Risk Report for

MONGOLIA

2012

MONGOLIA ECONOMIC FORUM ECONOMIC RESEARCH INSTITUTE

The Risk Report for Mongolia -2012 is published by the Mongolia Economic Forum

Contents
Preface ............................................................................................... 5 Introduction ...................................................................................... 3 Section I: Background..................................................................... 4 Section II: Risks ................................................................................ 8 ECONOMIC RESEARCH INSTITUTE II.1. Boom-Bust ycle .............................................................. 10 II.2 Resource urse ................................................................. 15 We are very grateful to Professor and Doctor of Economic Sciences Mr. B. Tuvshintugs, the National University of Mongolia, for his superb research study and invaluable collaboration with the Mongolia Economic Forum (MEF) team on the production of this Report. In addition, this is to express our special thanks to all persons, who have contibuted to the MEF project, and for their early comments on this Report. II.3 Environmental Risks ......................................................... 18 II.4 Political Risks .................................................................... 19 Section III. CONCLUSION .............................................................. 20 References ...................................................................................... 22

Figure 1: GDP, million Togrog Figure 2: real GDP growth, percent Figure 3: CPI inflation, rolling 12 months, percent Figure 4: International Trade, million USD Figure 5: Structural Change in the Economy Figure 6: World prices of major exporting commodities (Jan 2000=100) Figure 7: Nominal Exchange Rate (Togrog per USD) Depreciation and Trade Deficit (million USD) in 2008/2009 Figure 8: Pro-cyclical Fiscal Policy, in million Togrog Figure 9: Pro-cyclical Monetary Policy (inflation, monetary supply growth)

7 7 8 9 10 12 12 13 14

Concept of the Mongolia Economic Forum

The Mongolia Economic Forum (MEF) is an independent, nongovernmental, public organization committed to improving and creating common concept to accelerate development of Mongolia by organizing discussions between the business and political leaders, civil society and scholars. MEF shall invite acclaimed leaders to the Annual Forum Meetings with respect to the social and economic pressing issues and organize discussion on development policy and its implementation. Guests invited will attend the Forum Meetings.

Preface
The World Economic Forum produces and releases on annual basis the Global Risk Report, which provides a thorough analysis of present risks facing the state of the world. Thus, this report is meant to serve as an indispensible handbook for the domestic policy makers and international decision makers. As for our country, the Mongolia Economic Forum in collaboration with the Institute of Economic Studies and Research has prepared and presenting the first risk analysis and assessment study - Risk Report for Mongolia. In the current state of world, where the inter-dependency between national economies and financial markets are deepened and being globalized at rapid pace and prone to on-going crisis, at the same level the relevant risks are interconnected, on one hand. Whereas on the other hand, Mongolian economy is experiencing a mining sector boom, that is expected to continue in coming years at projected furious pace, and which in turn will heat up the fragile domestic economy, it is a daunting task and even greater challenge to identify and nail down the most crucial risks. The main objective of this Report is to assess and explain the key socio-economic issues facing Mongolia, including the on-going hyper economic growth as well as potential cyclical recession, the natural resource curse, environmental vulnerabilities and political risks, and their inter-connectivity. Moreover, it is expected this country risk analysis would be of immense help in bringing about the common understanding and appreciation thereof at the same level by the public policy makers and private decision makers, and ultimately to contribute to prevent whenever possible and to soundly manage these risks. These risks identified and highlighted in the present Report will surely be discussed in line within the framework of main themes during the upcoming annual meeting of the Mongolia Economic Forum -2012. Last but not least, I do hope that this very Report will be a crucial aid to its readers to fully grasp and appreciate the most critical risks imminent in Mongolia, and thus, not to be afraid or avoid the related issues and multitude of current risks, but be able to properly manage and tackle them accordingly.

