The Financial Crisis That Originated in the US Sub-Prime Mortgage Market, Engulfed Many

Country case study on the Impact of the Global Financial Crisis

in Asia and the Pacific

Case of MONGOLIA

Tuvshintugs Batdelger (PhD)

08/29/2009

Table of contents2

Executive summary3

List of graphs6

List of abbreviations7

I.Preface8

II.Pre-crisis Mongolian economy10

II.1Production sector11

II.2Foreign Direct Investment and remittances12

II.3Fiscal policy13

II.4International Trade16

II.5Monetary policy and inflation17

Mongolian economy during the crisis and government’s 20

mitigation policies

III.1 Real sectors of the economy are slowing20

III.2Global financial and economic crisis is affecting 21

Mongolian economy mainly through foreign trade

III.3Mongolia’s fiscal balance was hit hard; 22

the Government of Mongolia took several policy

actions to mitigate adverse effects

III.4Monetary policy actions23

III.5International financial organizations and donor 25

countries pledged help to the Government of Mongolia

IV.Employment, Poverty, Education and Health26

IV.1Employment26

IV.2Unemployment29

IV.3Poverty30

IV.4Health Sector33

IV.4.1Health Spending35

IV.5Education37

IV.5.1 Changes in educational results37

IV.5.2 Changes in educational service provision 40

V.Impact of the economic crisis on social safety 43

net programs and social insurance

V.1Social Insurance44

V.2Pension Insurance47

V.3Health Insurance49

V.4Social assistance fund50

VI.Conclusion53

Executive Summary

Mongolia has been hit hard by the current worldwide economic and financial crisis. We believe that Mongolia’s increasing dependence on primary goods’ exports made the country vulnerable to external shocks at the onset of the crisis.

The crisis affected Mongolia primarily through a sharp deacrease in its terms of trade.

Mongolia’s expansionary monetary policy between 2004 and 2007 led to sharp increases in inflation in 2008, reaching at one point 33%. Mongolia’s trade revenue from copper, coal and zinc decreased significantly in the second half of 2008, which resulted in over USD 1 billion trade deficit. The trade deficit has put national currency Togrog under significant pressure to devalue.

Rising inflation and unstable nominal exchange rate led the Bank of Mongolia to significantly tighten its monetary policy. As of June 2009, inflation is at low 4.5% and nominal exchange rate stabilized. We believe that monetary authority’s past tolerance to inflation around 10% and its expansionary policy bias makes the country vulnerable to future inflation.It is recommended that the Bank of Mongolia needs to consistently focus its policy on maintaing infaltion rate at low level in medium and long term.

Government budget revenue significantly decreased. In 2008, government budget deficit reached 5% of GDP. As of June 2009, government revenue decreased by 20% in comparison to the same period last year. The Government is reducing its spending from the intitally planned level in order to keep the budget deficit within the target level of 6% of GDP. We believe that with stabilizing and growing copper prices and loans from international financial organizations and donor countries, the Government is capable of maintaining the budget deficit within this target level. We recommend that the Government needs adopt “automatic fiscal stabilizer” in order to break the current pro-cyclical fiscal policy.

Latest survey on poverty indicated that the poverty incidence did not decrease substantially during the last five years of high economic growth, which stands at 35.2% as of 2008. The Government of Mongolia’s major strategy to combat the poverty concentrated on providing financial assistance to the poor through social assistance programs. We expect the current economic crisis will have a significant negative effect on poverty incidence since economic growth is expected to be in 2% range in 2009.

In the health sector, MDG targets for maternal mortality ratio, TB prevalence and number of deaths related to TB are not met and needs to be reduced further.

The current economic crisis is decreasing the accessibility of poor to the health care services. Although primary health care is provided for free to all, it is a common practice for patients to pay extra fees out of their pockets.Overall, there is a very limited data evidence on how the economic crisis is affecting the health care. The number of registered patients slightly increased by 1.6% in the first half of 2009 in comparison to the same period in 2008.

Although current economic crisis will have a negative impact on health expenditure, the most pressing need in this sector is to continue the structural reform that is already taking place.In particular, a decisive strategy needs to be devised with regard to the health insurance’s role in the country’s health sector financing. Needless to say, the Government spending on health care in Mongolia is one of the highest among countries with similar income level.

Government spending on education sector is expected to be at around 2008 level. Although real spending in the first half of 2009 decreased by 7 percent, in nominal terms it is expected to increase by 4 percent in 2009. The Government is committed in shielding the education sector from adverse effects of the economic crisis. It is difficult to find any hard evidence on the effect of the current economic crisis on education. We noted that enrollments in middle and high schools dropped substantially nationwide. Since the data is collected only once a year at the end of academic year, we can not attribute this total decrease to the school drop outs caused by the economic hardship only.

Spending on social safety nets increased drastically during the years of high economic growth. Current economic crisis is negatively affecting the financing of these programs.

