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p. 14 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia People's Republic of China Hong Kong, China Republic of Korea Mongolia Taipei,China Southeast Asia South Asia Central Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : East Asia

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Mongolia

Dynamism in services and a milder than expected winter helped the economy move out of stagnation in 2002, while a contained fiscal deficit and low inflation contributed to macroeconomic stability. However, the vital agriculture sector remains vulnerable to severe weather and suffers from a lack of investment. In the medium term, growth is expected to strengthen somewhat as mining—aided by promising new mineral deposits—and labor-intensive industries become important sources of economic expansion.

Macroeconomic Assessment

After 2 years of stagnation, prospects for the economy improved in 2002. In spite of unfavorable conditions in the world market for its exports, the economy grew by 3.9%, after 1.1% growth in the previous year, largely due to the robust performance of services. A milder than expected winter helped cushion losses in the livestock subsector, and agricultural output declined by a less steep 10.5%, after an 18.5% contraction in 2001.

Despite strong manufacturing activity, principally in textiles and meat processing, industrial output grew moderately by 4.7%, down from 11.9% growth in 2001, reflecting the impact of the poor performance of the mining sector. Lower copper production, triggered by falling prices in international markets, depressed both industrial output and exports receipts. Construction expanded by 11.0% as a result of the ongoing real estate boom in Ulaanbaatar. Services grew by 12.0%, propelled by the solid outcome in financial services, transport and communications, and wholesale and retail trade.

Improved economic performance had a favorable impact on the labor market. Actual unemployment is much higher than suggested by the official estimate of 3.6%, with high job losses in rural Mongolia driving migration to Ulaanbaatar. Moreover, employment estimates are also distorted by the size of the informal sector (around 35% of GDP). In this regard, the rapid development of informal gold mining is important, an activity helping counter the losses of employment in other sectors. This alternative source of income, involving an estimated 50,000-100,000 workers, has become a means of living for families who lost their herds in past harsh winters (dzud) and for individuals who failed to find employment in urban areas. Without any regulation, however, informal gold mining can contribute to environmental degradation of rivers and streams.

Growing efforts to restore macroeconomic stability are reflected in a fiscal deficit of 5.6% of GDP, which is below the IMF Poverty Reduction and Growth Facility (PRGF) target of 6.5%. Payments from the largest taxpayers—Erdenet copper mine, Gobi cashmere factory, and Mongol Telecom—fell short of estimates by midyear. The budget came under additional pressure when the Government committed to support herdsmen affected by the previous dzud and increased public sector pay by 20%. The budget was amended in late August, and revenue and expenditure targets for the 2002 budget were revised to meet the requirements of the PRGF. In the last quarter, however, an improved fiscal position resulted from higher than expected revenue collection and improved fiscal accountability and transparency, as well as from substantial privatization receipts from the sale of the Trade and Development Bank.

On the monetary front, rapid growth in the money supply (42.0%) was a result of substantial financial deepening. It did not affect inflation, which was more responsive to falling food prices, particularly meat and meat products (together accounting for more than 50% of the consumer price basket). Inflation slowed to an annual rate of 1.6% from 8.0% in 2001 (Figure 2.4).

The Government has taken positive steps to deepen financial services and introduce international competition through the privatization of two important banks. The banking system is experiencing rapid growth in bank deposits, active lending, and a moderate level of NPLs (falling from 8.0% in 2001) that represented 7.2% of total outstanding loans.

In addition, the Bank of Mongolia (BOM) is planning to raise the minimum capital requirement for banks to $2 million. BOM is also paying attention to the maintenance of an appropriate structure of interest rates to foster investment and growth. Though still high, interest rates are coming down, as confidence grows and competition is triggered by the entry of new banking and nonbanking financial institutions. Commercial bank interest rates declined from 30-40% a year to 12-18% for dollar-denominated loans, and down to 15-30% for togrog debt. Mongolia maintains a flexible exchange rate regime and the togrog depreciated by 2.4% against the dollar to stand at MNT1,125:$1 at the end of the year.

Total trade amounted to $1.2 billion, or more than 100% of GDP. Exports declined by 3.9% and imports grew by 3.3% over the course of 2002, widening the trade deficit to about 14% of GDP. On the export side, copper concentrate sales, accounting for 40% of total exports, declined in volume and value terms due to falling international copper prices. The value of cashmere exports also fell as a result of a sharp slowdown in demand for luxury textile products in the US. However, rising meat and meat product exports after the lifting of the foot-and-mouth ban, and higher gold production and prices, helped partially offset these trends. Increased purchases of vegetables, machinery, and electrical appliances pushed up imports to $659 million. Excluding transfers, the current account deficit widened in absolute terms to $175.0 million but, given the higher rate of economic growth, declined slightly as a proportion of GDP to 16.0%. However, it remains a concern at this level. The overall balance of payments showed a $42.6 million surplus, reflecting large inflows of external assistance and growing remittances from overseas workers. The net foreign reserves at BOM reached $225.9 million by the end of the year, covering 17.8 weeks of imports.

Amendments to the Foreign Investment Law, improvements in the investment environment, and promising new gold and copper deposits in the south helped boost FDI inflows. Cumulatively, FDI inflows have amounted to $734 million since 1991, with inflows from the PRC accounting for 90% of the country's FDI stock. External debt stood at 88.3% of GDP in 2002, and debt service remains low at 4.9% of exports, partly due to the fact that most debt is concessional.

Policy Developments

Economic policy developments took place within the framework of the Action Program of the Government of Mongolia for 2000-2004, guided by the IMF PRGF targets and recommendations. In this context, macroeconomic stability, private sector-led growth, and more equitable income distribution remained the main pillars of the Government's overall development strategy.

