Washington, DC: Mongolia is being buffeted by global shocks and problems at its borders. The economy is headed for stagflation with significant downside risks, even as Mongolia experiences an export price boom. Monetary policy should stay on hold for now, given the measures already taken and since high inflation is largely due to global price rises and supply disruptions. Further tightening may be needed if a wage-price spiral begins to emerge. However, tight fiscal and quasi‑fiscal policies and greater exchange rate flexibility are also necessary to support monetary policy efforts to ensure external and domestic price stability. Any additional fiscal support to relieve economic hardship—on top of the measures announced—should be targeted toward the vulnerable. Deep fiscal, financial, structural and governance reforms needed to build resilience to external shocks, should continue. In keeping with its mandate, the Bank of Mongolia (BOM) should conduct an asset quality review (AQR) of banks and exercise all its powers to ensure a sound IPO process that does not endanger financial stability. Strengthening governance is critical, notably to address the Development Bank of Mongolia’s (DBM) non-performing loans.
A Stagflationary Outlook
Mongolia has been hit hard by global shocks and problems at both its borders. Despite the government’s laudable success in bringing the pandemic under control and opening Mongolia’s borders to international travel, China’s persistent border closures have disrupted Mongolia’s ability to export and reap the windfall from an improvement in export prices. Disruptions in food imports via Russia and from China, and other supply disruptions are also hurting economic activity and heightening food security risks, compounding the economic hardships posed by rising global fuel and food prices. Inflation has well exceeded the BOM target on account of these factors, and has accelerated since the war in Ukraine started. Weaker export volumes and rising imports due to higher prices and the unleashing of pent-up demand, have led to mounting FX pressures and dwindling international reserves.
The much-anticipated post-pandemic recovery will be delayed. The outlook is for stagflation. The economy is expected to expand at a modest 1 percent in 2022, instead of the 7 percent forecasted in November 2021, as longer-lasting Chinese border closures weigh on exports and domestic activity, and declining real wages hurt domestic consumption. Import disruptions from Russia and China are also likely to hurt activity. Inflation is expected to remain high at an average rate of 14½ percent in 2022, reflecting global price increases.
The outlook is uncertain and subject to significant downside risks stemming from commodity price volatility; extended Chinese border closures; an escalation of sanctions on Russia; tighter global financing conditions, and the risk of a pandemic resurgence. In the worst-case scenario, the economy could come to a near-standstill if disruptions in correspondent banking relations due to sanctions on Russia are not resolved in a timely manner.
The medium-term outlook remains favorable. If border disruptions and geopolitical shocks were to be resolved by end-year, Mongolia is well placed to reap an economic windfall from favorable commodity prices and from the Oyu Tolgoi underground mine production starting in 2023. An acceleration in growth to above 6 percent in 2023-25, and strong commodity prices could lift up external and budget balances.
A Paramount Need for Tighter Policies
Containing inflation. Since inflation has been largely generated by supply-side factors outside the BOM’s control, and given the measures recently taken by the BOM and given low growth, monetary policy should remain on hold for now, and be data dependent. However, the BOM should continue to be vigilant to ensure that inflation expectations do not become unanchored (self-fulfilling). To this end, the BOM should closely monitor the inflationary impact of the government’s various support measures since 2020, the large real minimum pension increase, and the forthcoming minimum wage hikes. If a wage-price spiral begins to materialize, further tightening will be needed. Beyond monetary policy, quasi-fiscal operations which the BOM has been forced to continue till end-2022, should be phased out immediately as such untargeted support only adds to inflation and FX pressures in a supply-constrained economy, thereby undermining the impact of tighter monetary policy. Phasing out quasi‑fiscal operations would also ensure the BOM’s operational independence, and help meet Mongolia’s commitments to the IMF under the 2020 emergency financing assistance.
Addressing FX pressures. The BOM’s recent decision to allow the exchange rate to reflect market forces to some extent has been appropriate. Given Mongolia’s challenging external outlook, high external debt and import dependence, and declining international reserves, the exchange rate should be allowed to act as a shock absorber to mitigate the impact of the external shocks. While greater exchange rate flexibility will be a difficult policy trade-off as it will pass through to inflation, it will improve incentives for the private sector to manage their external liabilities and help contain imports and speculation. The BOM’s FX interventions, including through administrative measures in FX auctions, should be limited to disorderly market conditions. An effective communication strategy would also be critical to stem speculative pressures. International reserves should be bolstered by opportunistic interventions.
