in marked contrast to the rest of East Asia Percentage point cont’ns, % yoy, UB Headline CPI, % yoy, East Asia 40 Food Mng (UB) 17.8 35 Market (ex food & adm'td HK, SAR 4.9 prices) Viet 10.5 30 Administered Prices Th 2.5 25 TW, PRC Headline CPI 1.1 Jun 11 20 Sing 5.3 Dec 11 Ph. 3.0 15 Apr 12* Mal. 1.9 10 Idn 4.4 5 Ch. 3.4 Kor 2.5 0 0 5 10 15 20 25 -5Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Fig 21 Food prices have shot up, notably of meat Fig 22 which constitutes nearly a third of the food CPI basket under the revised CPI weights % yoy % 100 41 Overall Food 45 Meat and meat products 40 80 35 30 Bread, flour, cereals New 2010 weights Old 2005 weights 30 60 25 20 17 40 15 10 20 10 5 0 0 of which: Bread and Transport of which: Meat Education Restaur. & Hotels Housing, Water and Food -20 cereals Elect. -40 Sources: NSO, BoM, WB staff estimates. * Data for March in case April data not available. The government has previously intervened to keep meat prices in check, most recently in 2011 when it subsidized more than 2,000 herders and meat vendors in order to encourage the preparation of more meat reserves (16,000 tonnes in 2011 vs. 2,800 tonnes in 2010). While the additional supply of reserve meat helped to contain food inflation in 2011, prices rose again shortly after the sale. For 2012, 12,000 tonnes of meat was available from reserves accumulated during 2011, and in February, the government decided to accumulate another 15,000 for precautionary purposes, with MNT 40 bn budget allocated for the meat subsidy program. However, so far only about 5,000 tons of meat has been reserved and about MNT 4 bn has been disbursed to meat traders according to the City Municipality. This constitutes a small share of the total supply of meat in the market and has not been sufficient to keep prices down. Moreover, lingering effects of the dzud in late 2009 have limited the supply of 17 Mongolia Quarterly Update 2012 livestock available for slaughter, while large cash handouts have also allowed herders to delay selling stock and concentrate instead on increasing the size of their herds. It is worth noting that the NSO has revised the weights attached to the different components of the CPI basket. The most significant change is a reduction in the weight for food items which has dropped from 41 percent in 2005 to 30 percent from 2010 onwards, and a fall in the share of meat prices from roughly 17 percent to 10 percent in the overall basket. The BoM has acted to contain the inflationary effects of the expansionary fiscal policy, but it would be more effective for both policies to work in tandem The BoM has reacted to rising inflation over the past few months by tightening policy. The benchmark rate was raised by 50 basis points in March and another 50 basis points in April to 13.25 percent and credit growth has eased considerably compared to the start of the year as discussed in the next section. But with inflation at 17.8 percent, the real policy rate is negative in real terms and further tightening is needed. That said, as discussed in previous Quarterlies10, government spending also needs to be reined in if monetary policy is to be successful in subduing inflation. Government spending in 2011 was a staggering 56 percent higher than in 2010 and outlays rose by a further 34 percent yoy in Q1 2012. The growing excess demand and overheating pressures in the economy are showing up in rising prices, both of goods and services as indicated by rising core inflation, and also of wages as indicated by the World Bank’s informal labor market surveys. In the absence of fiscal restraint, there is a growing risk of higher inflation expectations becoming entrenched and of repeating the high inflation episode of late 2008 when inflation rose to nearly 35 percent. High domestic inflation also causes the currency to appreciate in real terms, hurting agricultural exports, on which the rural population depends. The poor are impacted the most by high inflation. Rising prices erode their purchasing power, incomes and the real value of their already meager savings. In addition, they have limited opportunities to hedge against inflation unlike the rich, for instance by investing in long-term assets which are unaffected by inflation, e.g. real estate. In Mongolia’s case, the rise in food inflation is worrying since food constituted 30 percent of household expenditures in 2011 among the households in the bottom 20 percent of income distribution. Because it is difficult to substitute away from essential food items, households tend to cut back on other discretionary expenditures such as health and education which could have long term consequences on the accumulation of human capital and skills. Fiscal developments Despite the economy showing signs of overheating, government spending continues to grow extremely fast Government spending in the first four months of the year was 32 percent higher in nominal terms and 13 percent higher in real terms compared to the same period last year (Fig 23). Capital expenditures grew by 103 percent yoy in April on a YTD basis, contributing to two-thirds of the overall growth. Current spending on wages and salaries11 and the purchase of goods and services rose by 28 and 27 10 www.worldbank.org/mongolia 11 As part of the second phase of the government's plan to increase public sector wages are to be raised by 23 percent on May 1, 2012 following an increase in February of MNT 80,000. 