Ganhuyag Ch. Hutagt Vice Minister of Finance, Secretary General of the Mongolia Economic Forum

COUNTRY RISK PROFILE: MONGOLIA (first draft)

COUNTRY RISK PROFILE: MONGOLIA

Introduction
Mongolian socio-economic conditions changed drastically in the past 15 years. Estimations suggest that the country will undergo even more drastic changes in the near future. For instance, led by significant expansion in the mining sector, the economy is expected to grow by 12%on average between 2010 and 2020. Related to this expected expansion and past experience of significant increase in the mining sector, Mongolia will also face various risks that foreign and domestic investors, producers and policy makers will have to consider carefully in their decision-making. However, in order to ensure that the country develops into a country with a stable and fast growing economy and stable political and environmental conditions, key areas of the Mongolian socio-economic environment that are vulnerable to external and internal risks should be identified. It is equally important for policy makers to carry out regular assessments of country risk so that policy makers can devise and update their policy stance to provide a better protection to investors, the economy and its citizens. This report will aim to identify four different areas of socio-economic environment of the country and risks associated with each of them and discuss inter-linkages of these risks. The report is organized as follows: In section I, we will look at significant changes that Mongolia experienced in the last 15 years by looking at some major macroeconomic indicators. Based on these observations, we will evaluate the current socio-economic environment of the country and 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 implications on socio-economic conditions and inter-linkages between these risks. This section has four parts. The first part discusses the boom-bust cycle that Mongolia experienced in the last 15 years. As the economy grew or declined, there were various risks at play that originated in these cycles and exacerbated them. Since fluctuations in major macroeconomic indicators can be explained by interplay between demand and supply, we concentrate on these two aspects. Firstly, we identify key risks on the demand side as commodity price fluctuations and policy risks that are responsible for rapid fluctuations in the aggregate demand. Secondly, we identify environmental risks as crucially affecting the supply side. Thus, we argue that a combination 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 that the country will face in near future.

Section I:
Background
Mongolian economy expanded rapidly in the last 15 years. In nominal terms, GDP increased tenfold during this period whereas in real terms it increased by twofold. According to World Development Indicator estimates, in nominal USD terms, Mongolian economy grew fivefold from USD 1.2 billion to USD 6 billion during this period. Mongolia was classified as low income country by the World Bank in 1996 with per capita income of USD 512. In 2010, the country is classified as a mid-low income country with per capita income of USD 2252, which implies fourfold growth of per capita income in the last 15 years. Figure 1: GDP, million Togrog
12000000 10000000 8000000 6000000 4000000 2000000 0

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 real GDP (2005 prices) nominal GDP

Sources: International Financial Statistics and National Statistical Office of Mongolia

Figure 2: Real GDP growth, percent

20.00

15.00

10.00

5.00

0.00

1997

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2011

-5.00

Sources: International Financial Statistics and National Statistical Office of Mongolia

COUNTRY RISK PROFILE: MONGOLIA (first draft)

COUNTRY RISK PROFILE: MONGOLIA

Mongolia experiences a volatile GDP growth. As can be seen from Figure 2 above, Mongolias GDP growth fluctuated between a contraction of -1.3% and a growth of 11.3% with an average growth of 5.6% per annum for the period. Between 2003 and 2008, Mongolian economic growth accelerated dramatically averaging 8.7% of growth per annum. In comparison, the lower middle-income countries GDP growth was 6.7% during this period, whereas the transition countries growth averaged 7.6%. It should be mentioned that, in 2009, Mongolian GDP decreased by 1.2% followed by a modest growth of 6% in 2010, significantly below its average growth in the previous years. Looking further into major macroeconomic variables we see similar volatile behavior. Inflation, measured in rolling 12 months, is shown below.

turnover increased from USD 1 billion to USD 6 billion. Figure 4 shows export and import dynamics for the same period in USD. We can see that this explosive growth accelerated between the early 2000s and 2008. Predictably, the composition of exports changed significantly during this period. Mineral exports accounted for 81% of total exports in 2010, whereas the composition of imports was relatively stable.

