Report on Risk Profile

8/4/2019 Report on Risk Profile

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COUNTRY RISK PROFILE: MONGOLIA

Introduction

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The report is organized as follows:

In section I, we will look at significant changes that Mongolia experienced in the last15 years by looking at some major macroeconomic indicators. Based on theseobservations, we will evaluate current socio-economic environment of the countryand will identify key risks that may potentially lead to destabilization of socio-economic conditions of the country.

In section II, we will identify key risks the country faces and discuss their implicationson socio-economic conditions and inter-linkages between these risks. This sectionhas four parts. First part of the section discusses boom-bust cycle that Mongoliaexperienced in the last 15 year. As the economy grew or declined, there werevarious risks at play that originated these cycles and exacerbated them. Sincefluctuations in major macroeconomic indicators often are explained by interplaybetween demand and supply, we concentrate on these two sides. Firstly, we identifykey risks on the demand side as commodity price fluctuations and policy risks thatare responsible for rapid fluctuations in the aggregate demand. Secondly, we identifyenvironmental risks as crucially affecting the supply side. Thus, we argue thatcombination of these aggregate demand and supply factors led to past volatile

economic conditions. Lastly, we also identify political risk as one of the key risks thatthe country will face in near future

Section I: Background

Mongolian economy expanded rapidly in the last 15 years. In nominal terms, GDPincreased tenfold during this period whereas in real terms it increased by twofold.According to WDI estimates, in nominal USD terms, Mongolian economy grewfivefold from USD1.2 billion to USD 6 billion during this period. Mongolia wasclassified as low income country by World Bank in 1996 with per capita income of


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USD512. In 2010, the country is classified as a mid-low income country with percapita income of USD2252, which implies fourfold growth in per capita income forthe last 15 years.

Figure 1: GDP, mln Togrog

Sources: International Financial Statistics and National Statistical Office of Mongolia

Figure 2: real GDP growth, percent

Sources: International Financial Statistics and National Statistical Office of Mongolia

However, Mongolia experiences a volatile GDP growth. As can be seen from Figure2 above, Mongolias GDP growth fluctuated between contraction of -1.3% andgrowth of 11.3% with average growth per annum of 5.6% for the period.

Between 2003 and 2008, Mongolian economic growth accelerated dramaticallyaveraging 8.7% of growth per annum. During this period, lower middle income

countries GDP growth was 6.7%, whereas transition countries growth averaged 7.6%.

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It should be noted that, in 2009, Mongolian GDP decreased by 1.2% followed by amodest growth of 6% in 2010, significantly below its average growth in previousyears.

Looking further into major macroeconomic variables we see similar volatile behavior.Inflation, measured in rolling 12 months, is shown below.

Figure 3: CPI inflation, rolling 12 months, percent

Source: Bank of Mongolia

As we can see from the figure above, Mongolia experienced volatile inflation as well.

During the last 15 years, average CPI inflation was 10% whereas its standarddeviation was 10%. In comparison, emerging and developing countries for the sameperiod experienced 8% of inflation, but standard deviation of 2.8% only. ThusMongolia experiences not only higher inflation rate, but significantly volatile inflation.Interestingly, Mongolia is more in line with other transition countries, which averaged10% of inflation with standard deviation of 15% according to World EconomicOutlook database.

Mongolias financial sector is growi ng rapidly. It should be noted that bankingsectors total assets represent 96% of the financial sectors total assets as of 2010.In the last 15 years, the domestic banking system s total assets increased fromTogrog 0.2 Trillion to Togrog 5.1 Trillion, or equivalently from 22% to 62% of GDP.More interestingly, between 2008 and 2010, it drastically increased from Togrog 3.6Trilllion to Togrog 5.1 Trillion which is equivalent to 62% of nominal GDP.

Mongolian stock exchange rapidly increased in the past years as well. Although, themarket capitalization is still relatively modest at Togrog 2.4 Trillion as of 2010, whichis equivalent to USD 2 Billion, it has become one of the most dynamic markets in theworld. Top-20 index rose by 233% in 2010 alone, thus making it one of the highestperforming markets in the world.

