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 Mongolia 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.