Figure 4: International Trade, million USD 7000.000 6000.000 5000.000

Figure 3: CPI Inflation, rolling 12 months, percent 60.00 50.00 40.00 30.00 20.00 10.00 0.00
2000 jan 2002 jan 2004 jan 2000 jul 2001 jan 2001 jul 2002 jul 2003 jan 2004 jul 2005 jan 2005 jul 2006 jan 2007 jan 2007 jun 2008 jan 2009 jan 2009 jul 2010 jan 2010 jul 2011 jan 1997 jan 1998 jan 1999 jan 1999 jul 2003 jul 2006 jul 2008 jul 1997 jul 1998 jul 2011 jul

4000.000 3000.000 2000.000 1000.000 0.000

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Exports

Imports

Sources: National Statistical Office of Mongolia and International Financial Statistics

-10.00

Source: Bank of Mongolia

we can see from the figure, Mongolia experienced volatile inflation as well. During the last 15 years, average CPI inflation was 10% whereas its standard deviation was 10%. In comparison, emerging and developing countries for the same period experienced 8% of inflation and a standard deviation of only 2.8%. Thus Mongolia experiences not only a higher inflation rate, but also a significantly volatile inflation. Interestingly, Mongolia is more in line with other transition countries, which averaged 10% of inflation with a standard deviation of 15% according to the World Economic Outlook database. Mongolias financial sector is growing rapidly. The banking sectors total assets accounted for 96% of the financial sectors total assets in 2010. In the last 15 years, the domestic banking systems total assets increased from Togrog 0.2 Trillion to Togrog 5.1 Trillion, or equivalently from 22% to 62% of the GDP. More interestingly, between 2008 and 2010, they drastically increased from Togrog 3.6 Trillion to Togrog 5.1 Trillion or 42% increase in two years. Mongolian stock exchange rapidly increased in the past years as well. Although, the market capitalization is still relatively modest at Togrog 2.4 Trillion (in 2010), which is equivalent to USD 2 billion, it has become one of the most dynamic markets in the world. The top-20 index rose by 233% in 2010 alone, thus making it one of the highest performing markets in the world. Mongolia trades extensively with foreign countries. For the period between 1997 and 2010, Mongolias trade

Mongolia experienced similar explosive growth in Government expenditure. In the last 15 years, Government expenditure rose from Togrog 0.29 trillion to Togrog 3.08 trillion. As a share of GDP, it also grew considerably from 35% in 1997 to 51% in 2009 implying increasing government intervention in the economy. Thus, major macroeconomic variables exhibited high volatility as well as explosive growth, which indicates that the country is undergoing significant changes and perhaps that the country is vulnerable to various risks.

COUNTRY RISK PROFILE: MONGOLIA (first draft)

COUNTRY RISK PROFILE: MONGOLIA

Section II: Risks

The volatility of the magnitude (which magnitude?) that Mongolia experienced in the last 15 years did not favorably affect decision making processes faced by foreign and domestic investors, producers and consumers and policy makers. Since this kind of economic volatility adds unpredictability, it would be interesting to discuss major reasons for these fluctuations. The large swings in major macroeconomic variables such as GDP and prices reflect corresponding large swings in supply and demand of goods and services. Therefore, we can describe factors causing this volatile economic environment by looking further into aggregate demand and supply factors. Mongolian economy has its own characteristics that differ from other countries economies. Therefore, we need to stress unique characteristics of the Mongolian economy, which makes the countrys economy vulnerable to these large swings. On the demand side of the economy, Mongolia experienced large increases as well as large decreases in aggregate demand, which resulted in fluctuations of prices and productions of goods and services. In order to explore the impact of changes in aggregate demand, we need to look carefully at the structure of the economy. Mongolian economy underwent significant structural changes in the past 15 years and became increasingly reliant on the mineral sector. In particular, the share of the mining sector in GDP increased considerably in the past, becoming the biggest sector in the economy in 2010. The following graph shows changes in the structure of the Mongolian economy for the period. Figure 5: Structural Change in the Economy