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Mongolia trades extensively with foreign countries. For the period between 1997 and2010, Mongolias trade turnover increase d from USD1 billion to USD6 billion.Following figure shows export and import dynamics for the same period in USD. Wecan see from the graph that this explosive growth accelerated starting in early 2000s

until 2008. Predictably, composition of exports changed significantly during thisperiod as mineral exports account for 81% of total exports, whereas composition ofimports was relatively stable.

Figure 4: International Trade, mln USD

Sources: National Statistical Office of Mongolia and International Financial Statistics

Mongolia experienced similar explosive growth in Government expenditure. In thelast 15 years, Government expenditure rose from Togrog 0.29 trillion to Togrog 3.08trillion. As a share of GDP, it also grew considerably from 35% in 1997 to 51% as of2009 implying increasing government intervention into the economy.

Thus, major macroeconomic variables exhibited high volatility as well as explosivegrowth, which indicate the country is undergoing significant changes and perhaps,the country is vulnerable to various risks.

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Section II: Risks

Volatility of the magnitude that Mongolia experienced in the last 15 years did notfavorably affect decision making processes faced by foreign and domestic investors,producers and consumers and policy makers. Since this kind of economic volatilityadds unpredictability to economic decisions at all levels, it would be interesting todiscuss chief reasons for these fluctuations.

These large swings in major macroeconomic variables such as GDP and pricesreflect corresponding large swings in supply and demand of goods and services.Therefore, we can describe what economic factors cause this volatile economicenvironment by looking further into demand and supply factors at work.

Mongolian economy has its own characteristics that differ from oth er countrieseconomies. Therefore, we need to stress what are the unique characteristics of theMongolian economy that makes the countrys economy vulnerable to these largeswings.

On the demand side of the economy, Mongolia experienced large increases as wellas a large decrease in aggregate demand, which resulted in fluctuations of pricesand productions of goods and services.

In order to explore the impact of changes in aggregate demand, we need to look atthe structure of the economy carefully.

Mongolian economy underwent significant structural changes in the past 15 yearsand became increasingly reliant on mineral sector. In particular, the share of themining sector in GDP increased considerably in the past becoming the biggestsector in the economy. Following graph shows changes in the structure of theMongolian economy for the period.

Figure 5: Structural change in the economy

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1997Mining and quarrying

Agriculture, forestry andfishing

Transportation and storage

Wholesale and retail trade;repair of motor vehicles andmotorcyclesManufacturing

Other


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Sources: National Statistical Office of Mongolia

Noticeably, agricultural sectors share decreased significantly indicating thatMongolia is transitioning from agriculture based to mineral based economy.

Thus the role of the mineral sector was of paramount importance for the country inthe past and it is expected that in the future it will be even more so. Mongolia hasvast natural resources. It is estimated that the country has more than 6000 knownmineral deposits of 80 different minerals. Mongolias abundance in natural resourcesmakes the country highly competitive in the world market for minerals. Namely,Mongolia has vast resources of coal, copper, molybdenum, gold, zinc, fluorspar anduranium. Out of these, the country produces significant amount of copper, gold andcoal that has deep impact on the countrys economy.

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Big mining projects

Mongolian-Russian joint venture Erdenet became operational in 1976 with resourcesof 1.2 billion tonnes of copper. This venture alone contributes around one third of thegovernment budget and around one fourth of the total exports. It produces 130,000tonnes of copper concentrate annually and exports it mostly to China and Europeanmarkets.

More significantly, the country is on the verge of having two mega mining projectsoperational in the near future. Tavan Tolgoi is one of the largest coal deposits in theworld with 4.5 billion tonnes of confirmed deposits of brown and coking coal. It isexpected that by 2020, the mine will produce 10 million tones of coking coal and 40million tones of thermal coal per year. At todays prices, it will worth more than USD2.5 billion. After 2020, some estimates suggest that the mine will produce as muchas 50 million tonnes of coking and 200 million tonnes of thermal coal per year.Government fully owns the deposit and now in negotiation with mining operators tomake the project operational.

The other significant project is Oyu Tolgoi mine. This is a mine with proven andprobable deposits of 1.39 billion tonnes of ore with copper and gold. It is expected

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that by 2020, the mine will reach its peak of production by producing more than800,000 tonnes of copper concentrates and more than 32 tonnes of gold. It isexpected that the mine will be operational for 70 years and is jointly owned byIvanhoe Mines LLC (66%) and Government of Mongolia (34%). Investment

agreement between Ivanhoe Mines LLC and Government was signed in October2009 and it is expected the mine will start its production as early as December 2012.

