Public Information Notice No. 02/130

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Mongolia

November 14, 2002

On October 25, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mongolia.¹

Background

Mongolia has made great strides since it initiated its transition to a market-based economy in the early 1990s, but it continues to face important challenges. Good progress toward promoting macroeconomic stability and market-oriented reforms resulted in a recovery from the collapse in output suffered during the early 1990s. However, the government's large recourse to deficit financing in the context of a generalized weakening of fiscal governance led to an unsustainable build-up of public debt. With the political consensus for privatization and reform weakening in the late 1990s, the prospects for sustainable economic growth diminished. The current government that took office in August 2000 embarked on a new adjustment program aimed at restoring macroeconomic stability and reinvigorating the reforms required to promote a more rapid pace of private sector-led growth.

Domestic economic performance was mixed during 2000-01 and the first half of 2002. The severe winters of 2000-01 took a heavy toll on output and rural incomes. Real GDP growth is officially estimated to have declined to about 1 percent a year in 2000-01, despite robust domestic demand in the industrial and service sectors. Inflation rose to 11½ percent in 2000, as the effects of weather-related decreases in food supplies and higher public utility tariffs were compounded by a 25 percent general increase in civil service wages. However, inflation fell back to 8 percent in 2001 and inflationary pressures continued to decline in 2002, as the togrog remained stable vis-à-vis the U.S. dollar and domestic food prices eased. The real effective exchange rate of the togrog appreciated by 9 percent in 2001, before leveling off in 2002, thus reverting to its level as of 1998.

The key challenge for fiscal policy has remained to promote fiscal sustainability. While continuing pressures on outlays for public wages, goods and services, and domestic capital expenditure pushed the ratio of government expenditure to GDP to well over 40 percent in 2001, an offsetting surge in government revenues, reflecting in part the effects of a package of tax increases adopted under the 2001 budget, helped reduce the overall fiscal deficit to about 5½ percent of GDP in 2001. Following the introduction of a number of reform measures to improve fiscal transparency and accountability, including fiscal data quality and reporting, the stock of government arrears declined by 1½ percentage points of GDP during 2001. Reflecting also favorable valuation effects, the stock of government debt (excluding the large stock of unresolved pre-1991 debt to Russia) fell from 100 percent of GDP in 1999 to 87½ percent of GDP in 2001. However, fiscal developments during 2002 have led to some reversal of the recent gains, as government wages and pensions were raised by an average rate of 20 percent from October 2002. In the absence of a credible civil service and pension reform strategy, existing plans to grant further large increases in government wages and pensions in 2003 and 2004 against the background of weakening prospects for revenue growth could pose a serious threat to fiscal sustainability.

Monetary and credit aggregates have risen sharply over the last two years. To a large extent, these developments reflect the welcome effect of an increase in confidence in the banking system as it continues to rehabilitate itself following the banking system crises of the 1990s. In these circumstances, monetary management by the Bank of Mongolia (BOM) has had to focus increasingly on keeping the growth of reserve money within a prudent range through the placement of BOM bills. Despite this effort, reserve money growth has accelerated from 8½ percent in 2001 to a year-on-year rate of more than 20 percent as of August 2002, while the year-on-year rate of growth of credit to the private sector has remained at more than 100 percent.

Mongolia's overall balance of payments has recorded significant surpluses over the last two years, but its external position remains vulnerable. Exports rose briskly in 2000 under the impetus of rising world prices for copper and cashmere exports, but they leveled off in 2001, as the earlier improvement in the terms of trade was largely reversed and China imposed a ban on exports of raw materials of animal origin following the outbreak of foot-and-mouth disease in Mongolia. While import growth also rebounded in 2000, it was subdued during 2001. With receipts from emigrants' remittances reported to remain buoyant, the current account deficit is estimated to have been kept within a range of 5½ to 7½ percent of GDP in 2000-01, which could be comfortably financed with the help of the existing pipeline of concessional external loans. Gross international reserves have risen steadily to a level of more than US$200 million or the equivalent of about 14 weeks of imports at end-2001. The stock of Mongolia's post-1991 external debt, which consists primarily of government debt secured on concessional terms, declined to 83 percent of GDP in 2001 and the debt service ratio has so far remained manageable. However, continuing heavy reliance on foreign assistance to finance a large current account deficit makes the economy highly vulnerable to changes in donor and investor sentiment. Moreover, a settlement has yet to be reached on the large stock of pre-1991 convertible ruble debt (equivalent to 10 times Mongolia's GDP), which could have serious implications for Mongolia's future debt service burden and external sustainability.

The government is making sustained efforts to implement its structural reform program. In the area of public sector management, the reforms to rationalize intergovernmental fiscal relations regarding VAT and other tax receipts have been largely completed. However, there has been no tangible progress in the key area of public administration reform, and the implementation of measures to shift all government deposits to a Treasury Single Account has been slower that expected. In the areas of bank reform and public enterprise privatization, notable progress has been made in the last two years, including through the continuing rehabilitation of the Agricultural Bank, the ongoing strengthening of bank supervision, and the recent privatization of the Trade and Development Bank, which is expected to be finalized by end-2002. However, the privatization of other large enterprises which are still carrying out loss-making quasi-fiscal activities has been delayed, while the energy sector's persistent financial imbalances continue to pose a threat to medium-term fiscal and external sustainability.