18 Mongolia Quarterly Update 2012 percent respectively (in nominal terms, year to date (YTD) basis). With delays in the disbursement of subsidies for meat reserves, spending on subsidies fell 30 percent yoy in the first trimester. Such high levels of spending represent a significant injection of demand into an already overheating economy. Furthermore, as highlighted in previous Quarterlies12, the extraordinarily large expansion in capital spending is stretching the already limited capacity of the government to effectively plan, appraise, and implement projects, raising concerns about the quality of this spending. There are also signs that the construction sector has been unable to scale up to meet this rising demand resulting in rapid increases in the prices of construction materials, again pointing to the limited absorptive capacity of the economy. But revenues are failing to grow at the same pace as expenditures… Revenues are not keeping pace with the increase in spending (Fig 24). Revenues were 4.2 percent higher in real terms (21 percent in nominal) on a YTD basis in April. This mainly reflects weaker growth in receipts from taxes on international trade, and negative growth in excise taxes, royalties and dividends from mining sector companies. The withdrawal of customs tax and excise taxes on imported petrol and diesel fuel in May and November of last year has reduced the excise tax base and resulted in a loss of revenues (importers of petrol only pay VAT). Meanwhile, receipts from royalties and dividends fell by 26 percent and 50 percent yoy in April (YTD basis), a substantial loss given that together the two items accounted for nearly 8 percent of total revenues in 2011. However, personal, corporate and domestic goods and service tax revenues generally remained buoyant reflecting strong economic growth. Mongolia has earned substantial revenue from VAT taxes on the imports of mining sector related inputs (equipment and machinery), helping to compensate for the loss in revenue associated with the withdrawal of the Windfall Profits Tax last year. Indeed revenues from this source amounted for nearly a fifth of total revenues in 2011, with receipts growing by 40 percent yoy YTD in April, 2011. … resulting in a deterioration of the fiscal balance … Even though Mongolia has experienced the largest growth in fiscal revenues compared to other economies in the region, its public sector balances have deteriorated by the most, reflecting the highly expansionary fiscal stance of the government (Fig 25). On a 12 month rolling basis, the fiscal deficit rose to 4.2 percent of GDP in April. Meanwhile the structural deficit which takes into account structural (or long term) mineral revenues stood at 6.1 percent of GDP in April (Fig 26). Although the 2 percent structural deficit ceiling under the Fiscal Stability Law becomes binding only after January 2013, the trend in the current structural deficit suggests that Mongolia will have to control expenditure growth in order to meet the target. The government adopted FSL in 2010 to promote the needed budget discipline in turning mineral wealth into economic prosperity with sustainable and equitable growth with low inflation. … as claims on budgetary resources could increase with the monetization of Erdenes-Tavan Tolgoi shares As part of fulfilling campaign promises of distributing MNT 1.5 mn to every citizen in Mongolia, the government allotted a notional 20 percent of the equity of the state owned mining company, Erdenes 12 www.worldbank.org/mongolia 19 Mongolia Quarterly Update 2012 Tavan Tolgoi13, to all Mongolians born before March 31, 2011. The new shareholders have the option of holding on to the shares or selling them once Erdenes TT completes its IPO, planned for March/April next year14. The first disbursement of MNT 1 million began in May, with 240,000 elderly, 130,00 disabled and 130,000 students receiving their payments to be paid in a set of three installments in 2012 with MNT 334.2 bn set aside in the budget for this purpose. Of the remaining population, over 1.5 million people have voted to trade their shares for cash, with the money expected to be paid by the government in during 2013. (The remaining population has chosen to receive shares in Erdenes TT) To meet these claims, the government has started selling 10 percent of Erdenes TT shares (from its 51 percent shareholding) to local companies. A successful sale which raises sufficient cash should not lead to any fiscal liabilities. If however the sums raised are insufficient, then the government would be liable to pay MNT 1 mn per person promised from budgetary resources. Either way, the handout will