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Thus, Mongolia is expected to significantly benefit from these two new large miningprojects. Since Government owns significant shares of both mines and it is expectedthat it will increase its share in the future, these two mining projects will have lastingimpact on the country.

Before discussing the risks associated with commodity driven economy, it should benoted that Mongolia is a landlocked country, which borders with China in the southand Russia in the north. This geographical feature poses added challenges to thecountry in terms of transportation. Because of underdeveloped transportationinfrastructure, Mongolian produced goods are uncompetitive in the internationalmarket. This makes it difficult to diversify the economy and makes it concentratemore on services and mineral sectors. It has been estimated that the cost of shippingis 3.4 times higher than that of other East Asian countries. As a result, China andRussia are Mongolias m ajor trading partners. In particular, trade with Chinaaccounts for more than 84% of exports and more than 30% of imports.

II.1. Boom-Bust cycle

We saw that Mongolia is vulnerable to boom-bust cycles. There are two majordrivers for this cyclical behavior. One is risks associated with commodity pricefluctuations and the other is heavy pro-cyclical policies that exacerbate cyclicalfluctuations.

We discussed that the share of the mining sector increased significantly. Althoughthe level of production of minerals increased in the past years, production of majorexporting commodities such as copper, gold has been relatively stable since early2000s . Namely, production and export of copper concentrates has been stable atthe level around 600,000 tonnes per year, whereas production of gold is estimated tobe around 15-20 tonnes. It should be noted that because of windfall taxes imposedon mineral exports, there was a strong tendency not to sell the gold to Bank ofMongolia (the Central Bank) and hence it became difficult to measure the productionlevel of gold with reasonable accuracy.


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With increasing coal prices, coal is starting to become major exporting commodity forthe country. Production of coal increased significantly for the last 10 years. In 2001Mongolia exported only 1.9 tonnes of coal, whereas it exported 2.2 million tonnes in2005 and 16 million tonnes in 2010. As of 2010, export of coal represents 30% of

total exports overtaking copper as the biggest item of exports.In the past years not only the level of commodity production increased, prices ofMongolias major exporting commodities significantly increased as well.

Figure 6: World prices of major exporting commodities (Jan 2000=100)

Sources: International Financial Statistics

Fluctuations in prices of commodities or terms of trade shock represent a majorrisk to the stability of the economy and hence continuation of the boom-bust cycle.Since the level of production cant be adjusted flexibly and the mineral sector isalready a significant sector of the economy and moreover, major mining projects areexpected to be operational in near term, fluctuations in commodity prices representmajor risk to the stability of the economy.

This source of risk was clearly on display during 2008/2009 crisis. Because of almostno exposure of the sector to the world financial markets, Mongolia did not suffer fromthe first wave of crisis. However, because of increasing dependence of the economy

on mineral sector and sudden fall of world commodity prices, the countryexperienced hardships.

As revenue from commodity exports took a significant hit, it put pressure on prices,exchange rates, government revenue, international reserves and consequently, onthe production and banking sector as the demand for goods and services declined.

In particular, export revenue decreased by 25.6% and total trade turnover decreasedby 30.4% in 2009. Because of the negative shock to the country s terms of trade,trade deficit was 13.8% of GDP in 2008 and 5.4% in 2009. The trade deficit put

pressure on the domestic currency to depreciate.

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Figure 7: Nominal exchange rate (Togrog per USD) depreciation and tradedeficit (mln USD) in 2008/2009

Source: Bank of Mongolia

From Figure 7, we see that trade deficit led the exchange rate to depreciatesignificantly in April of 2009. It should be noted that during the first few months of thecrisis, especially between September 2008 and April 2009, Bank of Mongoliaintervened in the foreign exchange market to fend off the sudden pressure onTogrog to depreciate by selling foreign currency out of its reserves. Inevitably, whenthe international reserves reached unacceptable low levels of only around USD500million, the Bank of Mongolia stopped the intervention and let the currency to

depreciate.This brings us to policy risks that threaten to exacerbate the boom-bust cyclecaused by fluctuations in the commodity prices.

