MONGOLIA ECONOMIC UPDATE Navigating Stronger Headwinds Special Topic – Fiscal Sustainability of the Mongolian Pension Scheme April 2022 MONGOLIAECONOMIC MONGOLIA UPDATE ECONOMICUPDATE Navigating Navigating stronger stronger headwinds headwinds April April 2022 2022 This report is a product of the staff of the International Bank for Reconstruction and Development / The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this report do not necessarily reflect the views of the World Bank, the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this report. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. 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Mongolia Economic Update – April 2022 Contents ABBREVIATIONS AND ACRONYMS........................................................................................................................1 ACKNOWLEDGEMENTS............................................................................................................................................. 2 EXECUTIVE SUMMARY .............................................................................................................................................. 3 I. ECONOMIC PERFORMANCE AND PROSPECTS ..................................................................................... 10 A. Recent Economic Developments .......................................................................................................... 10 A1. A sluggish recovery in 2021 ................................................................................................................ 10 A2. Despite slight improvements, labor market conditions remained weak .............................. 14 A3. Rising inflation complicates monetary policy management .................................................... 16 A4. The fiscal deficit narrowed notably in 2021 amid a one-off tax arrears collection but is expected to widen in 2022 ......................................................................................................................... 19 A5. Rising external pressures amid widening current account deficit ......................................... 24 A6. Conditions in the banking sector have improved but challenges remain ............................ 26 B. Outlook and Risks ...................................................................................................................................... 30 II. FISCAL SUSTAINABILITY OF THE MONGOLIAN PENSION SCHEME .............................................. 40 A. Mongolia has a relatively generous pension scheme with high levels of coverage and unsustainable fiscal costs ................................................................................................................................ 41 A1. The Pension Insurance Scheme is effectively universal for retirees with generous replacement rates and modest contribution rates .............................................................................. 41 A2. The current pension scheme requires substantial state subsidies and faces escalating projected fiscal costs..................................................................................................................................... 44 A3. Recent increases in minimum pensions further erode the contributions-benefits nexus as well as fiscal sustainability ............................................................................................................ 45 A4. Fiscal costs could be reduced by changes in parameters .......................................................... 46 B. Benefits and pitfalls of the new proposed scheme: A Funded Defined Contribution Scheme ................................................................................................................................................................... 47 B1. Potential Objectives of an FDC scheme – lessons for Mongolia ............................................ 47 B2. An optimal pensions scheme should balance risks and benefits and curb escalating fiscal costs .................................................................................................................................................. 50 ANNEX ......................................................................................................................................................................... 52 References ................................................................................................................................................................. 56 i MONGOLIA ECONOMIC UPDATE – April 2022 List of boxes, figures and tables Boxes Box I.1. Assessing the impact of the recovery package on employment .............................................. 16 Box I.2. Fiscal Relief Measures ............................................................................................................................ 23 Box I.3. Mongolia’s Market for Coins and Other Virtual Assets ................................................................ 29 Box I.4. Global and Regional Outlook and Risks ........................................................................................... 31 Box I.5. The New Recovery Policy ...................................................................................................................... 32 Box I.6. Why Central Bank Independence Matters........................................................................................ 34 Box I.7. Preliminary assessment of the impact of the war in Ukraine on Mongolia.......................... 36 Box II.1. Description of the Pension Insurance Scheme of Mongolia..................................................... 