Despite difficulties in early 2002, the Government made an effort to comply with these targets. This was shown by its willingness to amend the budget, and to desist from publicly announcing further wage and pension hikes for 2003, agreeing instead to limit future salary increases to the anticipated rate of inflation. To sustain a sound fiscal strategy, the Government acknowledged the need for a gradual reduction of the ratio of current expenditures to GDP and to reduce the burden of taxation on the private sector through a gradual expansion of the tax base.

One of the major achievements in 2002 was the approval of the long-delayed Public Sector Management and Finance Law, a legal framework to strengthen governance within the public sector. The law should improve the efficiency of public expenditures through comprehensive reforms of the budget process for line ministries and other government agencies.

Because of financial deepening, rapid growth in monetary aggregates did not push up inflation. However, as the rate of deepening decelerates, monetary growth must slow to sustain macroeconomic stability. Greater competition in the financial sector generally and enhanced public confidence in the banking sector specifically are leading to rapid credit growth. As a result, the Government should consider strengthening loan quality requirements, credit risk analysis, and capital-adequacy ratios.

Other parts of the financial sector outside the banking system remain, however, underdeveloped, while the stock exchange has been moribund over the last 2 years following a loss of public confidence in its operations. Only a few private banks offer modern payment services and sound lending practices are still being developed. Thus the population still relies on cash for many domestic and international transactions, with cash accounting for about 80% of the supply of narrow money (M1).

Volatile prices for Mongolian exports have resulted in both positive and negative effects. Gold production and export revenues have soared while copper and cashmere output and prices were depressed. Mongolia's trade structure will necessarily be heavily influenced by developments in the PRC and the Russian Federation, and it will be a challenge for it to diversify its exports and find a niche for its manufactured and services exports in these markets. The overall balance-of-payments surplus resulting from capital inflows is exerting upward pressure on the real exchange rate. This trend could erode the economy's competitiveness, a situation that may be exacerbated by the growing competition in manufacturing deriving from the PRC's membership of WTO.

An ongoing initiative aims to help industries develop and implement better business strategies, specifically, to generate more value added through improved productivity and quality improvement. The initiative is focused on cashmere and fine fibers, processed meat products, tourism, and the public sector.

Outlook for 2003-2004

The Government will be confronted with the challenges of meeting its targets under the Action Program for 2000-2004 and the PRGF, namely GDP growth of 6.0% and significant poverty reduction. Prospects for achieving these objectives in 2003-2004 are mixed. The industry sector, led by textiles and food processing, along with mining and construction, is expected to perform very well and will provide the growth momentum and resources for development over the medium term.

In contrast, the primary sector is likely to struggle. The deteriorating performance of the agriculture sector has been one of the factors hindering economic growth, and, in fact, GDP growth excluding agriculture grew by 9.4% in 2002. The primary sector is vital for the economy and accounts for 23% of GDP and 30% of the labor force. Highly vulnerable to climatic conditions, the sector is still recovering from the losses sustained during two dzud, an outbreak of foot-and-mouth disease, and a severe drought affecting 70% of the country. Furthermore, a poor harvest and meager reserves of hay and fodder might delay the recovery of the sector, which is plagued by an array of shortcomings ranging from overgrazing and desertification to the deterioration in the supply of critical support services. A significant improvement in agricultural output is critical to accelerate growth and poverty reduction, and resources have to be marshaled to deal with the challenges that the primary sector faces.

Concerns are growing over debt sustainability in the short to medium term. Despite the concessional nature and long-term structure of the debt, the debt service burden is increasing. This is particularly worrisome given Mongolia's vulnerability to external price shocks. Hence, prudent external debt management policies need to be maintained. This will be a challenge since domestic savings rates are low. In addition, the capital market is underdeveloped and the banking system lacks the capacity for large-scale lending. Although FDI could represent a means to overcome these limitations, successful efforts to attract significant FDI inflows demand long-term planning as well as an innovative and more liberalized regulatory framework.

Macroeconomic stabilization therefore remains a priority for the Government. In the fiscal area, the Government's strategy will need to focus on the rationalization of both the expenditure and revenue structures of the budget, while aiming to improve social coverage and to reduce the tax burden on the private sector. Fiscal stability will facilitate the development and conduct of monetary and exchange rate policies to enhance private sector development and export-led growth, goals that will equally benefit from further development and liberalization of the financial system.

Given the vulnerability and narrow base of the economy, growth estimates must be tentative. PRGF projections show a rising rate of targeted growth for the next 2 years (5.0% and 5.2%), sustained by a more stable macroeconomic environment. Official estimates for 2003-2004, under the PRGF commitments, target inflation at below 5.0% and the fiscal deficit at 6.0% of GDP (both indicators are currently below these targets).

Growing demand for capital goods to fuel expansion of manufacturing, mining, and construction in the private sector will keep the current account under pressure and generate a deficit of about 13% of GDP during the forecast period. It is expected that this will be covered by inflows from international donors and growing FDI, particularly in mining. Increasing capital inflows should lift foreign exchange reserves to a comfortable level of 19 weeks of imports in 2003. Increasing worker remittances, foreign aid inflows, and FDI will strengthen the overall balance-of-payments surplus.

In the fight against poverty, encouraging progress has been made in meeting many of the social sector millennium development goals, an achievement facilitated by the already high level of education established under socialism. Nevertheless, improvements in the key area of poverty reduction are lagging due to low rates of economic growth. To promote a more even distribution of income, the Government should consider paying special attention to improving public goods delivery, intensifying the pro-poor focus of social expenditures, and developing social protection for the very poor.

Sustainable economic growth and poverty reduction will be possible only if concerted efforts are made to develop and strengthen the private sector within the context of a stable macroeconomic environment. However, the accompanying legal framework for the rapidly growing private sector is still weak and needs strengthening.

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