Public Information Notice No. 97/25

Press Information Notice: IMF Concludes Article IV consultation with Mongolia

September 3, 1997

The IMF Executive Board on July 30, 1997 concluded the 1997 Article IV consultation¹ with Mongolia

Mongolia has made extensive progress toward economic reform since it began its transition to a market economy in the early 1990s. However, important structural weaknesses still remain, including a weak banking system; a distortionary tax system; a large and inefficient public sector; and an inadequate legal infrastructure. While these weaknesses were temporarily masked in 1995 by the boom in copper prices, the reversal of these prices in 1996 exposed the vulnerability of the economy. Growth slowed to 2 1/2 percent in 1996, budget revenue fell sharply, and the fiscal deficit widened to 9 percent of GDP. Extensive central bank credit was provided to help finance the budget deficit and keep the increasingly illiquid banking system afloat. Under these circumstances, the public became reluctant to hold tugrik-denominated deposits, and the exchange rate depreciated by 30 percent in the second half of the year. As a result, inflation picked up from a monthly rate of about 2 1/2 percent in early 1996 to 3 percent by the end of the year due, in part, to the impact of large energy price adjustments. The external current account deficit doubled to 11 percent of GDP in 1996, and gross official international reserves fell from 12 weeks to 10 weeks of import cover.

In the second half of 1996, the authorities began implementing a wide-ranging program of monetary, fiscal, and structural reforms designed to reduce the size of the public sector and promote rapid development of the private sector. Stabilizing macroeconomic conditions and restoring confidence in the banking system were among the highest priorities. In late 1996, the authorities launched a major bank restructuring program which resulted in the immediate closure of two large insolvent banks and cleared nonperforming loans that had been made previously by banks at the direction of the government. The Bank of Mongolia significantly tightened monetary policy, progressively raising the interest rate on central bank bills from a monthly rate of 3 percent at end-1996 to 4.75 percent in July and sharply expanding the volume of bills on issue. Central bank lending to banks was also curtailed. This succeeded in stabilizing the exchange rate and halting the decline in bank deposits. However, despite these positive developments, inflation, at 3 1/2 - 4 percent per month, has remained high.

Over the medium-term, fiscal policy aims at reducing distortions in the tax system and streamlining government operations. As a first major step in the tax reforms, the 1997 budget eliminated virtually all import dutie--making Mongolia one of the most open trade regimes in the world--and reduced direct taxes, while the base of the sales tax was extended and excises on alcohol, automobiles, and petroleum were raised. Achievement of the deficit reduction objective will also require tight expenditure restraint, and the budget sets a tight limit on current expenditures and cuts low priority capital projects. Despite these important steps, the budget deficit is expected to rise from 9.0 percent in 1996 to 10.5 percent in 1997, owing to the large up-front costs of bank restructuring and the loss of revenues from import duties. The deficit will be financed entirely by concessional foreign loans, enabling the government to build-up significantly its deposits in the banking system. With the planned introduction of a VAT and lower bank restructuring costs, the deficit is expected to narrow significantly in 1998, and to fall to about 6 percent of GDP over the medium term.

With regard to structural policies, in addition to the bank restructuring and fiscal reforms, the government has launched an ambitious program to complete the privatization of publicly-owned assets over the next three years, including most public enterprises. Measures to improve expenditure controls and achieve greater accountability for performance are also being implemented to pave the way for a gradual decentralization of administrative decision making. In the important areas of health and education, reforms are being elaborated to expand the role of the private sector in the delivery of health services to enhance efficiency, and to improve the quality of education and meet the human capital needs of a market economy.

Executive Board Assessment

Executive Directors welcomed the authorities' bold and ambitious approach to reforms, which they believed would contribute to the achievement of strong sustainable growth if the program were fully and consistently implemented. The authorities' willingness to take politically difficult steps at an early stage, including the implementation of large energy price adjustments, the elimination of import duties, and the closure of some insolvent banks, provided convincing evidence of their strong commitment to the reform process.

Directors noted that the economic situation remained difficult and the strategy had important risks, particularly on the fiscal side. They expressed concern about the deterioration in macroeconomic performance since 1995, particularly the pickup in inflation and the increase in the budget and external current account deficits. Although those imbalances were partly due to terms of trade shocks and one-time adjustment costs stemming from market-oriented reforms, Directors considered that the main cause was the slippage in fiscal and monetary policies, which in part reflected the slow pace of reform in the enterprise sector. They therefore welcomed the tightening of macroeconomic policies since the beginning of 1997 and urged the authorities to persevere in the years ahead.

Directors emphasized that early and substantial progress in reducing inflation will be essential. They welcomed the steps taken by the central bank during the first half of 1997 to raise interest rates and limit access to its credit facilities, which had already helped stabilize the exchange rate. However, Directors noted that confidence in the banking system remained fragile and inflation had not yet started to decline. Under those circumstances, they advised the authorities to maintain the interest rate on central bank bills at a significantly positive level in real terms. The authorities should be prepared to tighten monetary policy further, if necessary, to place inflation convincingly on a downward trend by the end of 1997.

Directors noted that significant fiscal consolidation would be needed over the medium term to contain demand pressures and reduce reliance on foreign savings. Most Directors considered that the bulk of the adjustment should come on the expenditure side. While endorsing the authorities' emphasis on expenditure reforms to achieve efficiency improvements, Directors noted that the scope for such gains was uncertain, and the authorities should therefore be prepared to take additional fiscal measures, if necessary, to achieve the targeted reduction in the deficit.

Directors welcomed the authorities' decision to eliminate import duties, which had given Mongolia one of the world's most liberal import regimes, and could be expected to encourage a more efficient pattern of investment. In view of the loss of revenue that would likely result from the abolition of tariffs and other tax reforms, Directors stressed the importance of implementing other improvements in the tax system, especially the early implementation of a value-added tax with a broad base.

Directors supported the authorities' emphasis on privatization as a way to promote public sector reform and private sector development. They stressed that achieving the targets for privatization would require early sales of large profitable enterprises and the restructuring of some loss-making enterprises. A few Directors encouraged the authorities to eliminate the premium which must be paid by foreign bidders for small enterprises.

Directors cautioned that it would be important to develop a more effective social safety net, since the sale and restructuring of many enterprises and public administration reform could result in retrenchments. They noted that improvements in the social safety net should be generated by better targeting of support.

Directors commended the authorities for their resolute response to an impending banking crisis in late 1996. The closure of two large banks at the end of 1996, and establishment of a strict timetable for strengthening the financial position of two other weak banks, had been particularly important steps in that regard. Directors stressed that the Bank of Mongolia must be prepared to take further strong action if necessary. A few Directors observed that the privatization of banks and the entry of reputable foreign banks could facilitate the development of the financial sector.