World Bank criticizes 2011 budget proposals

The revised 2011 budget proposal envisages a steep increase in government spending, together with a sharp rise in the fiscal deficit to 8.6 percent of GDP. This budget, if approved, will compound already existing inflationary pressures caused by the sharp economic rebound and the lack of spare capacity in the economy, says the World Bank.

The budget proposal contravenes the Fiscal Management Principles contained in the recently passed Fiscal Stability Law, in particular the principle to aim to create macroeconomic stability and restrain inflation. The World Bank economic analysis strongly suggests that the current budget proposal makes Mongolia set to witness a replay of the 2006-8 boom years, leaving it vulnerable to a bust similar to the one that occurred in 2008-2009.

The 2011 draft budget is inconsistent with the guidelines set out in the Medium Term Budget Framework (MTBF). First, the overall deficit target of 8.6 percent of GDP in 2011 is a significant deviation from the 5 percent deficit ceiling specified in the MTBF. It is also a sharp deterioration compared to the 2.2 percent deficit outcome expected by the IMF for 2010. Moreover, both expenditure and revenue estimates in the 2011 budget proposals are much higher than that of the MTBF baseline scenario. Under the proposal for 2011, general government spending will reach a whopping 50.5 percent of GDP, compared to the 40.4 percent in the MTBF.

The 2011 increase is primarily driven by a 22 percent rise in spending on wages and salaries compared to the 2010 budget (reflecting the 30 percent increase in public sector wages and salaries that took place in October 2010) and a nearly 50 percent increase in spending on transfers.

“We estimate that this budget will add about 15 percent inflation on top of the already existing inflation of around 10 percent. Such a high inflation rate will quickly erode the real value of the cash transfers, making these politically less attractive than they seem today.” noted Rogier van den Brink, Lead Economist for Mongolia, the World Bank. “Moreover, there is a substantial risk of second-round effects in the form of a wage-price spiral as a direct consequence of the expansionary fiscal policy and if higher inflation expectations become entrenched.”

High domestic inflation also causes the currency to appreciate in real terms, hurting the export sectors. For instance, this would hurt both agricultural exports, on which the rural population depends and an already small manufacturing sector.

“With the 2011 budget proposals, Mongolia would be following a well-trodden path adopted by many other resource rich economies, such as the Netherlands (my home country) in the 1960s, after which the infamous “Dutch Disease” is named.” emphasized Rogier van den Brink. These countries provided huge subsidies and transfers to citizens that resulted in upward wage-price spirals that eventually proved difficult to control, fed domestic asset price bubbles (e.g in housing) and severely undermined profitability in the traded sectors. The eventual bust e.g in the case of the Netherlands was severe, requiring comprehensive and painful structural reforms, and the decline in the non-mineral traded sectors proved difficult to reverse.

Another bout of extremely high inflation could also, again, undermine confidence in the currency and the financial system. Mongolia’s banking system remains fragile and a number of problems including undercapitalization, high levels of non-performing loans, and systemic problems of poor governance and risk management systems combined with poor oversight remain to be fully addressed.

Finally, there are significant risks in the global environment. The external risk factors which could set this downturn in motion again include continuing uncertainty in international financial and debt markets, a severe slowdown in growth in developed countries, an external terms of trade shock (commodity prices once again seem to be entering a super cycle and it is hard to ascertain the degree to which commodity price increases over the past year are warranted by fundamentals or not) and a domestic confidence shock to the banking sector that is currently weighed down by high levels of non-performing loans on its books.

In conclusion, this is a risky budget, and the World Bank team hopes it can be adjusted to better reflect the lessons from the previous boom and bust.