MONGOLIA MARO UPDATE March 13, 2012 · downside risks to the global outlook, moreover, add urgency to the need for tighter macroeconomic policies and avoiding a repeat of the missteps

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KEY DATA Real GDP Growth, 2011

17.3%

Consumer prices (end period) Proj.2011

15.1%

Real GDP Growth, Proj.2012

15.1%

Consumer prices(end period) Proj.2012

17.9%

According to IMF in March 2012, Mongolia completed successfully its IMF-supported Stand-by Arrangement last October. The government’s commitment to implement sound policies was a critical ingredient to the success of the program. Since the end of the program, however, macroeconomic discipline has eroded, placing in jeopardy the gains achieved during the course of the program. Parliamentary elections are sched-uled for June 2012 and electoral politics are already starting to exert a stronger influ-ence on policies.

The economy is undergoing a vigorous recovery, fueled by strong global commodity prices and excessively loose macroeconomic policies. The economy is now overheating and inflation has accelerated sharply in the past few months.

Such rapid growth is not sustainable and is driving inflation upwards. Momentum in underlying inflation—which excludes food and administered prices—has remained high throughout this year and is running well-ahead of the authorities’ policy targets

The economy is expected to grow rapidly in the next few years as two large mining projects start production. As a result, U.S. dollar GDP per capita could triple from 2010 to 2016. OT mine construction is ahead of schedule, and production is expected to start in mid-2012. An initial public offering of 30 percent of Erdenes Tavan Tolgoi shares is expected to take place in 2012. The government hopes to finalize the selec-tion of companies and conclude investment agreements later this year. When opera-tional, the mines will lead to massive increases in export earnings and fiscal revenue. Staff project that export proceeds from these mines will total US$2.4 billion in 2013, rising to US$10 billion by 2020. The 2020 export earnings are, for comparison, equal to about 140 percent of 2010 GDP. Fiscal revenue is projected to grow in tandem, though with some delay, as much of the initial government proceeds from Oyu Tolgoi must be used to repay the advance payments and a loan used to finance the government’s eq-uity stake. By 2016, however, fiscal mineral revenue is projected to amount to 28 per-cent of non-mineral GDP, compared with 18 percent of non-mineral GDP in 2010.

The economy has undergone a vigorous recovery, boosted by mineral exports, and overheating is now a key concern.

Risks. Mongolia is susceptible to a global downturn, and would be especially hard hit by a collapse in commodity prices. This is all the more worrying since copper prices have fallen sharply in recent weeks. Global financial volatility could also lead to delays in the two large mining project investments that are underway. This would hurt growth in the short run, reduce the value of contracts under negotiation, and delay the eventual fiscal revenue and export inflows. The economy, however, is more resilient to external shocks than before, largely thanks to the reforms put in place as part of the Stand-byArrangement. International reserves are at their all time high, the flexible exchange rate will act as a critical shock absorber, and the recently signed renminbi swap line with the People’s Bank of China provides a further buffer. At the same time, there are similarities be-tween the current episode and the macro-policies in the run-up to the last crisis . The downside risks to the global outlook, moreover, add urgency to the need for tighter macroeconomic policies and avoiding a repeat of the missteps that fueled the 2009 crisis.

HIGHLIGHTS

MONGOLIA MACRO UPDATE

MACRO RESEARCH F R O N T I E R S E C U R I T I E S March 13, 2012

CHIEF INVESTMENT STRATEGIST: Dale Choi [email protected] TEL: +976-70 11 99 99 FAX: +976-70 11 19 91

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FRONTIER SECURITIES CONCLUSION Another hike by authorities in salaries of public servants and pensions of senior citizens just a few days ago is further in line with the trend of electoral politics exerting stronger and stronger influence on macroeconomic policies and continued deteri-oration of macroeconomic discipline. We view that the current excessively loose macroeconomic stance is unlikely to change until the Parliamentary elections that are to be held in June 2012. Because of that and coupled with continued commodities export boom, we expect continued overheating of the economy this year, further and further increasing vulnerability of the economy to external shocks. After elections and depending on the outcome of the said elections, there could be possibly ac-cumulation of political will for revision by the next authorities of their current stance of misinterpretation of economic reali-ty, overly confidence and optimism and possibly resulting in much needed restraining of fiscal spending and tightening of monetary conditions to cool the overheated economy and make it more resilient.