exacerbate domestic demand and inflation pressures. Fig 23 Government spending is rising extremely fast, Fig 24 while revenue growth has stalled mostly on capital projects % yoy increase in expenditures, YTD April 2012 % yoy increase in revenues, YTD April 2012 120 103.5 real nominal 100 real nominal 60 80 40 20.9 60 20 31.7 4.2 40 0 20 13.5 -20 0 -40 -26.4 -20 -60 Personal income tax VAT domestic Royalty Total rev. & grants Corp. income tax Excise taxes Taxes on foreign trade -40 VAT on imports Subsidy Curr. Exp Cap Exp. Transfers Total exp. & net lending Wages & salaries Goods & services 13 The Tavan Tolgoi coal deposit, in Mongolia’s south Gobi region, has estimated reserves of as much as 7.5 bn tonnes of coal, including the world’s largest untapped deposit of coking coal used to make steel. The deposit is owned by Erdenes MGL, a new state owned company set up in December 2010 which in turn has a 51 percent stake in Erdenes TT which owns the eastern block of Tavan Tolgoi. 14 The company is planning to float 29 percent of its equity in an IPO estimated at around USD3bn, in London, Hong Kong and Ulaanbaatar. 20 Mongolia Quarterly Update 2012 Fig 25 Despite revenue growth being the strongest, Fig 26 and the deficit has risen sharply public balances have deteriorated the most in Mongolia compared to other East Asian economies change in revenues and fiscal balance, from 2010 to 2011, % of GDP, 12 month rolling balances as share of GDP 5 Government revenues, change Non-mining balance 4 fiscal balance, change 5 Fiscal balance 3 Structural fiscal balance 2 1 0 0 -1 -5 -2 Manufacturing exporters Commodities exporters -3 -10 -4 -15 China Fiji Lao PDR Cambodia PNG Indonesia Malaysia Vietnam Thailand Philippines Mongolia Solomon Is. -20 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Sources: NSO, BoM, Haver, Datastream, WB staff estimates. …and fiscal space looks constrained in the near term Mongolia has successfully saved some of the windfall (2 percent of GDP) from the mineral sector in a rainy day Fiscal Stability Fund. However, rising fiscal deficits increase vulnerability at a time when global economic uncertainties are mounting. In particular, with Chinese growth (a key driver of global commodity prices) slowing, a softening in commodity prices will bear down on government revenues, at least in the bridging period until net revenues from the Oyu Tolgoi mine begin to flow into the budget starting in Q3. Furthermore fiscal space will likely remain constrained in the near term. For one, the government has already received a share of future tax revenues in the form of pre-payments from OT and TT. In addition, as OT mine construction winds down, taxes derived from the imports of construction equipment and materials will dry up too. Such a deterioration in budget balances undermines the credibility of the FSL and more importantly it undermines the credibility of the government in wanting to adopt prudent fiscal policies for the future. Actual 2012 expenditures should therefore be lower than budgeted both to prevent further overheating and to control expenditure growth once the Fiscal Stability Law’s structural deficit rule goes into effect. In addition there are growing concerns that infrastructure spending by the Development Bank of Mongolia (DBM), which issued US$ 600 mn of debt in international financial markets for this purpose, earlier this year will bypass fiscal limits. It is therefore important that projects financed by the DBM generate sufficient returns on those borrowings as they will otherwise add to the government’s contingent liabilities (Box 2). 21 Mongolia Quarterly Update 2012 Box 2 Controlling Off-budget Financing for Infrastructure Mineral-rich countries need to effectively deal with the volatility of mineral prices and to take care to avoid real-exchange rate appreciation due to over-spending. Mongolia has already suffered from the consequences of a “boom-and-bust” cycle, and is currently risking another one with the real exchange hitting a new record high in April 2012. The FSL, passed by the parliament in June 2010, recognized this problem and put in place fiscal rules to smooth volatility by using long-term prices to estimate mineral revenues and required budgets to comply with a structural deficit of less than 2 percent of GDP (which comes into effect in 2013); to control expenditure growth to less than nominal GDP growth and therefore avoid over-heating of the economy; and to ensure long-term fiscal solvency through caps on public debt. There is a risk that the FSL will not be effectively implemented due to the growing volume of off-budget financing of infrastructure that bypasses the fiscal rules, in particular the expenditure growth rule. In 2008, a Mongolian parliament resolution allowed “build -transfer” (BT) projects in the roads and energy sectors that were financed by construction companies themselves on the condition of repayment from the budget at a later date. The number of such schemes increased from 3 percent of the total cost of the budget funded projects in 