Executive Board Assessment

Executive Directors recognized Mongolia's achievements in its transition to a market-based system, which—despite harsh climatic conditions—included a decline in the rate of inflation to the single-digit range, a significant buildup of international reserves, a recovery of output from the collapse suffered in the early 1990s, and progress in institutional and other reforms.

Directors considered that, despite these achievements, Mongolia faced daunting challenges in its efforts to promote robust growth, reduce poverty, and achieve fiscal and debt sustainability. These challenges have been exacerbated by the pressures on government spending, which have led to a large buildup of external public debt, and heightened the economy's external vulnerability. Considering the weak output growth during 2000-01, Directors were concerned that emerging macroeconomic imbalances could threaten to undermine the prospects for sustainable, pro-poor growth in the period ahead.

Directors stressed that enduring fiscal consolidation will be essential to place the public debt on a sustainable path, improve the operation of monetary and exchange rate policies, and facilitate private sector-led growth. A sustainable fiscal position will require a rationalization of public expenditures to make room for essential public investment, basic social services, and safety nets for the poor, while reducing over time the high tax burden. In this context, Directors cautioned that the authorities should ensure that further large increases in civil service wages and pensions do not jeopardize the attainment of a sound fiscal position. They therefore welcomed the authorities' decision to suspend the increases proposed in the 2003 draft budget, while taking early steps to adopt an effective civil service and pension reform strategy, with technical assistance from the World Bank.

Directors encouraged the authorities to build on recent progress toward improving fiscal transparency and accountability in the period ahead, in line with the recommendations of the Fund's Fiscal Affairs Department. In this connection, they welcomed the recent decision to reincorporate into the budget for 2002 the operations of entities that are slated to be privatized but which continue to conduct quasi-fiscal operations. Steadfast implementation of the government's re-phased treasury reform program, including through its timely extension to the social security system, was also underscored.

Directors commended the BOM for its track record in containing inflation. They noted that the recent rapid expansion of the monetary and credit aggregates suggested a return of confidence in the banking system. However, they cautioned against an excessive easing of monetary conditions, and considered that more decisive steps might need to be taken in the period ahead to control liquidity. In an environment of rapid credit expansion, Directors encouraged the BOM to tighten overall bank supervision, particularly the enforcement of loan classification and provisioning standards. They welcomed the recent distribution to banks of new anti-money laundering recommendations in line with the Financial Action Task Force guidelines, and looked forward to legislation that would require stricter reporting of questionable accounts, and prompt implementation of United Nations Resolutions in this area. In addition, to improve the transparency of its own operations, the BOM was urged to adopt and implement fully International Accounting Standards, and to continue implementing the recommendations in the recently completed safeguards assessment.

Directors observed that relatively large and persistent inflows of official and private capital in recent years, together with the BOM's intervention practices, may have exerted upward pressure on the real exchange rate. They noted that future developments in the exchange rate would need to be monitored closely in order to ensure that the competitiveness of the country's export sector and the authorities' efforts to diversify the economy are not adversely affected.

Directors encouraged the authorities to persevere in their efforts to establish a competitive, market-oriented economy, while maintaining a vibrant rural sector. They welcomed, in particular, the rehabilitation of the Agricultural Bank, which had enabled the government to offer it for privatization ahead of schedule, and considered the privatization of the Trade and Development Bank to be an important step in the further development of an efficient banking system in Mongolia. Directors urged the authorities to address quickly the problems of other large enterprises that still carry out loss-making quasi-fiscal activities, including in the important energy sector.

Directors expressed concern about the size of Mongolia's external debt burden and debt service costs. In these circumstances, they stressed that prudent fiscal and debt management policies as well as the avoidance of external public borrowing on nonconcessional terms are essential to ensure external viability over the medium term. Directors also stressed the importance of maintaining orderly relations with all creditors, and taking prompt action to resolve outstanding claims. To promote export-led growth and investment, the authorities were encouraged to streamline Mongolia's trade and investment regime further by simplifying customs administration, licensing, and regulations as well as by taking steps to ensure that national laws and regulations are enforced on a nondiscriminatory basis.

Directors recognized the progress made in developing Mongolia's statistical base in recent years. They encouraged the authorities to continue their efforts to improve the quality and reliability of real sector, fiscal, and balance of payments data.

Directors welcomed the authorities' willingness to reconsider their wage and pension policies in consultation with the Fund and Bank staffs, and looked forward to prompt agreement on a sound policy framework that could pave the way for the completion of the Poverty Reduction and Growth Facility review. Directors noted the ongoing progress toward the development of a Poverty Reduction Strategy Paper (PRSP) and encouraged the authorities to take timely steps to prepare a full PRSP.