42 Box II.2. Draft Pensions Legislation Submitted to Parliament ................................................................. 47 Box II.3. Principles of an FDC Scheme and its Applicability to Mongolia ............................................. 48 Box II.4. Mongolia needs a regulatory framework for private, voluntary supplementary pensions ....................................................................................................................................................................................... 49 Box A.1. Preliminary impact assessment of petrol price changes on food, housing, and transport prices ........................................................................................................................................................................... 52 Box A.2. Characteristics of Government Managed National Provident Funds ..................................... 53 Figures Figure ES.1. Key indicators ..................................................................................................................................... 6 Figure ES.2. Key indicators (continued) ............................................................................................................... 7 Figure I.1. Gross capital formation supported the aggregate demand … .............................................. 10 Figure I.2. … and was increasingly driven by large coal inventories buildup amid border frictions in H2 2021 ................................................................................................................................................................. 10 Figure I.3. Household consumption contracted, dragging down final consumption ….................... 11 Figure I.4. … as elevated inflation eroded real incomes despite government income support to compensate pandemic-stricken households’ labor income ....................................................................... 11 Figure I.5. Households cut their non-food expenditure to preserve food expenditure.................... 12 Figure I.6. Consumption contracted despite decelerated saving, as saving is concentrated mostly among non-poor HHs with a lower propensity to consume ..................................................................... 12 Figure I.7. Net exports contracted … ................................................................................................................. 12 Figure I.8. … as exports weakened and imports recovered ....................................................................... 12 Figure I.9. On the supply side, growth in 2021 was supported mainly by services and net taxes ....................................................................................................................................................................................... 13 Figure I.10. Mining sector contracted sharply in H2 as coal inventories built up .............................. 13 Figure I.11. Manufacturing, trade, and services were the main contributors to non-mineral GDP growth in Q1 ............................................................................................................................................................. 14 Figure I.12. Broad-based contraction in construction activities in 2021 .............................................. 14 Figure I.13. Job loss was significant in the services sector … ................................................................... 15 Figure I.14. … however, labor force participation is starting to recover ............................................... 15 Figure I.15. Total employment could have been lower without the economic stimulus ................ 15 ii Mongolia Economic Update – April 2022 Figure I.16. Employment counterfactuals using different approaches .................................................. 16 Figure I.17. Food and fuel prices drove headline inflation in Ulaanbaatar … ..................................... 17 Figure I.18. … especially imported goods contributed to surging inflation ......................................... 17 Figure I.19. Mining prices, a key driver of PPI inflation, exhibited a limited pass-through to CPI inflation … .................................................................................................................................................................. 17 Figure I.20. … meanwhile, non-mining producers shifted the higher costs to the end consumers ....................................................................................................................................................................................... 17 Figure I.21. MNT liabilities support M2 growth … ........................................................................................ 18 Figure I.22. … while NDC is driving on the asset side ................................................................................. 18 Figure I.23. The BoM belatedly embarked on a tightening cycle but … ................................................ 19 Figure I.24. … despite the recent hike, Mongolia’s real interest rates remain negative and lowest in the region .............................................................................................................................................................. 19 Figure I.25. Social welfare spending dominated government expenditure ......................................... 20 Figure I.26. Revenue performance was supported by OT tax arrears collection and robust tax revenue intake, reflecting expiry of COVID-related exemptions and higher commodity prices ... 20 Figure I.27. Budget deficit narrowed in 2021, but is expected to widen in 2022 .............................. 