2008 to over 25 percent in 2009 and 2010, and continue to be sizeable today (Box Figure 1). A bigger source of contingent liabilities may come from the DBM, established in 2011, which is fast becoming a major source of public financing for infrastructure projects. As per the Law on the Development Bank (2011), and a subsequent parliamentary resolution, the DBM is meant to finance the development of the new railways to transport minerals, roads connecting the aimags to Ulaanbaatar and each other, energy sector projects, public housing, including subsidized mortgages to low income households, and the Sainshand industrial park. The DBM’s project plan for 2012 amounts to approximately US$ 1 bn or 19 percent of the 2012 capital budget in terms of cost (Box Figure 1) and expanding to US$ 4 bn by 2015. It has also issued a guarantee on a US$200 mn loan from the China Export-Import Bank for a housing development project. The DBM, if it operates under a sound macroeconomic and corporate governance framework, can play an important role in Mongolia’s infrastructure development. The logic of development banks is Box Figure 1: Alternative forms of infrastructure financing one of compensating for market failure whereby have been prominent recently commercial banks underfund socially beneficial Contractor funded and DBM projects as a percentage projects such as long gestation infrastructure of budget-funded projects projects, or do not provide access to finance to small borrowers. Implicit in the Government’s decision to establish the DBM is also the issue of timing. While revenues from the mines will start flowing in the future, the infrastructure needs are 29% 25% great, and it is believed that borrowing now to 19% meet these needs is a sensible decision given that 15% in the future revenues will be sufficient to meet 3% 14% the costs of financing these projects. 2008 2009 2010 2011 2012 This view is understandable, and there are a Contractor funded DBM funded few prominent examples of well-functioning infrastructure development banks — in Korea, Source: Bank staff estimates using MoF and DBM data Brazil, Turkey, and South Africa — that demonstrate that under a proper framework these institutions can indeed be instrumental in providing finance to address market gaps. However, the history of development banking is also littered with examples where these institutions were used as a non-transparent way to finance pet infrastructure projects, or to bypass fiscal limits, which ultimately required costly budget-funded bailouts as the projects financed by the development banks did not generate sufficient cash to pay back the 22 Mongolia Quarterly Update 2012 creditors. In a natural resource context such as Mongolia’s, the decisions on volume and timing of project financing need to take into account the following two critical factors. First, while in general public investments in infrastructure, education, and health, together with straight savings in foreign currency, are the best use of natural resource revenues, they need to be phased in a way so as to avoid Dutch disease effects from an investment boom. Public investments will over the medium to long-term increase the productive capacity of the economy and help to diversify economic activity away from the natural resource sector. However, in the short run if investments increase at a pace much higher than the absorptive capacity of the economy then this will result in inflation and an appreciation of the real exchange rate with its consequent negative macroeconomic effects. In Mongolia, this effect is visible today with the soaring prices of construction materials as the construction sector is unable to expand capacity at a commensurate pace. An optimal strategy would therefore, be to priorities and sequence investments over time by limiting the growth in annual investment spending to avoid such over-heating of the economy, which is precisely the logic of the expenditure growth rule of the FSL. Second, these alternative forms of financing are sensible only if the projects undertaken generate a sufficiently positive cash flow to justify the higher cost of capital as compared to budget funding. The BT schemes for rural roads are an expensive financing option as construction companies need to borrow at commercial rates to finance them, rendering these projects an estimated 25 percent to 30 percent more expensive than the equivalent budget- funded project. These BT schemes also involve very little transfer of risk from the government to the private sector partner, and the increase in the financing costs of the project — which will eventually be passed back to the budget — is therefore not compensated with any efficiency gains in delivering the services involved. For the DBM, arguably only the new railway project, which accounts for roughly 40 percent of the current loan portfolio, meets these criteria. The other projects, in particular roads connecting the aimags, which are generally non-toll roads, and mortgage loans to low income households, will never