Big mining projects

The Mongolian-Russian joint venture Erdenet became operational in 1976 with resources of 1.2 billion tons of copper. This venture alone contributes around one third of the government budget and around one fourth of total exports. It produces 130,000 tons of copper concentrate annually and which is exported mostly to China and Europe. More significantly, the country is on the verge of having two mega mining projects operational in the near future. Tavan Tolgoi is one of the largest coal deposits in the world with 4.5 billion tons of confirmed deposits of brown and coking coal. It is expected that by 2020, the mine will produce 10 million tons of coking coal and 40 million tons of thermal coal per year. At todays prices, it is worth more than USD 2.5 billion. After 2020, some estimates suggest that the mine will produce as much as 50 million tons of coking and 200 million tons of thermal coal per year. The government fully owns the deposit and is now in negotiation with the mining operators to make the project operational. The other significant project is Oyu Tolgoi mine. This is a mine with proven and probable deposits of 1.39 billion tons of ore of copper and gold. It is expected that by 2020, the mine will reach its peak of production by producing more than 800,000 tons of copper concentrates and more than 32 tons of gold. It is also expected that the life span of the mine will be 70 years. The Oyu Tolgoi LLC is jointly owned by Ivanhoe Mines LLC (66%) and Government of Mongolia (34%). Investment agreement between Ivanhoe Mines LLC and the Government was signed in October 2009 and it is expected the mine will start its production as early as December 2012.

Thus, Mongolia is expected to significantly benefit from these two new large mining projects. Since the government owns significant shares of both mines and it is expected that the government will increase its share in the future, and that these two mega mining projects will have lasting impact on the country. Before discussing the risks associated with commodity driven economy, it should be mentioned that Mongolia is a landlocked country, which borders with China in the south and Russia in the north. This geographical feature poses the additional challenge of transportation to the country. Because of an underdeveloped transportation infrastructure, Mongolian produced goods are uncompetitive in the international market. This makes it difficult to diversify the economy and leads to a concentration on services and mineral sectors. It has been estimated that the cost of shipping is 3.4 times higher than that of other East Asian countries. As a result, China and Russia are expected to continue to be Mongolias major trading partners. Currently, the trade with China accounts for more than 84% of exports and more than 30% of imports.

II.1. Boom-Bust Cycle

Mongolia is vulnerable to boom-bust cycles and it looks increasingly likely to continue to be vulnerable to these cycles. There are two major reasons for this cyclical behavior. One is risks associated with commodity price fluctuations and the other is heavy pro-cyclical policies that exacerbate cyclical fluctuations. We discussed that the share of the mining sector increased significantly. Although the level of production of minerals increased in the past years, production of major exporting commodities such as copper and gold has been relatively stable since the early 2000s. Namely, production and export of copper concentrates has been stable at the level around 600,000 tons per year, whereas production of gold is estimated to be around 15-20 tons. It should be mentioned that because of windfall taxes imposed on mineral exports, there was a strong tendency among miners not to sell gold to the Bank of Mongolia (the Central Bank) and hence it became difficult to measure the production level of gold with a reasonable accuracy. With coal prices increasing, coal is starting to become a major exporting commodity for the country. The production of coal increased significantly in the last decade. In 2005 Mongolia exported only 2.2 million tons of coal, whereas it exported 16 million tones in 2010. Export of coal accounts for 30% of the total exports overtaking copper as the biggest commodity in exports.

Sources: National Statistical Office of Mongolia

Noticeably, the agricultural sectors share decreased significantly indicating that Mongolia is transitioning from an agriculture based to a mineral based economy. Thus the role of the mineral sector was of paramount importance for the country in the past and it is expected that in the future it will be even more so. Mongolia has vast natural resources. It is estimated that the country has more than 6000 known mineral deposits of 80 different minerals. Mongolias abundance in natural resources makes the country highly competitive in the world market for minerals. Namely, Mongolia has vast resources of coal, copper, molybdenum, gold, zinc, fluorspar and uranium. Out of these, the country produces significant amounts of copper, gold and coal, which have deep impact on the whole economy.