The downside risks to the global outlook, moreover, add urgency to the need for tighter macroeconomic policies and avoiding a repeat of the missteps that fueled the 2009 crisis.

An export boom is mixing with excessively loose macroeconomic policies to drive up growth and overheat the economy, showing striking similarities to the run-up to the last crisis.

The authorities expect rapid growth to continue and the draft 2012 budget assumes real GDP growth of some 20 percent for this year and next. However, they did not believe the economy was overheating and thought that inflation could be contained to single digits in 2012 (and below 8 percent in 2013–14) in line with their policy objective. Nevertheless, the budget assumes an increase in the GDP deflator of around 20 percent. More broadly, they cited under-developed infra-structure as the key impediment to sustaining high growth with moderate inflation and underlined the importance of their plans to increase infrastructure spending through both the budget and the Development Bank. They understood the risks to the global outlook, and the implications for Mongolia, but were confident that the economy was now much more resilient than in the past and that they would be able to adjust policies, if needed, in the event of a sharp drop in global commodity prices.

Mongolia has a bright economic future. Its vast mineral deposits offer the potential to create strong and sustained growth, lasting economic prosperity, and a substantial reduction in poverty. Success, however, will depend on a shift in approach in managing the economy. At present, macroeconomic policies are too expansionary. This has created inflationary pres-sures and made the economy vulnerable to external shocks. This is especially dangerous at this juncture given the height-ened downside risks to the global economy. The large mining projects under development, moreover, are still some time away from full production. If global mineral prices drop precipitously, exports and fiscal revenue would fall sharply and pressure would come on international reserves. This would necessitate a potentially painful and disorderly reduction in fiscal spending that would exact a heavy toll on the economy, particularly on the poor. Top priority, therefore, should be to restrain fiscal spending and tighten monetary conditions to cool the overheated economy and provide insurance in the event of future commodity price shocks.

HIGHLIGHTS


F R O N T I E R S E C U R I T I E S

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Contents

Contents 3

Macroeconomic discipline has eroded 4

Such rapid growth is not sustainable and is driving inflation upwards 5

Exports from OT/TT will total US$2.4b in 2013, rising to US$10b by 2020. 6

Overheating is now a key concern. 7

There are similarities between the current episode and the macro-policies in the run-up to the last crisis.

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An export boom is mixing with excessively loose macroeconomic policies to drive up growth and overheat the economy, showing striking similarities to the run-up to the last crisis

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Authorities did not believe the economy was overheating 10

Success will depend on a shift in approach in managing the economy. 11

SELECTED ECONOMIC AND FINANCIAL INDICATORS, 2009-2012 12

SELECTED ECONOMIC AND FINANCIAL INDICATORS, 2008-2016 13

Conclusion 14

Disclosures and Disclaimers 15

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F R O N T I E R S EC U R I T I E S

MACROECONOMIC DISCIPLINE HAS ERODED

In March 2012, IMF released to the public staff report on Mongolia prepared by a staff team of the IMF, following discussions that ended on September 20, 2011, with the officials of Mongolia on economic developments and poli-cies. Based on information available at the time of these discussions, the staff report was completed on October 25, 2011 The views expressed in the staff report are those of the staff team and do not necessarily reflect the views of the Executive Board of the IMF. 1. Context. Mongolia completed successfully its Fund-supported Stand-by Arrangement last October. The govern-

ment’s commitment to implement sound policies was a critical ingredient to the success of the program. Since the end of the program, however, macroeconomic discipline has eroded, placing in jeopardy the gains achieved during the course of the program. Parliamentary elections are scheduled for June 2012 and electoral politics are already starting to exert a stronger influence on policies.

2. Macroeconomy. The economy is undergoing a vigorous recovery, fueled by strong global commodity prices and excessively loose macroeconomic policies. Mining output, moreover, is set to increase substantially as two huge mineral projects start production. Growth accelerated sharply this year, reflecting booming mineral exports driven by global prices and rising coal production, ongoing development of large mining projects, surging credit growth, improved agricultural output (primarily a base effect from last year’s severe winter), and expansionary macroeconomic policies. The economy is now overheating and inflation has accelerated sharply in the past few months.