generate sufficient funds to recover the borrowing costs. Therefore, these projects should be funded from tax revenues in the state budget and not from more expensive borrowing from international capital markets that will eventually require to be repaid from the budget. In addition to these clear criteria on how much to spend and on which projects to spend, the successful development banks have been characterized by sound corporate governance principles, a clear mandate, strong supervision, regular performance assessments, and a supportive enabling environment. It is therefore, important for Mongolia to learn from the lessons of the many failures, and the few successes, to avoid repeating the costly mistakes made by other countries. Source: World Bank Staff In July, Mongolia’s universal cash transfers is scheduled to be replaced by a system of proxy means tested benefits targeted to the poorest households. The Social Welfare Law (SWL) passed in January 2012 was a significant achievement in terms of legislating the provision of targeted benefits to poor households, and setting in place a system for a fiscally sustainable social welfare system. In July, Mongolia’s universal cash transfers is scheduled to be replaced by a system of proxy means tested benefits targeted to the poorest households. While the level of benefits to be provided to each beneficiary is yet to be determined (Box 3), the program is likely to be targeted to the bottom 20 to 30 percent of income distribution of the population and is expected to reach about 130,000 households, over one-fifth of total households in Mongolia. 23 Mongolia Quarterly Update 2012 Box 3 Key Considerations for setting up a targeted social welfare benefit In January, Parliament approved a set of Amendments to the Social Welfare Law, paving the way for a benefit targeted to members of households in need of assistance. The program, to be implemented starting in July 2012, will select beneficiaries using a Proxy-Means-Testing (PMT) approach. The poverty status of a household is thus the key determinant of eligibility for the program. The size of the benefit and the coverage of the program are yet to be determined by the government. International experience reveals that there are some tradeoffs and key principles to be taken into account in setting the level of the transfers. In particular:  Transfers should be meaningful but modest. On one hand, the benefit should help improve the lives of the beneficiaries (that is, transfers should not be “too small”). On the other hand, transfers should not be “too large”, as generous payments may create disincentives for employment and contribute to inflationary pressures. In many countries the benefit size is set at about 15-20% of either average consumption of poor households or of the poverty line.  Benefit size should be set against a benchmark that can be easily explained and understood by beneficiaries and population. In most countries the benefit size is set up as a percentage of a well known and understandable benchmark (such as the poverty line, the minimum living standard, the minimum wage, etc). This makes the benefit more intuitive to understand, and provides the basis for adjusting transfer size over time. For instance, as the poverty line increases in nominal terms over time to keep up with inflation, by setting the benefit level at a fixed percentage of a poverty line amounts to building a clear indexation rule into the social transfer over time.  There is a clear trade-off between benefit size and coverage. Under a fixed budget there is always a trade-off between the benefit size (per beneficiary) and coverage (the portion of the population receiving the benefit). Under a given budget, higher benefits mean smaller coverage (i.e. reaching only the most vulnerable); lower transfers allow to cast the safety net more widely (more beneficiaries). At the same time, setting benefits and coverage at unrealistically high levels can result in unsustainable budgetary costs (and hence inflationary pressures) as Governments attempt to maintain their promises to the people.  Administrative costs need to be included when budgeting for the program. Many developing countries fail to budget for the administrative costs of social programs. This results in lower benefits for the poor and overstretches the capacity of administrative staff. While the amount of administrative cost depends on country-specific factors, international evidence suggests that such costs often range from 7% to 9% of total program budget.  The size of the poverty benefit should take into account other benefits and overall economic conditions. The poverty benefit cannot be considered in isolation from other social assistance benefits received by a single household. The role of the program should therefore be considered in the context of the cumulative income transferred to households.  