Relieving economic hardship. A significant share of the necessary, but excessive, policy support during the pandemic has been saved by recipients and remains available to tide them through the current economic hardships. Moreover, the pandemic era support measures have been extended to end-2022. Any additional support to mitigate economic hardship should therefore be temporary and targeted toward vulnerable households. Permanent changes in fiscal policies should be avoided as they will undermine necessary fiscal consolidation. In that regard, given the supply bottlenecks, the large hikes in minimum pensions and minimum wages in real terms, is likely to be inflationary and therefore, counterproductive. Supply side disruptions should be addressed by continuing to accelerate public investment and improved processes to facilitate automated zero-contact exports at the Chinese border. The government’s policy to allow energy prices to reflect market values is the right course of action as it will help preserve limited fiscal resources and help conserve energy use.
Tight fiscal policy to contain inflation, external pressures and debt . Strong fiscal consolidation is essential to support monetary policy efforts to contain inflation; relying only on monetary policy tightening to address inflation could be destabilizing. Fiscal prudence is also necessary given Mongolia’s high external debt and major debt repayments coming due in 2023, amidst significant global economic uncertainty. In that regard, the 2022 supplementary budget appropriately targets new policy support measures toward the vulnerable, and saves some of the revenue windfalls by tightening current spending and prioritizing investments. Regrettably, allowing the full use of the expanded child money support will increase demand (and inflationary) pressures unless these monies are saved by recipients for precautionary purposes. The 2023 budget should be conservative and strike a careful balance between consolidation and fiscal support. Raising revenues through progressive personal income taxation would be an equitable way to fund vital necessary investments in education, health and infrastructure to improve medium-term growth prospects. The social assistance program should be better targeted toward the vulnerable to reduce poverty without raising inflation, improve equity and spending efficiency. Given heightened uncertainty and commodity price volatility, any revenue windfalls should be saved after protecting priority spending (e.g., on healthcare) in real terms. The financing of new capital projects and fiscal incentives (e.g., for decentralization) should be well‑designed and consistent with medium‑term development plans. The authorities should refrain from using fiscal buffers in lieu of reforms to contain debt. To this end, the 2021 legislative changes to forgo future savings in the Future Heritage Fund to fund the permanent expansion of untargeted social assistance should be reversed.
Building resilience to external shocks. Strong structural reforms plans should continue to be fleshed out and implemented well to reduce Mongolia’s reliance on external borrowing. The successful implementation of a new medium-term debt strategy, with a nominal debt anchor and domestic debt issuance, would help support fiscal prudence and debt sustainability. To reduce significant longer-term fiscal spending pressures, strong reforms in pension parameters, state-owned enterprises, and sound public investment and fiscal risk management, remains essential. The planned sovereign wealth and development funds should be integrated into the state budget for proper oversight. Modernizing and expanding the insolvency framework is necessary to help individuals, companies and banks address impaired balance sheets.
Allowing the BOM to fulfil its financial stability mandate. The prospects for sound and successful IPOs of some of the systemically important banks in June 2022 may have deteriorated, especially in light of the heightened economic uncertainty. The BOM’s decision to suspend the initiated AQR raises concerns that the IPO listings may proceed with less than full transparency of bank asset quality and financial positions. Ideally, Parliament should delay the June IPO deadline until economic uncertainty abates and AQRs can be completed to vet bank balance sheets. Given the Parliament’s reluctance to do so, a second-best approach would be for the BOM to continue with, and complete, the AQR before larger amounts of shares are issued by the 2023 deadline to reduce shareholder concentration. The BOM should assess the impact of adverse developments in the mining sector on bank balance sheets by conducting forward-looking stress tests, and engage in robust contingency planning. Should any of the IPOs fail, the BOM should take appropriate corrective measures as outlined in the Banking Law to stabilize the banks and put them in a stronger position to launch IPOs at an appropriate future date. Should the BOM feel compelled to delay the IPOs of some banks, such actions should be considered appropriate and in line with their legislative mandate to maintain financial stability.
Improving DBM’s governance. DBM’s balance sheet problems should be promptly but judiciously addressed to avoid adverse fiscal and external stability implications in 2023. Unless the long-standing governance concerns at DBM can be decisively fixed, the use of public funds to address its balance sheet problems would be a short-term fix and inadvisable as it would continue to pose fiscal risks in the future. Appointing an independent external advisor to conduct a diagnostic review of DBM’s balance sheet is recommended to develop a credible plan and course of action. The governance challenges of DBM needs to be effectively and credibly strengthened and the long-term viability of its business model clearly determined in the context of the ongoing efforts to strengthen the government’s public investment management, before DBM’s operational future is determined.
An IMF team visited Ulaanbaatar to conduct discussions during April 28–May 4, 2022. The IMF mission would like to thank the Mongolian authorities for frank and constructive discussions and their kind hospitality.