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SUCH RAPID GROWTH IS NOT SUSTAINABLE AND IS DRIVING INFLATIO N UPWARDS

A. The Economy is Overheating 3. Growth. Real GDP growth in the third quarter reached 20 percent, making Mongolia one of the fastest grow-ing economies in the world. At the same time, private sector credit has increased by nearly 50 percent in real terms and imports of consumer goods have increased by over 80 percent. Such rapid growth is not sustainable and is driv-ing inflation upwards. Momentum in underlying inflation—which excludes food and administered prices—has re-mained high throughout this year and is running well-ahead of the authorities’ policy targets. The mission’s projec-tions assume that monetary policy is tightened in line with our recommendations, the 2011 budget is amended to increase spending 8 percent of GDP, and fiscal expenditure in 2012 is as specified in the draft budget submitted to parliament. With these assumptions, real GDP growth would surpass 10 percent both this year and next. End-year


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EXPORTS FROM OT/TT WILL TOTAL US$2.4B IN 2013, RIS ING TO US$10B BY 2020.

Box 1. Mongolia: Large Mining Projects The economy is expected to grow rapidly in the next few years as two large mining projects start production. As a result, U.S. dollar GDP per capita could triple from 2010 to 2016.

Oyu Tolgoi. Oyu Tolgoi, located in the south near the border with China, will be one of the largest copper and gold mines in the world. Sizeable deposits of silver were also recently discovered during drilling. The government owns 34 percent of the mine, and the rest is owned by Ivanhoe Mines (Canada), in which Rio Tinto has a 46.5 per-cent stake. Mine construction is ahead of schedule, and production is expected to start in mid-2012.

Tavan Tolgoi. Tavan Tolgoi, also located in southern Mongolia, is one of the world’s largest untapped coal depos-its with estimated reserves of about 6.4 billion tonnes. Erdenes Tavan Tolgoi LLC, a subsidiary of a 100 percent state-owned enterprise, has the mining license for what is called the eastern bloc. It is currently negotiating an op-erating contract with foreign companies. An initial public offering of 30 percent of Erdenes Tavan Tolgoi shares is expected to take place in the first quarter of 2012, another 10 percent of the shares will be sold to national compa-nies at a nominal price, and 10 percent will be distributed at no cost to all Mongolian citizens. For the western block, the government is negotiating with international and domestic mining consortiums for the mining rights, and hopes to finalize the selection of companies and conclude investment agreements later this year. The government is receiving prepayments of taxes and sales revenue from these two projects. The advance pay-ments are used for general budget financing, and in particular to help pay for the universal (monthly) cash transfers that were put in place to fulfill a promise from the last election. In June, the final US$100 million (out of a total of US$250 million) in Oyu Tolgoi related prepayments were received. In July, Erdenes Tavan Tolgoi signed an agree-ment with a Chinese firm to supply coal in exchange for advance payments that would total US$250 million, money that will be transferred to the budget. When operational, the mines will lead to massive increases in export earnings and fiscal revenue. Staff project that export proceeds from these mines will total US$2.4 billion in 2013, rising to US$10 billion by 2020. The 2020 export earnings are, for comparison, equal to about 140 percent of 2010 GDP. Fiscal revenue is projected to grow in tan-dem, though with some delay, as much of the initial government proceeds from Oyu Tolgoi must be used to repay the advance payments and a loan used to finance the government’s equity stake. By 2016, however, fiscal mineral revenue is projected to amount to 28 percent of non-mineral GDP, compared with 18 percent of non-mineral GDP in 2010.


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OVERHEATING IS NOW A KEY CONCERN .

Figure 1. Mongolia––Macroeconomic Developments Main Message: The economy has undergone a vigorous recovery, boosted by mineral exports, and overheating is now a key concern.