Mongolia is in the process of setting up a self-sustaining social insurance system which incorporates pension, health, unemployment, social benefit and industrial accident and occupational disease insurance programs with separate funds.Although, in the current economic environment the Government finds it hard to fulfill all its commitments, we strongly believe that the government will have all necessary resources to support social insurance payments.However, we recommend that the government need to clarify and improve the calculation of contributing insuree’s pension payments and its duration to have a self-sustaining social insurance system at the same time keeping pension payments at current level.

Transfers from social wealth fund severely affected by the current crisis. Since 2004, several new social transfer programs such as “Child Money”, “Newly Born Babies” and “Newly Wedded Couples” were initiated. They constitute almost 9% of total government expenditure. From various interviews given by government officials, we have an impression that there is no strong commitment to keep the current level of transfers. In particular, some of these transfers are expected to halt if Mongolia Development Fund runs out of money.

One of the criticisms about these transfer programs is that they are not specifically targeting the poor. In the last few years several social transfer programs were initiated. However, these programs have high leakage to the population above the poverty line. Therefore, our recommendation is to enhance these programs with better targeting of the poor.

We believe that the effect of the crisis on the real economy is still being realized. In particular, unemployment increased significantly in the first six months of 2009. Although official data shows unemployment level of 3.4 percent, it is widely accepted that this official data significantly underestimates the true unemployment level.

List of Graphs

Graph 1: Prices of major commodity exports11

Graph 2: GDP by production sectors: In current prices12

Graph 3a: Government expenditure structure: In current prices14

Graph 3b: Government expenditure between 2004 and 2008: In current prices14

Graph 3c: Real growth of Government expenditures: In percent15

Graph 4: Government budget balance16

Graph 5: International trade and trade balance 17

Graph 6: Interest rates, money supply growth and CPI inflation18

Graph 7: Employment elasticity of growth, real GDP and employment growth27

Graph 8: Composition of total health expenditure35

Graph 9. Enrollments in primary, secondary and high schools, by location39

Graph 10. Changes in current and investment expenditure of the MESC41

Graph 11: Share of Social Safety Net programs44

Graph 12: Shares of social assistance fund revenue and spending 46

Graph 13: Health insurance fund revenue and expenditure49

Graph 14: Shares of social assistance fund revenue and spending51

List of Abbreviations

FDI Foreign Direct Invesment

HIES/LSMSHousehold Income and Expenditure Survey/Living Standards Measurement Survey

HIF Health Insurance Fund

HSES Household Socio-Economic Survey

IMF Interantional Monetary Fund

MDG Millennium Development Goal

MESCMinistry of Education, Science and Culture

MOF Ministry of Finance

MOH Ministry of Health

MHDR Mongolia Human Development Report

NDS National Development Strategy

NGO Non-Government Organization

NSO National Statistical Office

SME Small and Medium Enterprises

USDUS Dollar

I. Preface

The financial and economic crisis that was originated in the US sub-prime mortgage market engulfed many countries into economic difficulties across the world. Globalization of the past few decades made countries deeply integrated through its financial and economic interactions. Although globalization brought economic development and prosperity to many corners of the world, it also brought economic hardship to these countries through the same channels.

First victims of the economic crisis were developed countries with its deep interconnected financial markets. Developing countries are becoming increasingly vulnerable as the economic crisis drags on. Mongolian financial system is not deeply interconnected to the world financial system. Therefore, first wave of global financial crisis did not have deep impact on Mongolian economy. Mongolia is a net exporter of primary goods. As Mongolia’s major trading partner countries’ real economy hit by the crisis, the derived demand for Mongolian export goods decreased, depressing the price of its major exporting goods. This decrease in terms of trade makes Mongolian economy increasingly vulnerable as the world economic crisis continues.

In general, we can classify transmission channels through which economic and financial crisis affect developing countries into two categories. One is direct channels. Since countries’ economies are becoming increasingly interconnected through financial products and innovations, difficulties in the world financial market affect developing countries through depressed stock markets and volatile currency markets. The second channel can be described as indirect channels. Developing countries are being affected through depressed terms of trade, remittances, foreign direct investment.

In this study, we first discuss Mongolia’s pre-crisis economic condition, major trends in the real economy and in the economic policy making. We argue that current economic crisis is affecting Mongolian economy predominantly through indirect channels. We determine which channels play dominant roles in current economic difficulties. Next we discuss policy actions taken by the Government of Mongolia and the Bank of Mongolia (the Central Bank) to minimize impact of the crisis. Based on these discussions, we explore policy options that would mitigate the impact of the current economic crisis. This is especially important for instituting economic policies to make Mongolian economy less vulnerable to similar economic disturbances in the future.

Current economic difficulties started affecting social aspects of the country through sluggish real economy, high inflation and reduced government spending. In particular, sluggish economy is resulting in high unemployment. Official data on unemployment is increasing. However, it is widely accepted that the data underestimates true unemployment. Although we know unemployment is increasing, there is no reliable data on unemployment and we have no clear idea how much unemployment is being affected by the economic difficulty. High inflation reduced the real social spending on health, education and social transfers.Health and education sectors in Mongoliaare highly subsidized by the Government.There is no clear indication that the government spending on health and education is decreasing because of economic crisis. The Government is committed to keep the spending on health and education at the pre-crisis level. Although the Government is reducing its total spending to keep the fiscal deficit at thetarget level, we believe that the spending on health and education will not be significantly affected.These sectors, however, are in need of significant structural changes to provide the country with more efficient and better quality services.