The introduction of a new benefit should go hand-in-hand with a clear information/communication campaign. A strong communication campaign explaining the rationale behind transfer size, targeting method and selection of beneficiaries is vital. This is especially true for Mongolia, given that the introduction of the poverty benefit will coincide with the elimination of the HDF supported universal transfer. Source: World Bank Staff 24 Mongolia Quarterly Update 2012 Labor Markets and Poverty Registered unemployment is falling Formal unemployment figures which include only those who are registered with the Labor and Social Welfare Service Center show a decrease in the unemployment rate to 4.4 percent in March down from 5.5 percent in November 2011. The overall number of registered unemployed decreased to around 50 thousand persons from 63 thousand since November 2011. However these numbers have tended to underestimate the true extent of unemployment, which is better gauged through labor force surveys15. The last survey from the NSO for Q4 2011 estimated the unemployment rate at 9 percent, down from 13 percent in Q4 2010. Fig 27 Real wages in informal labor markets in UB have Fig 28 But nearly 60 percent of those surveyed reported increased since January despite the acceleration in that wages were insufficient to meet basic needs inflation No of workers Av. real wages, MNT % of total surveyed Railway cargo unloading in UB "44" area: Triangle bridge district 70% Container loading and unloading for freight companies May-12 3000 Cement loading at “Botanic” market at Amgalan district 3000 60% Supermarket shipments loading and unloading at “Bars” market Merchandise carter Narantuul “Black market” in UB 50% Jan-12 Construction materials delivery “100 family” district Jan-12 Average real wage per hour (MNT thousand) RHS 40% May-12 2000 2000 30% 20% 1000 1000 10% May-12 Jan-12 0% 0 0 Wages don’t meet Wages meet only Wages sufficient for basic needs basic needs living Sources: NSO, WB staff estimates Real wages in informal labor markets are increasing Informal surveys conducted by the World Bank in informal labor markets in May 2012 show on average, real wages reported by workers are some 11 percent higher than in January despite a sharp acceleration in the rate of inflation over the same period (Fig 27). But nearly 60 percent of those surveyed also indicated that, notwithstanding the increase in real earnings in these markets, their earnings were insufficient to meet their basic needs - a substantial increase from the 39 percent figure reported in January (Fig 28). The survey also indicated that a quarter of the survey participants were unskilled workers from rural regions (compared to 30 percent in January) and that nearly 40 percent of surveyed workers were working in the informal sector because of the unavailability of formal jobs. Following a recent collaboration on poverty analysis and statistical capacity building, the Mongolia National Statistical Office and the World Bank jointly announced the 2010 and 2011 poverty estimates16. 15 These also take into account those who are not officially registered as unemployed with the Labor and Social Welfare Service Centers. 16 http://www.worldbank.org/en/news/2012/04/17/poverty-level-estimated-at-nearly-30-percent-in- mongolia 25 Mongolia Quarterly Update 2012 The poverty headcount was estimated to be 29.8 percent in 2011, down 9.4 percentage points from 2010 (Box 4). Box 4 2011 poverty level dropped to 29.8 percent in Mongolia Recent poverty analysis conducted by the NSO, with technical support from the World Bank, finds that the national poverty headcount rate declined from 39.2 percent in 2010 to 29.8 percent in 2011, a decrease of 9.4 percentage points. Rural areas experienced an even faster pace of poverty reduction, from 47.8 percent in 2010 to 33.3 percent in 2011, a decrease of 14.5 percentage points (Box Figure 2). This remarkable progress in poverty reduction took place during one year of GDP per capita growth of 15.4 percent, sizeable social transfers, and large investments to help recovery from the 2010 dzud--especially in livestock in rural areas. Box Figure 2 Poverty levels have dropped sharply in Mongolia in recent years Official Poverty Headcount Rate (%) 60 47.8 50 39.2 40 32.2 33.3 29.8 30 26.6 20 10 0 National Urban Rural 2010 2011 Source: NSO, World Bank Staff These official 2010 and 2011 poverty estimates are comparable, and the estimation follows the international standard practice for consistent poverty estimation over time. Poverty comparison over time requires using a 17 constant poverty line in real terms, in other words, adjusting poverty lines for inflation only . NSO estimated the 2011 poverty headcount based on the 2010 national poverty line, fixed in real terms, to allow for comparison. Specifically, the food component of the poverty line is adjusted using a food price index estimated from the 2010 and 2011 Household Socioeconomic Surveys. The non-food component of the poverty line is adjusted using the non-food CPI. The adoption of this methodology for poverty analysis allows for inter-temporal comparisons of poverty numbers, which will help policy makers in Mongolia monitor social progress