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In the past years not only the level of commodity production increased, prices of Mongolias major exporting commodities significantly increased as well. Figure 6: World Prices of Major Exporting Commodities (Jan 2000=100)
900 800 700 600 500 400 300 200 100 0 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3

From Figure 7, we see that the trade deficit led the exchange rate to depreciate significantly in April 2009. During the first few months of the crisis, especially between September 2008 and April 2009, the Bank of Mongolia intervened in the foreign exchange market to fend off the sudden pressure on the Togrog by selling foreign currencies out of its reserves. Inevitably, when the international reserves reached unacceptable low levels of only around USD 500 million, the Bank of Mongolia stopped the intervention and let the currency depreciate. This brings us to policy risks that threaten to exacerbate the boom-bust cycle caused by fluctuations in commodity prices. During the economic boom years before 2008, fiscal and monetary policies were highly pro-cyclical. Because of increasing commodity prices and revenues generated from mineral exports, both public and private demand for goods and services increased. Government revenue increased from Togrog 227 billion or 27.3% of GDP in 1997 to Togrog 3.1 Trillion or 37.3% of GDP in 2010. During this period, dependence of the budget revenue on the mineral sector increased as well. The mineral sector contributed around 6% of the fiscal revenue in 2003 (World Bank (2003)), whereas in 2010 the sector contributed around 25%. More importantly, with increasing revenues, the government implemented pro-cyclical fiscal policies. The government expenditure rose drastically as can be seen from the figure below. As the government spending increased, the structure of the fiscal spending changed as well. In particular, the share of spending on social safety net programs increased. New transfer programs such as Child Money and Newly Wedded Couples were created. Figure 8: Pro-cyclical Fiscal Policy, in million Togrog
12,000,000.0 10,000,000.0 8,000,000.0 6,000,000.0 4,000,000.0 2,000,000.0 1997 1998 1999 2007 2000 2004 2008 2009 2001 2002 2003 2005 2006 2010 GDP 2011 0.0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

GOLD

ZINC

COPPER

COAL

Sources: International Financial Statistics

Fluctuations in prices of commodities or terms of trade shock represent a major risk to the stability of the economy and hence origination of boom-bust cycles. Since the level of production cant be adjusted flexibly and the mineral sector is already a significant sector of the economy and moreover, major mining projects are expected to be operational in near term, fluctuations in commodity prices represent a major risk to the stability of the economy. This source of risk was clearly on display during the 2008/2009 crisis. Because of almost no exposure of the sector to the worlds financial markets, Mongolia did not suffer from the first wave of the crisis. However, because of increasing dependence of the economy on mineral sector and sudden fall of world commodity prices, the country experienced hardships. As revenue from commodity exports took a significant hit, it put pressure on prices, exchange rates, government revenue, international reserves and consequently, on the production and banking sector. In particular, export revenue decreased by 25.6% and total trade turnover decreased by 30.4% in 2009. Because of the negative shock to the countrys terms of trade, the trade deficit was 13.8% of GDP in 2008 and 5.4% in 2009. It imposed drastic pressure on the domestic currency to depreciate. Figure 7: Nominal Exchange Rate Depreciation (Togrog/USD) and Trade Deficit (million USD) in 2008/2009
12 month trade surplus 500.0 1,500.00 0.0
2008 01 04 07 10 2009 01 04 07 10 2010 01 04 07 10 2011 01 04 07 10

Government Expenditure
Source: Bank of Mongolia, National Statistical Office of Mongolia

2,000.00

EXCHANGE RATE

When the world commodity prices tanked in late 2008 and early 2009, the governments revenue took a significant hit by missing the target level by 14% or 5.7% of GDP in 2008. Furthermore it decreased by 6% in 2009 adding a significant pressure on government spending. However, in 2010, as world commodity prices increased the government revenue increased and so did the expenditure. Thus fiscal spending closely followed fiscal revenue, which in turn closely followed the increase of the world commodity prices. The government of Mongolia attempted to break this habit by creating a Mongolia Development Fund, which was designed to collect receipts from windfall tax on mineral exports and one third of it was to be saved for rainy days. However, the fund also financed social safety net 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 policy measure, the government not only did not have resources for stimulus but it also did not have financial resources to maintain the level of