21 Figure I.28. The revenue projections in the 2022 budget are optimistic.............................................. 21 Figure I.29. The size of external bonds maturing during 2023–24 period is significant ................ 22 Figure I.30. Mongolian sovereign bond yields are on an increasing trend .......................................... 22 Figure I.31. COVID-19 Fiscal relief measures ................................................................................................. 23 Figure I.32. Widening current account deficit led to a BOP deficit … .................................................... 24 Figure I.33. … as the import bill and profit repatriation increased ......................................................... 24 Figure I.34. Investment, consumption and fuel dominated the imports bill … ................................... 25 Figure I.35 … while high commodity prices mainly supported nominal exports ............................... 25 Figure I.36. BoM’s supply of FX intensified in the second half of 2021 ................................................ 25 Figure I.37. Real effective exchange rate (REER) has been appreciating ............................................. 25 Figure I.38. Dollarization of current account jumped in February 2022 ............................................... 26 Figure I.39. FX Rationing amid deteriorating market expectations widened the spread between non-bank and interbank exchange rates ......................................................................................................... 26 Figure I.40. Income relief and stimulus program supported resumption of bank lending.............. 27 Figure I.41. Problematic loan ratios are converging back to their pre-pandemic levels ................. 27 Figure I.42. Ratio of problematic loans and provisioning rate (SME & Corporate Loans) ............... 27 Figure I.43. Ratio of problematic loans and provisioning rate (Household Loans) ............................ 27 Figure I.44. Banks appear adequately capitalized ….................................................................................... 28 Figure I.45. … while overall liquidity remains high...................................................................................... 28 Figure I.46. Net open position-to-capital ratio improved, indicating mitigation of FX risk ........... 28 Figure I.47. Balance sheet FX risk is partially-hedged by off-balance sheet contingent assets ... 28 Figure I.48. Role of NBFI increased in recent years ..................................................................................... 29 Figure I.49. The stock market is also booming .............................................................................................. 29 Figure I.50. Market capitalization (Coins) ........................................................................................................ 29 Figure I.51. Market capitalization (VASPs)....................................................................................................... 29 Figure I.52. Global developments ...................................................................................................................... 32 Figure I.53. Mongolia’s CBI in 2012 was below average in terms of legal measure ......................... 34 Figure I.54. Similarly, the measure for Mongolia in 2014 was below the average ........................... 34 iii MONGOLIA ECONOMIC UPDATE – April 2022 Figure I.55. Fuel imports constitute more than half of imports from Russia ....................................... 36 Figure I.56. Mongolia relies mainly on imports of fuel and fertilizers from Russia .......................... 36 Figure I.57. Global prices of key imported goods spiked ........................................................................... 37 Figure I.58. BoP pressure led to a shortage of FX and banks’ FX rationing ......................................... 37 Figure I.59. The growth forecast in 2022 was downgraded due to several factors .......................... 37 Figure II.1. Coverage of the labor force by pension contributors has been high ............................... 41 Figure II.2. Mongolia’s coverage of elderly is effectively universal as in former Soviet countries ....................................................................................................................................................................................... 41 Figure II.3. Replacement rates in Mongolia are among the highest relative to comparators … ... 42 Figure II.4. … characterized by lower contribution rates ............................................................................ 42 Figure II.5. Replacement rate is expected to be significantly lower for the cohort born after 1978 ....................................................................................................................................................................................... 43 Figure II.6. Financing gap is expected to increase under the current system ..................................... 44 Figure II.7. Retirement age in Mongolia remained unchanged despite increasing life expectancy ....................................................................................................................................................................................... 45 Figure II.8. Parametric reforms will help improve the financial sustainability ................................... 46 Figure II.9. FDC Scheme - Projected fiscal costs of a full conversion to FDC and one hybrid option .......................................................................................................................................................................... 