During the economic boom years before 2008, fiscal and monetary policies werehighly pro-cyclical. Because of increasing commodity prices and revenues generatedfrom mineral exports, both public and private demand for goods and servicesincreased. Government revenue increased from Togrog227 billion or 27.3% of GDPin 1997 to Togrog3.1 Trillion of 37.3% of GDP in 2010. And, more interestingly

during this period dependence of the budget revenue on mineral sector increased aswell. Mineral sector contributed around 6% of the fiscal revenue in 2003 (footnote:

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World Bank (2003)), whereas this contribution significantly increased to reacharound 25% as of 2010.

More importantly, with increasing revenues, Government implemented pro-cyclical fiscal policies during this period. Government expenditure rose drastically as canbe seen from the figure below. Interestingly, as the Government spending increased,the structure of the fiscal spending changed as well. In particular, the share ofspending on social safety net programs in the budget increased to finance spendingon new transfer programs such as Child Money and Newly Wedded Couples.

Figure 8: Pro-cyclical fiscal policy, in mln Togrog

Source: Bank of Mongolia, National Statistical Office of Mongolia

However, with unfavorable changes in the world commodity prices, Government srevenue took a significant hit by missing the target level by 14% or 5.7% of GDP in2008 and decreased by 6% in 2009 adding a significant pressure on governmentspending. However, in 2010, as world commodity prices increased governmentrevenue increased so did expenditure.

Thus fiscal spending closely followed fiscal revenue, which in turn closely followedworld commodity prices. Government of Mongolia attempted to break this habit bycreating a Mongolia Development Fund, which was designed to collect receipts from

windfall tax on mineral exports and one third of it to be saved for rainy day.However, the fund financed regular government expenditures such as social safetynet programs and quickly ran out of money when windfall tax receipts diminished.

During the height of the crisis, when fiscal stimulus was the most needed policymeasure, Government not only did not have resources for stimulus but it also did nothave financial resources to maintain the level of spending. When economy wasbooming government expenditure increased which further boosted aggregatedemand and when economy declined government expenditure decreased, whichfurther aggravated the economic decline.

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Pro-cyclical fiscal policy was not the only factor exacerbating boom-bust cycle.During the period of high growth monetary policy was also accommodative.

Figure 8: Pro-cyclical monetary policy (inflation, monetary supply growth andCBB rate)

Source: National Statistical Office of Mongolia and the Bank of Mongolia

As we mentioned above, the country experienced highly volatile and high level ofinflation.

Although there were many factors contributed to the inflation increase, one of thechief reasons was indeed expansionary monetary policy conducted by the Bank of

Mongolia (the Central Bank). For the past 15 years, money supply increased onaverage 28.4% on 12 months rolling basis with standard deviation of 15.1%.Interestingly, during the pre-crisis period between 2005 and 2008, money supplyincreased twofold. Although, during the period between 2005 and 2007 inflation wason average 7% on rolling 12 month basis, it significantly increased in 2008 reachingaverage 12 month inflation of 26.7%.

Moreover, because of heightened inflation during the crisis, the Bank of Mongoliatightened its policy by raising policy rate and intervening in the foreign exchangemarket which resulted in 5% decrease in money supply by the end of 2008.

Thus, in the same manner as in fiscal policy, monetary policy was highly pro-cyclical.During the period of boom money supply increased significantly and accelerated theeconomic growth, whereas during the economic decline monetary supply wastightened because of high inflation concerns thus limiting the supply of credit andworsening the real sector decline.

For Mongolia, demand side risks are closely related to risks associated withfluctuations in the world commodity prices or terms of trade risks, which is the majororigin of shocks to the economy and a major driver for aggregate demand. However,fiscal and monetary policies pose yet additional risks or policy risks to the stability ofthe economy. We discussed that past experiences suggest that pro-cyclical policies

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exacerbated the terms of trade shocks further destabilizing the economy andcontinuing the boom-bust cycle.

II.2 Resource curse

Boom-bust cycles threaten to destabilize socio-economic conditions in the short tomedium term.

In the longer run, increasing share of mining sector and increasing dependence onthe mineral export might lead the country to experience resource curse symptoms.