-500.0 -1,000.0 -1,500.0 -2,000.0

1,000.00 500.00 0.00

2008 01 04 07 10 2009 01 04 07 10 2010 01 04 07 10 2011 01 04 07 10

Source: Bank of Mongolia

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spending. When economy was booming government expenditure increased which further boosted aggregate demand and when economy declined government expenditure decreased, which further aggravated the economic decline. Thus fiscal policy was one of the culprits of boom and bust cycles by exacerbating them. Figure 9: Pro-cyclical Monetary Policy (inflation, monetary supply growth) 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 -10.0

the country to experience resource curse symptoms. Resource curse is a phenomenon that refers to an empirical observation that resource abundance does not always translate into economic development. In particular, there are many cases of resource rich countries that failed to materialize its resources into high economic growth, better institutional quality, and in general to increase the well-being of its citizens. For Mongolia, resource curse presents a major long-term risk to the stability of the economy and society in general. There are at least two important aspects that we should carefully consider. First, in terms of long term 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. the mining sector, leads to drastic real exchange rate appreciation, which in turn makes other sectors of the economy uncompetitive in the world market. This loss of competitiveness leads the country to specialize in mineral exports, as well as to concentrate more on the sector of non-tradable goods. Moreover, since goods and services become more expensive in the domestic market, there will be a growing competition for the tradable goods market between domestic and foreign producers. Hence, there will be an increasing pressure on the government to protect domestic producers from foreign competition. Because Mongolia borders with China, who trades extensively and has comparative advantage in many goods and services, and because Mongolia is too dependent on exports of minerals, this risk is expected to pose a real challenge for Mongolian authorities. Some estimates suggest that development of two big mining projects will lead the services sector to drastically expand by 2020, whereas construction and transport services will have an increasing share beyond 2020. (The development of the Oyu Tolgoi copper mine: an assessment of the macroeconomic consequences for Mongolia (2011)) However, it also estimates that agriculture and manufacturing sectors will significantly decline in terms of shares of the GDP by 2020. Thus, in the longer term, the economy might suffer from loss of competitiveness in terms of narrower diversification of the economy and hence, lower economic growth. The second aspect that we want to stress is that there are other risks that can directly lead to resource curse symptoms. Quality of institutions and governance plays critical role in translating resource wealth into a proper economic development. Weak enforcement of law and contracts, bureaucratic hurdles, corruption, weak government accountability and overall, unfavorable business environment all significantly derail the country from fully capitalizing its resource abundance. Unfortunately, Mongolia does not fare well in terms of institutional quality. Various surveys on business environment consistently rank the country low. In many countries, natural resources became a source of rent seeking from political groups and lobbyists. In terms of corruption, Mongolia was ranked 102th out of 179 countries by Transparency International. Indeed, many enterprise surveys specifically cite corruption as one of the major hurdles in business environment. Business Environment and Enterprise Survey by the International Financial Corporation and the European Bank for Restructuring and Development shows that 31.1% of firms mentioned corruption as a major constraint in their activities. There are other institutional shortcomings in the country as well. In terms of law and contract enforcement, the Economic Freedom of the World index by the Frasier Institute

1997

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2011

GPI inflation

2-growth

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

As we mentioned above, the country experienced highly volatile and high level of inflation. Although there were many factors contributed to the inflation increase, one of the main reasons was indeed expansionary monetary policy conducted by the Bank of Mongolia (the Central Bank). For the past 15 years, money supply increased on average by 28.4% on 12 months rolling basis with standard deviation of 15.1%. Interestingly, during the pre-crisis period between 2005 and 2008, the money supply increased twofold. Although, during the period between 2005 and 2007 inflation was on average 7% on rolling 12 month basis, it significantly increased in 2008 reaching average 12 month inflation of 26.7%. Moreover, because of heightened inflation during the crisis, the Bank of Mongolia tightened its policy by raising its policy rate and intervening in the foreign exchange market, which resulted in a 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 boom period money supply increased significantly and accelerated the economic growth, whereas during the economic decline monetary supply was tightened because of high inflation concerns, thus limiting the credit supply and worsening the real sector decline. For Mongolia, demand side risks are closely related to risks associated with fluctuations in the world commodity prices or terms of trade risks, which is the major origin 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 of the economy. We discussed that past experiences suggest that pro-cyclical policies exacerbated the terms of trade shocks further destabilizing the economy and continuing the boom-bust cycle.