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THERE ARE SIMILARIT IES BETWEEN THE CURRENT EPISODE AND THE LAST CRIS I S

5. Risks. Mongolia is susceptible to a global downturn, and would be especially hard hit by a collapse in commod-ity prices. This is all the more worrying since copper prices have fallen sharply in recent weeks. Global financial vol-atility could also lead to delays in the two large mining project investments that are underway. This would hurt growth in the short run, reduce the value of contracts under negotiation, and delay the eventual fiscal revenue and export inflows. The economy, however, is more resilient to external shocks than before, largely thanks to the re-forms put in place as part of the Stand-by Arrangement. International reserves are at their all time high, the flexible exchange rate will act as a critical shock absorber, and the recently signed renminbi swap line with the People’s Bank of China provides a further buffer. At the same time, there are similarities between the current episode and the macro-policies in the run-up to the last crisis. The downside risks to the global outlook, moreover, add urgency to the need for tighter macroeconomic policies and avoiding a repeat of the missteps that fueled the 2009 crisis.


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EXPORT BOOM IS MIXING WITH EXCESS IVELY LOOSE MACROECONOMIC POLIC IES

Figure 3. Mongolia––Comparing Now and Then Main Message: An export boom is mixing with excessively loose macroeconomic policies to drive up growth and overheat the economy, showing striking similarities to the run-up to the last crisis.


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AUTHORIT IES DID NOT BELIEVE THE ECONOMY WAS OVERHEATING

6. Authorities’ views. The authorities expect rapid growth to continue and the draft 2012 budget assumes real GDP growth of some 20 percent for this year and next. However, they did not believe the economy was overheating and thought that inflation could be contained to single digits in 2012 (and below 8 percent in 2013–14) in line with their policy objective. Nevertheless, the budget assumes an increase in the GDP deflator of around 20 percent. More broadly, they cited under-developed infrastructure as the key impediment to sustaining high growth with moderate inflation and underlined the importance of their plans to increase infrastructure spending through both the budget and the Development Bank. They understood the risks to the glob-al outlook, and the implications for Mongolia, but were confident that the economy was now much more resilient than in the past and that they would be able to adjust policies, if needed, in the event of a sharp drop In global commodity prices.


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III. STAFF APPRAISAL 15. Context. Mongolia has a bright economic future. Its vast mineral deposits offer the potential to create strong and sustained growth, lasting economic prosperity, and a substantial reduction in poverty. Success, however, will depend on a shift in approach in managing the economy. At present, macroeconomic policies are too expansionary. This has created inflationary pressures and made the economy vulnerable to external shocks. This is especially dan-gerous at this juncture given the heightened downside risks to the global economy. The large mining projects under development, moreover, are still some time away from full production. If global mineral prices drop precipitously, exports and fiscal revenue would fall sharply and pressure would come on international reserves. This would neces-sitate a potentially painful and disorderly reduction in fiscal spending that would exact a heavy toll on the economy, particularly on the poor. Top priority, therefore, should be to restrain fiscal spending and tighten monetary condi-tions to cool the overheated economy and provide insurance in the event of future commodity price shocks.


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SELECTED ECONOMIC AND FINANCIAL INDICATORS , 2009 -2012


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SELECTED ECONOMIC AND FINANCIAL INDICATORS , 2008 -2016


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FRONTIER SECURIT IES CONCLUS ION

Another hike by authorities in salaries of public servants and pensions of senior citizens just a few days ago is further in line with the trend of electoral politics exerting stronger and stronger influence on macroeconom-ic policies and continued deterioration of macroeconomic discipline. We view that the current excessively loose macroeconomic stance is unlikely to change until the Parliamentary elections that are to be held in June 2012. Because of that and coupled with continued commodities export boom, we expect continued overheating of the economy this year, further and further increasing vulnerability of the economy to external shocks. After elections and depending on the outcome of the said elections, there could be possibly accumulation of political will for revision by the next authorities of their current stance of misinterpretation of economic reality, overly confidence and optimism and possibly resulting in much needed restraining of fiscal spending and tightening of monetary conditions to cool the overheated economy and make it more resilient.

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Other Disclosures:

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MONGOLIA MARO UPDATE March 13, 2012 · downside risks to the global outlook, moreover, add urgency to the need for tighter macroeconomic policies and avoiding a repeat of the missteps