Government spending on social transfers are affected by the current economic crisis. These transfers are the major mechanism for the Government of Mongolia to combat poverty. During economic boom years government social spending significantly increased through several social transfer programs. However, it proved to be a difficult task to keep the level of social transfers at pre-crisis level during the economic difficult times. We expect some impact on these social transfers since the Government is reducing its expenditure level.

This report is organized as follows. Chapter II describes pre-crisis Mongolian economy. We believe that Mongolia started getting severely affected by the global financial and economic crisis in August/September 2008.Therefore, we describe the economy as of the end of 2008 assuming the real sector takes some time to get affected by the crisis. Chapter III discusses the macroeconomic impact of the crisis and government’s mitigation policies. Chapter IV discusses the effect of the economic crisis on poverty, employment, education and health. Chapter V describes the effect of the crisis on social safety net programs. Chapter V concludes.

II. Pre-crisis Mongolian economy

Mongolian economy faced severe economic difficulties in early to mid 90’s. Mongolia had triple digit inflation with a rapid slump in economic activity. However, these difficulties were not caused by external shocks, rather it was a direct result of the structural reforms the country was undertaking. In contrast, the origin of today’s economic difficulties was independent of the country’s domestic economy. It was “imported” from the global market.

Mongolia is a country in transition. Populated by 2.7 million people, it has its own unique characteristics. The transition from a centrally planned economic system to a market based economic system has been difficult and challenging. Fundamental reforms such as privatization of state owned companies, price liberalization, establishment of market based institutions have taken place in the last nineteen years. Needless to say, Mongolia is achieving a self sustaining market based open economy.

During the years of transition, Mongolian government policies have been geared toward stabilizing macroeconomic conditions as well as adopting and instituting market based economic policies. Although it is true that Mongolia went through severe socio-economic obstacles in the early years of transition, there has been a great advancement in Mongolia’s macroeconomic performancesincemid 90s. Real economic growth averaged more than 6% in the last 13 years and macroeconomic policies have generally been prudent with decreasing foreign debt, manageable fiscal deficit (mostly surplus), increasing international reserves, moderate inflation levels and rapid increases in foreign direct investment.

However, we should note there are two main characteristics to Mongolian economy. Combination of these two presents the country with its own advantages and disadvantages.

Mongolia is a landlocked country, which borders with China in the south and Russia in the north. Poor transportation infrastructure makes Mongolian produced goods expensive and uncompetitive in the international market. Because of the geographic location, shipment of goods must be transported by land and through neighboring countries. 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 Mongolia’s main trading partners, which are developing countries themselves. China has become Mongolia’s biggest trading partner, accounting for more than 60% of exports and more than 30% of imports. China tends to import raw, primary goods and export manufactured goods. Mongolian producers must directly compete with Chinese manufacturers.

On the other hand, Mongolia is a country with vast natural resources. It was estimated there are over 6000 known mineral deposits of 80 different minerals. Mongolia’s abundance in natural resources makes it increasingly reliant on these natural resources.

The combination of these two factors determines the dynamics of Mongolian economy. For the past four years, Mongolian economy grew rapidly at an annual rate of 9%. Income per capita grew from USD721 to USD1290, which classifies Mongolia as a lower-middle income country according to the World Bank classification. Mongolia’s total GDP denominated in USD grew from 1.8 billion in 2004 to 5.2 billion by the end of 2008.

The growth of this magnitude came about because of increase in prices of minerals. In particular, prices of Mongolia’s main exporting commodities such as copper and gold grew 2-3 fold during this period. (See Graph 1) Because of these favorable conditions in global primary goods’ market, the real economy became increasingly reliant on exports of these two commodities, which currently constitute 57% of total exports. Moreover, exports of top 6 commodities (copper, gold, cashmere, coal, oil and zinc) accounted for 81% in 2008. Export revenue grew on average 30% annually for the last four years. As of 2008, total export was equivalent to 48% of GDP.

Graph 1: Prices of major commodity exports

Sources: International Monetary Fund

Export of copper is particularly important to the country’s economy. Copper is exclusively mined by a company called “Erdenet”, a joint venture with Russia where Mongolian government owns 51% of the company. Copper exports account for roughly half of total export and a quarter of GDP. Moreover, dividend and tax payments of the “Erdenet” account for one third of the government revenue. Increasing copper prices made copper exports one of the most important sources of revenue for the Government of Mongolia.

II.1Production sector

The combination of the two main economic characteristics makes Mongolia a net exporter of commodities and a net importer of manufactured goods. Mongolia is also a net food importer, which makes the country’s consumer prices susceptible to changes in foreign food market andin foreign exchange rates.Because of favorable changes in terms of trade, the domestic production sector is becoming more concentrated towards the mining and agricultural sectors. The following graph illustrates the point.