Resource curse is a phenomenon that refers to an empirical observation thatresource abundance does not always translate into economic development. Inparticular, there are many cases of resource rich countries that failed materialize itsresources into high economic growth, better institutional quality and generally,increase in the well-being of its citizens.

For Mongolia, resource curse presents a major long term risk to the stability of theeconomy and society as a general.

There are at least two important aspects that we should pay attention in thediscussion of the resource curse that we need to be aware of. First, in terms of longterm economic structure, the country will be vulnerable to Dutch disease effects.

Dutch disease effects refer to the fact that disproportionate increase in one sector,i.e. mining sector, leads to drastic real exchange rate appreciation, which in turnmakes other sectors of the economy uncompetitive in the world market.

This loss of competitiveness leads the country to specialize in mineral exports, aswell as to concentrate more on non- tradable goods sector. Moreover, since goodsand services become more expensive in the domestic market, there will be agrowing competition for tradable goods market between domestic and foreignproducers. Hence, there will be an increasing pressure on the Government to protectdomestic producers from foreign competition. Because Mongolia borders with China,who trades extensively and has comparative advantage in many goods and services,and Mongolia is too dependent on exports of minerals, this risk is expected to pose areal challenge for Mongolian authorities.

Some estimates suggest that development of two big mining projects will leadservices sector to drastically expand by 2020, whereas construction and transportservices will have increasing share beyond 2020. However, it also estimates thatagriculture and manufacturing sectors will significantly decline in terms of share inGDP by 2020.

Thus, in the longer term, the economy might suffer from loss of competitiveness interms of narrower diversification of the economy and hence, lower economic growth.


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The second aspect that we want stress is that there are other risks that can directlylead to resource curse symptoms. That is quality of institutions and governance plays critical role in translating resource wealth into proper economic development.

Weak law and contract enforcement, bureaucratic hurdles, corruption, weakgovernment accountability and overall, unfavorable business environment allsignificantly derail the country from fully capitalizing on its resource abundance.

Mongolia does not fare well in terms of institutional quality.

Various business environment surveys consistently rank the country very low. Inmany countries, natural resources became a source of rent-seeking from politicalgroups and lobbyists. In terms of corruption, Mongolia ranked in 102 out of 179countries by Transparency International. Indeed, many enterprise surveysspecifically cite corruption as one of the major hurdles in business environment.(footnote to be added) Business Environment and Enterprise Survey byInternational Financial Corporation and European Bank for Restructuring andDevelopment shows that 31.1% of firms mentioned corruption as a major constraint.

There are other institutional shortcomings in the country as well.

In terms of law and contract enforcement, Economic Freedom of the World indexby Frasier Institute ranked Mongolia at 70 out of 141 countries in 2010.

In general, Mongolia ranks very low in business environment surveys. World Banks

Doing Business report ranked the country at 73 out of 183 countr ies, whereasWorld Competitiveness Index by World Competitiveness Forum ranked it at 117 outof 133 countries. Although these surveys were conducted not long after theeconomic crisis of 2008/2009, it still shows symptoms of unfriendly businessenvironment in the country.

Governance arrangements pose additional challenge for the country. Generally, it ispossible to dampen risks associated with Dutch disease effects and to avoidResource curse altogether as several countries showed. However, it also showedthat it requires self restraint and political leadership to implement policies that are

beneficial for the country in the long term. Pro-cyclical policies that we discussedabove, which exacerbated the boom bust cycle, are one of the symptoms of poorgovernance in the country further accentuating policy risks.

The country is expected to experience significant capital inflow related to expectedboom in the mining sector and the current policy framework for regulating capitalinflows will be tested. In other words the country is susceptible to financial risks .

Current regulatory framework does not adequately deal with capital inflow. In otherwords, capital flight that we experienced during 2008/2009 crisis happened because

of inadequate capital control mechanisms. After the crisis, the policy framework


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dealing with capital control did not change. Therefore, the country is still susceptibleto the large swings capital flight.

Currently, there are discussions taking place about what mechanisms of capitalcontrol the country should be using and how much of government interventionshould be allowed. There are two types of capital control that other countriesimplemented. One is foreign exchange related prudential regulations. Theseregulations on one hand protect Mongolian banks from exchange rate risks and onthe other hand, it also protects the domestic financial market from sudden flow ofcapital in and out of the country.

