Wednesday, May 28, 2014

Growing Pains: An external analysis of the Mongolian economy

By James Watkins

It is immediately clear to all external observers that Mongolia’s is a unique and fascinating economy. With the fifth highest growth rate in the world in 2013 according to the CIA World Factbook, Mongolia’s ongoing rapid transition from nomadic agriculture to booming industry, and from a planned economy to competitive markets, ever since the democratic revolution in 1990, makes the country a hugely interesting case study for an economist.

However, it is clear that the economic outlook is not all rosy. High inflation creates economic uncertainty, erodes wealth, and imposes unnecessary economic inefficiencies, all of which deter valuable investment, as well as diminishing the proceeds of growth that improve individuals’ living standards. Inflation threatens to derail the economy, as Mongolia increasingly becomes a less attractive recipient of foreign investment.

What problems face Mongolia?

The economy faces dual issues that create the need for both short-term and long-term strategies. The deeper issue is one of economic dependence on export revenues from primary industry (mining) and therefore the country relies on importing most of its manufactured goods, resulting in an unbalanced economy that is vulnerable to external shocks. This is exactly what has happened over the last few years in Mongolia – the business cycle has been almost wholly determined by the mineral demand of its main trading partners, Russia and China, which dipped substantially in 2007-2009, causing an economic crisis in Mongolia. This vulnerability and lack of balance must be tackled by long-term structural plans and fiscal policies pioneered by the government to change the emphasis of economic activity in the country.

The secondary problem is a consequence of the former: high inflation and a rapidly depreciating exchange rate,which are both threatening to run out of control. This must be tackled with short-term monetary policy changes led by MongolBank to stabilize the economy, but should not be considered impetus to change the necessary long-term economic strategy.

What needs to change?

Mongolians often despair that the government is pursuing policies for decades in the future while they see prices rising in the shops week by week, with annual CPI (Consumer Prices Index) inflation rate running at over 12 percent for several months, according to MongolBank, Mongolia’s central bank. There is a very real dilemma here, as structural economic reform is necessary. Consumers’ current woes are clearly a product of structural issues, as inflation is being caused by a weakening MNT as a result of the balance of payments deficit (imports are greater than exports), so the resulting low demand for the MNT makes the currency fall in value). This requires a long-term readjustment to improve the balance of payments by basing more production locally to boost exports and decrease reliance on imports. This would both strengthen the MNT directly, and also ensure that future international shocks, either from rising import costs or falling foreign demand, will have less of an inflationary impact in Mongolia.

However,it is clear that short-term instability in the form of inflation could weaken the strong growth of the last few years, so in addition to this long-term plan, more immediate action must also be taken now to tame inflation.

What policies can achieve both of these goals?

The trade-off between structural reform and short-term prosperity is not as stark as it currently seems. Firstly, accepted economic wisdom since the 1980s holds that the most important tool to tackle short-term inflationary issues is monetary policy. There is a proven link between money supply and prices, and monetary policy has faster effects than other policy options. Therefore, MongolBank should take bolder steps to reign in inflation and to control the exchange rate, as the IMF has proposed. In 2013, the IMF called for MongolBank to tighten monetary policy by halting its mortgage program and price stabilization program which have pumped excess liquidity into the economy, encouraging currency depreciation and inflation. Both programs are still in place. Reversing these policies, as well as more aggressive raising of interest rates to combat inflation, are steps that can quickly and effectively control the immediate inflationary crisis facing Mongolia.

Secondly, the long-term economic strategy that the government is currently pursuing should be promoted using different mechanisms. Currently, approaches such as the “Let’s Construct and Create in Mongolia” program involve high government spending, investment and effective subsidies, all of which create large government budget deficits, only worsening short-term inflation.

According to the IMF, government expenditure increased by 70 percent from 2010 to 2012 – an unsustainable strategy. Instead, incentives to promote domestic production could be created through a discretionary tax system, giving tax breaks to companies in desirable industries (those that manufacture goods locally, to replace imports), and increasing tax revenues in other areas. Industry incentive tax credits have been implemented in many successful economies, principally the United States. This policy shift would achieve the same end-goal that the government is already targeting, while lessening the negative short-term consequences that high government spending currently has.

An external perspective of Mongolia in the world economy

Economists often refer to the “resource curse,” a paradigm whereby most countries rich in natural resources suffer from worse development outcomes than countries who have to import minerals and fuel. This is because the resource-rich economies are excessively biased towards primary industries, leaving the nation open to turbulent and destructive boom-and-bust cycles, as well as the fact that prices rise faster in secondary products than primary goods. Whereas economies across Africa demonstrate the negative consequences of this, other nations such as Norway and the UAE show that an alternative sustainable and prosperous future is possible for resource-rich nations, so long as there is effective macroeconomic management. As these nations have shown, this involves government-sponsored investment in more diversified industries such as manufacturing and services, funded by efficient taxation policies.

All of this can be summarized as targeting sustainable growth. Mongolia’s extraordinarily high growth rates of recent years are to be admired, but they are difficult to achieve continuously without experiencing the negative externalities associated with growth—inflation, environmental degradation, underinvestment in both physical and human capital, and of course the bust that inevitably follows the boom.

Mongolia is well situated for the transition towards diversification and sustainability. Compared to other economies of the same size, Mongolia has a very successful education system (with high levels of numeracy and literacy) and a sound financial system, both of which act as a strong basis to allow a more diversified economy to flourish. The increasing prosperity of all Mongolians will surely be a consequence of this more balanced economic strategy.

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