50 Figure A.1. Scatterplots, histograms, and Pearson correlations ............................................................... 52 Tables Table ES.1. Selected macroeconomic indicators ............................................................................................. 5 Table I.2. Selected indicators of the consolidated budget ........................................................................ 22 Table I.3. Key macroeconomic indicators ........................................................................................................ 31 Table II.1. Parameters of the minimum pension ........................................................................................... 43 Table A.II.1. Parameters of Mongolia’s pension insurance scheme ........................................................ 54 Table A.II.2. Establishment, parameters, and reversals of FDC schemes in Central and Eastern Europe ......................................................................................................................................................................... 55 iv MONGOLIA ECONOMIC UPDATE – April 2022 ABBREVIATIONS AND ACRONYMS MONGOLIA – GOVERNMENT FISCAL YEAR January 1 – December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of March 31, 2022) Currency Unit = Tugrug (MNT) US$1.00 = MNT 2,949 BoM Bank of Mongolia MC market capitalization CAPEX capital expenditure MoF Ministry of Finance CBI central bank independence MSE Mongolia Stock Exchange COOB currency outside of banks MTFF Medium Term Fiscal CIT corporate income tax Framework CMP Child Money Program NBFI non-bank financial institutions CPI Consumer Price Index NDC net domestic credit DB Defined Benefit NDC scheme Notional Defined Contribution DBM Development Bank of Mongolia scheme EAP East Asia and Pacific NFA net foreign assets EMDEs Emerging Market and NPLs nonperforming loans Developing Economies NRP New Recovery Policy FDC Funded Defined Contribution NSO National Statistics Office scheme OECD Organization of Economic FDI foreign direct investment Cooperation and Development FHF Future Heritage Fund OT Oyu Tolgoi FRC Financial Regulatory PAYG Pay-as-you-go scheme Commission PBOC People’s Bank of China FSF Fiscal Stabilization Fund PIT personal income tax FX foreign exchange PPI Producer Price Index GDP gross domestic product PROST Pension Reform Options GoM Government of Mongolia Simulation Toolkit H1, H2 first and second half of a year SMEs Small and Medium Enterprises HH household SOEs State Owned Enterprises ICO initial coin offering SSC Social Security Contribution ICT information and TOR turnover rate communication technology VASPs virtual asset services providers IPO initial public offering VAT value-added tax IMF International Monetary Fund y/y year-over-year LFPR labor force participation rate 1 MONGOLIA ECONOMIC UPDATE – April 2022 ACKNOWLEDGEMENTS This edition of the Mongolia Economic Update (MEU) was prepared by Jean Pascal Nganou (Senior Economist), Undral Batmunkh (Research Analyst), Ganbaatar Jambal (Extended Term Consultant), Mark Charles Dorfman (Senior Economist), and Ibrahim Saeed Chowdhury (Senior Economist and acting Lead Economist). Mongolmaa Norjinlkham (Senior Social Protection Specialist) and Robert J. Palacios (Lead Specialist on Social Protection and Labor) provided constructive comments. Yang Huang (Economist), Anne- Lore Fraikin (Consultant), Mahama Samir Bandaogo (Economist) and Eka Vashakmadze (Senior Country Economist) provided key inputs on labor market developments, analysis on central bank independence and global economic outlook. The MEU was prepared under the direction of Martin Raiser (Country Director), Hassan Zaman (Regional Director), Sebastian Eckardt (Practice Manager) and Andrei Mikhnev (Country Manager). The team is grateful to Sukhchimeg Tumur (Program Assistant) and Indra Baatarkhuu (External Affairs Officer) for their support on administrative and communication affairs. The findings, interpretations, and conclusions expressed in this update are those of the World Bank staff and do not necessarily reflect the views of the Executive Board of the World Bank or the governments they represent. For information about the World Bank and its activities in Mongolia, please visit https://www.worldbank.org/en/country/mongolia. For questions and comments on the content of this publication, please contact Jean Pascal Nganou (jnganou@worldbank.org). The cutoff date for this edition of the MEU is March 31, 2022. 2 MONGOLIA ECONOMIC UPDATE – April 2022 EXECUTIVE SUMMARY Recent Economic Developments Mongolia’s economic recovery in 2021 was weak. After a strong economic rebound in early 2021, the recovery stalled in the last three quarters due to trade disruptions. Growth consequently was disappointing, reaching only 1.4 percent following the contraction of 4.4 percent in 2020. Economic growth was mainly supported by a strong rebound of coal mining in Q1 which dissipated during the remainder of the year, significant improvement in copper ore grade, and recovery in the services sector. The services sector (including health, information and communication technology, trade, hotels and restaurants, and financial services) accounted for 1.8 percentage points of GDP growth in 2021, reflecting the gradual relaxation of domestic COVID-19 restrictions in H2 2021. In contrast, the manufacturing sector stagnated, and construction contracted significantly amid supply shortages caused by border disruptions. Agriculture also contracted reflecting an outbreak of animal disease and harsh weather conditions. On