II.2 Resource Curse

Boom-bust cycles threaten to destabilize socio-economic conditions in the short to medium term. In the longer run, increasing share of mining sector and increasing dependence on the mineral export might lead

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ranked Mongolia 70th out of 141 countries in 2010. The World Banks Doing Business report ranked the country 73th out of 183 in terms of overall business environment, whereas the World Competitiveness Index by the World Competitiveness Forum ranked it 117th out of 133 countries. Although these surveys were conducted not long after the economic crisis of 2008/2009, they still show symptoms of institutional difficulties firms face. Governance arrangements pose additional challenges for the country. Generally, it is possible to both dampen risks associated with Dutch disease effects and to avoid Resource curse , as several countries showed. However, it also showed that 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 discussed above, which exacerbated the boombust cycle, are one of the symptoms of poor governance in the country further accentuating policy risks. The country is expected to experience significant capital inflow related to the expected boom in the mining sector and the current policy framework for regulating capital inflows will be tested. In other words, the country is susceptible to financial risks. The current regulatory framework does not adequately deal with capital inflow. Capital flight that we experienced during the 2008/2009 crisis happened because of inadequate capital control mechanisms. After the crisis, the policy framework dealing with capital control did not change. Therefore, the country is still susceptible to the large swings of capital flight. There are discussions taking place about what mechanisms of capital control the country should be using and how much government intervention should be allowed. There are two types of capital control that other countries implemented. One is foreign exchange related prudential regulation. These regulations on one hand protect Mongolian banks from exchange rate risks and on the other hand, they also protect the domestic financial market from sudden flow of capital in and out of the country. Currently, banking regulations state that foreign exchange open positions of a bank should not exceed 15% of the banks capital for a single foreign currency and 40% for all foreign currencies. These ratios should be maintained every day. The Trade and Development Bank of Mongolia and the XAC Bank are exceptions to these regulations as the bank was allowed to implement the value at risk model by the Central Bank. Needless to say, since this kind of regulation restricts the banking operation, many banks are interested in value-at-risk models. Therefore, it should be mentioned that if a significant number of banks are allowed to implement value-at-risk models, banks will be vulnerable to un-hedged currency risks which means that risks of untamed fluctuations in capital flow in and out of the country will be more prominent. Since it is expected that the country will be experiencing significant capital inflows, authorities are contemplating further actions on capital control. In particular, imposition of taxes on the capital or unremunerated reserve requirements are control tools of interest.

Because animal husbandry is such an important sector for the domestic economy, drastic climatic changes affect the countrys economy significantly. Severe winters, dry summers and the combination of the two pose real challenges to herders. In the last decade, Mongolia experienced two dramatic climatic changes. During the 2000/2001/2002 and 2009/2010 severe winters (dzud) countrys livestock was severely depleted. For example, during the latest 2009/2010 dzud around 8 million or almost 20% of total livestock was lost. Climate changes crucially affect the food supply and therefore have a destabilizing effect on prices and levels of production. Climatic risks are not man-made and can be at least partially addressed by a proper insurance system for herders. The country also suffers from man-made environmental degradation. In particular, pollution in Ulaanbaatar reaches catastrophic levels during winter, which severely impacts health and life quality of its citizens. According to the Mongolian Social Health Institute estimations, Ulaanbaatar has between 1.5 to 7.8 times higher nitric acid, carbon dioxide and dust particles in the air than the allowed level. Air pollution not only decreases productivity, as it is one of major sources of various diseases and disabilities of labor. It also increases the cost of healthcare. Moreover, in relation to the expanding mining sector, land and water degradation, deforestation and desertification are becoming one of the major sources of unrest in rural areas. Environmental degradation is not sitting well with herders as their livelihood crucially relies on pastureland and good supply of water. It also intersects with political risks, since growing unrest over environmental issues spills over into political movements.

