Public Information Notice No. 05/140

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Mongolia

October 6, 2005

On September 21, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Mongolia.¹

Background

Mongolia's overall economic performance was stronger than expected and broad based in 2004 and early 2005. Sectoral contributions to high growth included a rebound in the livestock sector from harsh winter shocks of 2000-01 (the "dzuds") and strong mining exploration and exports, boosted by a favorable environment of unusually high copper and gold prices. The balance of payments has been strong, with favorable terms of trade, new gold operations, good performance by the service sector, and robust capital flows in the mining sector. The current account (including transfers) is estimated to have been in a surplus equivalent to about one percent of GDP in 2004. High commodity export prices and strong tourism and private transfers helped offset the increased cost of oil imports (more than a fourth of total imports).

After several years of moderation, however, inflation has accelerated, reaching 17½ percent through June 2005 (before easing significantly in August), as prices of fuels and meat have increased very sharply in the past twelve months. These inflationary pressures threaten the hard-won gains in macroeconomic stabilization in recent years.

Fiscal performance was good in 2004, with excellent prospects for 2005. Strong revenue receipts reflected overall economic growth as well as higher-than-expected prices for copper and volume for gold. The lowest overall deficit since the beginning of transition, about 2 percent of GDP, allowed a notable decrease in indebtedness. For 2005, better-than-projected revenue performance in the first half suggest the overall fiscal deficit is likely to be lower than the budget target of about 3½ percent of GDP.

Monetary policy accommodated supply-side shocks, namely the close-to-full pass-through of higher world oil prices, regulatory changes in the meat supply chain, and administrative price adjustments in utilities. Although broad money grew at about the rate of nominal GDP growth in 2004, slowing down from rates above 40 percent in earlier years, private credit growth was still high in early 2005, reaching nearly 33 percent year-on-year at end-June 2005.

Concerns for the vulnerability of the banking sector have been heightened by high credit growth and remaining weaknesses in supervision and enforcement of prudential rules. The incidence of nonperforming loans (NPLs) increased from 8.3 percent at end-2003 to more than 10 percent at mid-2005. Moreover, credit risk management of banks remains fragile due to weaknesses in bank corporate governance, compounded by the sufficient enforcement of applicable prudential standards.

Progress continues on structural reform, with efforts continuing to improve the tax administration, banking supervision, and public enterprise restructuring. The authorities are currently focusing attention on the vital energy sector. In addition, Mongolia's poverty reduction strategy concentrates on enhancing growth prospects and improving provision of key services and social assistance.

Medium-term prospects are broadly favorable, provided the authorities manage to slow inflation back to single digit and sustain supportive fiscal policies. Growth is expected to settle around at least 5 percent, with a return to trend growth for the livestock sector. With appropriate policy action, mainly on the monetary side, inflation should slow down, to about 10 percent year-on-year at end 2005, returning to a 5 percent trend in 2006. The balance of payments is projected to weaken moderately, in line with a modest decline in the terms of trade. Export growth is likely to turn negative in 2006 as world prices of copper are projected to decline by a third from their record levels. However, import growth should slow down, as oil prices are projected to stabilize. The current account balance (including official transfers) is projected to move back into a deficit in the range of 4-5 percent of GDP over the medium-term. Public debt, although high, is broadly sustainable because of its concessional terms and the external and fiscal outlook.

Executive Board Assessment

Executive Directors commended the Mongolian authorities for the recent strong growth performance, the maintenance of broad macroeconomic stability, and for bringing the public debt onto a more sustainable path. The potential for large increases in mineral extraction was strengthening the medium-term economic outlook. Directors observed, however, that Mongolia remains vulnerable to pronounced declines in copper prices and weather conditions affecting the agricultural sector. They encouraged the authorities to implement an ambitious structural reform agenda in order to strengthen sustainable growth and the resilience of the economy, in particular by improving the environment for the private sector, and to maintain their efforts to tackle poverty and achieve the Millennium Development Goals. They also saw the need to take advantage of the favorable external environment to continue debt consolidation and lower inflation further.

Directors welcomed the authorities' aim to keep the overall deficit in 2005 well below the original budget target in light of inflationary pressures and weaker current account prospects. They urged the authorities to avoid expenditure slippages and save additional revenues. For 2006 and beyond, Directors considered that the fiscal stance should be broadly neutral, provided that inflationary pressures will have subsided. This would allow a further sharp fall in borrowing from the domestic banking sector, with public debt declining in GDP terms, while infrastructure improvements that will be critical for growth would be fully financed.

Directors encouraged the authorities to proceed with revenue-neutral reforms aimed at improving the overall efficiency of the tax system, broadening the tax base, eliminating distortions in income taxes and the VAT, and strengthening revenue administration. On the spending side, they recommended that the authorities avoid embarking on large infrastructure projects with low rates of return. Given the still high debt level and the need to preserve external sustainability, project borrowing should only be on concessional terms, and without government or central bank guarantees. Directors welcomed plans for further improvements in public financial management, including consolidating all budget resources into the treasury single account, to ensure a tight control over public finances and to improve transparency. They encouraged the authorities to press on with their plans for reform of the civil service and pension systems.

Directors emphasized that further tightening of the monetary stance is needed to help prevent supply-driven price increases from becoming embedded in persistent double-digit inflation. They supported the use of central bank bills to mop up liquidity. Some Directors, noting the high cost of these operations to the Bank of Mongolia (BOM), also recommended that the BOM undertake a review of its monetary policy instruments.

Directors emphasized that Mongolia's flexible exchange rate regime remains appropriate. Directors urged the government to resist demands for trade-based measures to support sectors hit by shocks, or other actions that would undermine the country's open trading system.

Directors stressed that further progress to strengthen the financial system is essential. They urged the authorities to resolve the capital weakness of the BOM and improve its independence and decision-making structure, noting that an enhanced supervisory board could assist in providing oversight. They recommended that the BOM disengage from gold operations. Forceful corrective actions should be taken to tighten supervision and enforce strictly prudential norms for banks, and signs of problems in the non-bank financial sector should be dealt with expeditiously and vigorously. Directors encouraged the authorities to complete the process of drafting laws on Anti-Money Laundering and Combating the Financing of Terrorism, and move to their implementation.

Directors observed that restructuring of public enterprises remains a priority. The governance of enterprises intended to remain in the public sector needs to be improved, and the privatization program should be reinvigorated. Directors underlined the need for reforms in the energy sector.

Directors encouraged the authorities to improve the quality and coverage of fiscal statistics and address the priority issues for the national accounts and balance of payments. Also, they urged the authorities to focus on improved poverty indicators to assist their work on the Millennium Development Goals.

Turning to the Ex Post Assessment of the Fund's long-term engagement with Mongolia, Directors agreed that the overall program design for macroeconomic policies for the last four Fund-supported programs had generally been appropriate. Nevertheless, a large part of the structural agenda remained unfinished, with the financial sector still weak, public enterprises in need of further restructuring, and poverty reduction goals yet unrealized. Directors stressed the need to continue efforts to forge a broad political consensus on the reform agenda to strengthen political ownership and improve implementation of policies. Directors welcomed a continued close policy dialogue between the Fund and the authorities, which could be backed, as appropriate, by a strong Fund-supported program that is fully owned by Mongolia.