and evaluate the impacts of growth and public policies on poverty. The collaboration between the NSO and the WB on the 2011 poverty analysis has also set the stage for future collaboration in other areas of poverty and inequality analysis. Source: World Bank Staff 17 http://www.worldbank.org/en/country/mongolia/research/all?qterm=&lang_exact=English&os=20 26 Mongolia Quarterly Update 2012 Economic outlook The global economic outlook has darkened in recent months following a respite in Q1 due to the orderly restructuring of Greek debt in February and actions by policy makers to supply liquidity to European banks. The euro area is expected to experience a recession this year, core issues regarding the sustainability of its monetary union are yet to be fully addressed, and the banking sector is expected to deleverage to the tune of some US$ 2.6 tn. China, the growth engine of Asia, too seems to be slowing and incoming data suggest that activity may be weakening further. Accordingly, Mongolia remains vulnerable to headwinds from the Euro zone and from related developments in the global economy. The channels through which these operate include financial and trade linkages —namely volatility in commodity prices and through demand for its mineral exports from China. Signs of this vulnerability are already visible as demonstrated by the yoy decline in exports in April, the first fall in more than two years. Other financial market linkages should also not be discounted: Mongolia’s banking system, which has shown signs of overheating over the past year, is highly dollarized, with about a third of deposits denominated in dollars and easy convertibility between the Mongolia Togrog and the US dollar. Any shock to confidence or a deterioration in NPLs (which are already large) could adversely impact bank balance sheets. On the domestic front, rising debt service payments that fall due in the next few years could constrain fiscal space in the near term. Claims on budgetary resources could also grow with the monetization of Erdenes TT shares. The rapid increases in government expenditures, as well as the significant investments planned by the Development Bank of Mongolia, do not provide for any cushion in the event of a negative external shock. Although Mongolia has saved some of the windfalls from the mineral sector in a rainy day Fiscal Stability Fund, the amount saved as yet is fairly small – only 2 percent of GDP. In this climate of global economic uncertainty, Mongolia needs to manage its public finances in a prudent manner, in lines with the rules of the Fiscal Stability Law, and to keep a close eye on financial sector risks and strengthen macroprudential regulation and supervision. In particular, this entails the “hold your horses” metaphor; controlling the growth in expenditures, minimizing off-budget financing activities and ensuring that money spent is well spent, namely on activities that help to build the public and human capital infrastructure of Mongolia and maximize the returns of the country’s mineral wealth to its people. 27 Mongolia Quarterly Update 2012 Table 1 Mongolia: Key Indicators 2008 2009 2010 2011 2012f 2013 f Output, Employment and Prices Real GDP (% yoy change) 8.9 -1.3 6.4 17.3 17.2 11.8 Industrial production (2006=100) 113 109.6 120.5 % yoy change 2.7 -3.3 10 132.2 145.4 159.9 CPI Ulaanbaatar (% yoy change, eop) 23.2 1.9 14.3 11.1 17.8 (Apr) 12.0 Public Sector Government expenditures (as % of 37.6 35.2 36.6 44.2 39.1* 34.1 GDP) Government revenues (as % of GDP) 33.1 30.2 36.6 40.6 38.1* 33.1 Government balance (% of GDP) -4.5 -5 0 -3.6 -1.0* -1.0 Non-mineral govt balance -14.1 -12.4 -10.5 -16.0 -11.4 (Apr) -13.1 Public Sector Debt (% of GDP) (1) 31 49.4 42.2 38.6 37.1 27.3 Foreign Trade, BOP and External Trade balance (US$ mn) -613 -229 -379 -1747.0 -700.0 265.0 Exports of goods (US$ mn) 2534.5 1903 2899 3825.0 4680.0 5288.4 (% yoy change) 30 -25 52 31.9 22.4 13.0 Imports of goods (US$ mn) 3147 2131 3278 4874.0 5290.0 4761.0 (% yoy change) 57.1 -32.3 53.8 53.4 8.5 -10.0 Current account balance (US$ mn) -690.1 -592.0 -886.7 -2586.9 -2663.6 -269.4 (% of GDP) -12.3 -12.9 -14.3 -15.1 -13.6 Foreign direct investment (US$ mn) 838.5 1037.6 1629.7 5309.5 1500.0 1200.0 External debt (% of GDP) (2) 31 43.3 30.3 22.8 19.8 14.7 Foreign exchange reserves, net (US$ 637 1145 2091 2407.0 2635.7 (Apr) .. mn) In month of next years imports 3.6 4.2 5.1 5.6 .. .. of g&s Financial Markets Domestic credit (% yoy change) 59.11 -9.33 26.69 72.8 49.4 (Apr) Base policy rate (eop) 9.75 10.00 11.00 12.25 13.25 (Apr) Exchange rate (MNT/USD, avg) 1267 1443 1257 1264.8 1316 (Apr) REER (real effective exch rate) (% yoy 13.7 -15.5 26.9 -4.6 … eop, +app) Stock Market Top 20 index (2000=100, 1182 1229 2931 4059.0 … eop) Memo: Nominal GDP (MNT bn) 6556 6591 8414.5 10829.7 14207.7 Nominal GDP (US$ mn) 5174 4567 6694 8562.5 … GDP per capita (US$) 1946 1685 2434 3066.8 … Notes: 1) Total public sector debt. (2) On public and publicly guaranteed debt. * 2012 Budget projections. Sources: NSO, BoM, World Bank, IMF 28