II.4 Political Risks

The aforementioned risks are all associated with economic conditions of the country in general. However, there are other risks that affect the countrys socio-economic conditions. These risks are tightly interconnected with economic, policy and environmental risks, but are not necessarily classified as those. Since 20 years ago Mongolia made a transition from a one party political system into a democratic system, it experienced comparatively stable political life and successfully held 5 parliamentarian and 6 presidential elections. Because of this political stability, the country ranks highly in comparison to other transitional and developing countries. However, with expected increase in the mining sector and in GDP growth, there is a growing concern about future political stability. There have been occasional political demonstrations in the past, especially during the spring, dubbed as spring syndrome. Moreover, after the results of the 2008 election, there was a violent clash between demonstrators and police in front of the winning partys headquarter, resulting in the death of five citizens. Growing revenue from the mining sector may lead to more populist policies such as cash handouts by the ruling party. 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 the policy risks we discussed before, test the willingness of the ruling party to self restrain and conduct policies that are beneficial to citizens in long run. On the outside, because Mongolia borders only with China and Russia, it is highly dependent on these countries economically and perhaps to a lesser extent, politically. Mongolia seeks a balanced approach towards the interests of its neighbors, but it also seeks close relationship with other countries through its third neighbor policies.

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 are environmental risks. The agriculture sector was a dominant sector for the Mongolian economy in the 90s and is still an important sector for the economy accounting for 23% of GDP in 2010 and employing around 30% of the population. The Mongolian agriculture sector primarily consists of livestock, which represents around 90% of the sector. The contribution of agricultural products to the countrys exports is also losing its significance. In early the 2000s, export of agricultural products were around 5% of total exports whereas in 2010, it accounted for less than 2%.

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COUNTRY RISK PROFILE: MONGOLIA

Section III. CONCLUSION

In this report, we discussed major risks the country faces and inter-linkages of these risks. Past experiences show that Mongolia is vulnerable to various risks and this vulnerability is reflected in volatile behavior of major macroeconomic indicators. Since volatile interplay between aggregate demand and supply results in a volatile behavior of the whole economy, we identified key factors that affect demand and supply. On the demand side we identified boom-bust cycles as a major impediment to the stability of the economy. There are two contributing aspects to these cycles. One is in terms of trade risks. Past experiences show that fluctuations in terms of trade are major origin of shocks to the economy and a major driver for aggregate demand. The other is policy risk. We discussed that past experiences suggest that pro-cyclical policies exacerbated the terms of trade shocks further destabilizing the economy and continuing the boom-bust cycle. These two risks pose key risks to volatile aggregate demand. Moreover, in the long run, there are two important issues we have to consider carefully. First, the country is vulnerable to Dutch disease effects. Because it leads to real exchange rate appreciation, the economy is exposed to loss of competitiveness in terms of narrower diversification and hence lower economic growth. Secondly, we stress that the quality of institutions and governance plays a crucial role in translating resource wealth into proper economic development. In particular, weak enforcement of law and contract, bureaucratic hurdles, corruption, weak government accountability and overall, unfavorable business environment all might significantly derail the country from fully capitalizing its resource abundance. Pro-cyclical policies that we discussed above, which exacerbated the boombust cycle, are one of the symptoms of poor governance in the country further accentuating policy risks. We also argued that the country is susceptible to financial risks and the current regulatory framework does not adequately deal with capital flows. In particular, it needs to be adjusted to properly deal with the expected inflow of foreign capital. Environmental risks pose added challenge to the stability of the country. We stressed that the country is susceptible not only to natural disasters, but it also is becoming increasingly vulnerable to man-made environmental degradations such as urban pollution, deforestation and land and water degradation. Moreover, the country is exposed to some political risks. We discussed that although past experience suggest that the country enjoys a stable political system, increasingly populist policies conducted by the government and environmental degradation because of mining, may become a source of political risk in the future.

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