Currently, banking regulations state that foreign exchange open positions of a bankshould not exceed 15% of banks capital for a single foreign currency and 40% for allforeign currencies. These ratios should be maintained every day. Trade and

Development Bank of Mongolia and XAC Bank are exceptions to this regulation asthe bank was allowed to implement value at risk model by the Central Bank.Needless to say, since this kind of regulation restricts the banking operation, manybanks are interested in value-at-risk models. Therefore, it should be noted that if asignificant number of banks are allowed to implement value-at-risk models, bankswill be vulnerable to un-hedged currency risks which means that risks of untamedfluctuations in capital flow in and out of the country will be more prominent furtherdestabilizing the financial market.

Since it is expected that the country will be experiencing significant capital inflows

into the country, authorities are contemplating further actions on capital control. Inparticular, imposition of taxes on the capital or unremunerated reserve requirementsare control tools of interest.

II.3 Environmental risks

Past experiences suggest that the country is also vulnerable to supply side risks.One of the prominent risks on the supply side is environmental risks .

Agriculture sector was a dominant sector for the Mongolian economy in 90s and isstill an important sector for the economy accounting for 23% of GDP as of 2010 andemploying around 30% of population. Mongolian agriculture sector primarily consistof livestock, which represent around 90% of the sector. Contribution of agriculturalproducts to countrys exports is also losing its significance. In early 2000s , export ofagricultural products were around 5% of total exports whereas as of 2010, itaccounted for less than 2%.

Because animal husbandry is such an important sector for the domestic economy,drastic climatic changes affect the countrys economy significantly. Severe wintersand dry summers pose real challenges to herders. In the last decade, Mongolia


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experienced two dramatic climatic changes. During the 2000/2001/2002 and2009/2010 severe winters (dzud) countrys livestock was severely depleted. Forexample, during the latest 2009/2010 dzud around 8 million or almost 20% of totallivestock was lost. Climate changes crucially affect supply of food and therefore,

have destabilizing effect on prices and levels of production.However, climatic risks are not man-made and it can be at least partially addressedby a proper insurance system for herders. The country also suffers from man-madeenvironmental degradation. In particular, pollution in Ulaanbaatar reachescatastrophic levels during winter, which severely impacts health and quality of life ofcitizens. According to the Mongolian Social Health Institute estimations Ulaanbaatarhas between 1.5 to 7.8 times higher nitric acid, carbon dioxide and dust particles inthe air. Air pollution not only decreases productivity as it is one of major sources ofvarious diseases and disabilities of labor, it also increases cost of healthcare.

Moreover, in relation to expanding mining sector, land and water degradation,deforestation, desertification are becoming one of the major sources of unrest inrural areas. Environmental degradation is not sitting well with herders as theirlivelihood crucially relies on pastureland and good supply of water. It also intersectswith political risks, since growing unrest over environmental issues spills over intopolitical movements.

II.4 Political risks

Abovementioned risks are all associated with economic conditions of the country ingeneral. However, there are other risks that affect the country s socio-economicconditions. These risks are tightly interconnected with economic, policy andenvironmental risks, but are not necessarily classified as those.

Since Mongolia made transition 20 years ago from one party political system intodemocratically elected system it experienced comparatively stable political systemand successfully held 5 parliamentarian and 6 presidential elections. Because of thispolitical stability, the country ranks highly in comparison to other transitional anddeveloping countries.

With expected increase in the mining sector and in GDP growth, there is a growingconcern about future political stability. There have been occasional politicaldemonstrations in the past especially during spring time, dubbed as springsyndrome. Moreover, after results of 2008 election, there was a violent clashbet ween demonstrators and police in front of the winning party s headquarterresulting in the of five citizens. Growing revenue from the mining sector may lead tomore populist policies such as handouts by the ruling party. This is a major politicalrisk because although the policy may lead to more equal distribution of the receipts,it will also enable the running party to win more votes in elections. These politically

motivated policies intersect with policy risks we discussed above and test the


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willingness of the ruling party to self restraint and conduct policies that are beneficialto citizens in the longer run. Moreover,

However, new economic environment will test political stability of the country. We areproposing to discuss stability of the current political environment and related aspectsthat would challenge its stability.

Geopolitical risk: between Russia and China.

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