the demand side, gross capital formation was the key driver of growth, but investment was largely underpinned by a substantial buildup of mineral inventories. Investment recovered strongly, but this was mainly driven by a build-up of coal inventories, reflecting stalled coal exports due to COVID-19 related border closures that impeded exports to China. The accumulation of inventories reached 13.4 percent of GDP in 2021 from 8.5 percent of GDP in 2019. Foreign direct investment (FDI) and subsidized loans under the government stimulus program also supported private investment in the mining and services sectors. Meanwhile, consumption and net exports were negatively affected by the lingering impact of the pandemic on household labor income and border frictions. Despite continued income support, private consumption remained depressed as COVID-19 restrictions constrained mobility, rising inflation weighed on real incomes, and households increased precautionary saving amid persistent uncertainty. Final consumption is estimated to have contracted by 4 percent in 2021, mainly driven by a 6.6 percent contraction in household consumption. While Mongolia benefited from rising export prices, the improvement in the terms of trade was more than offset by border restrictions, resulting in negative contribution of net exports to GDP. The labor market remained weak throughout 2021 amid the prolonged impact of the COVID-19 pandemic. Total employment declined by 5 percent (y/y) in 2021 as about 60,000 jobs were lost. Employment losses would have been much worse, were it not for the 2021 economic recovery package which is estimated to have protected between 168,000 and 230,000 jobs during the pandemic. Labor force participation improved to 58 percent in the last quarter of 2021 from 55 percent in Q1 2021, as people returned to the labor market following the gradual easing of the COVID-19 restrictions on businesses. Monetary policy remained accommodative during 2021, despite rising inflation and deteriorating balance of payments. Headline inflation accelerated sharply to 14.4 percent (y/y) by March 2022, due to supply bottlenecks amid border closures as well as accelerating credit growth. With nearly half of Mongolia’s consumer basket composed of imported goods and services, disruptions in trade and ensuing logistical challenges also led to an increase in imported inflation. Core inflation, excluding volatile food and energy prices, also accelerated rapidly, reaching 12.7 percent (y/y) in December 2021 and 15.1 percent in February 2022. Substantial real exchange rate appreciation and weak exports led to a widening current account deficit and the erosion of gross international reserves from over 7 months (in mid-2021) to 3.7 months of imports as of February 2022. The war in Ukraine has exacerbated the pressure on Mongolia’s external accounts, prompting the Bank of Mongolia (BoM) to tighten policy. The erosion of confidence related to the war in Ukraine and the persistent border frictions fueled increasing demand for foreign exchange, prompting banks to ration FX liquidity, and 3 MONGOLIA ECONOMIC UPDATE – April 2022 thus negatively affecting some import payments by domestic and foreign firms. To stem these pressures the central bank raised its policy rate by a cumulative 300 basis points within the last 4 months, but real interest rates nevertheless remain negative. Following two years of expansionary fiscal policies, policy space is increasingly constrained with persistent fiscal imbalances threatening long-term sustainability. Public spending increased in 2021 mostly driven by the generous but poorly targeted Child Money Program (CMP). The headline budget deficit nonetheless narrowed to 3.1 percent of GDP amid a one-off tax arrears collection (2.3 percent of GDP). Meanwhile, the financing of the CMP through the Future Heritage Fund (FHF) has weakened the fiscal framework and long- term sustainability. Public debt increased sharply in the past two years, driven by large fiscal support. Public debt is estimated to have increased to about 81 percent of GDP in 2021 due to various COVID-related fiscal and quasi-fiscal measures to support the economy. The overall debt ratio would be even higher at about 92 percent of GDP at end-2021, including the People’s Bank of China (PBOC) swap line in the amount of US$1.8 billion. Outlook and Risks Economic growth is projected to remain modest at 2.5 percent in 2022, reflecting lingering border frictions with China and the impact of the war in Ukraine. Coal exports are expected to recover modestly toward the end of the year when border frictions with China may ease. Mining output growth will be temporarily weakened in 2022, by a drop in the quality of ore from Oyu Tolgoi (OT), Mongolia’s largest copper mine. While gradually improving labor market conditions amid a reopening of the economy would support domestic demand, the recovery is expected to be modest as real incomes and household consumption are weighed down by high inflation. Gross fixed capital formation will rise moderately relative to its pre-COVID average largely thanks to the recently concluded agreement with Rio Tinto over OT, which will support steady FDI inflows. These investments will provide some short-term support to the construction and services sectors and expand mining capacity in the long run. Over the medium-term, economic growth is expected to accelerate to above 6 percent in 2023-24, as the underground mining phase of OT becomes operational during H2 2023. The fiscal deficit is projected to widen more than envisaged in the government budget. Even with higher global commodity prices, the path to fiscal consolidation will be difficult if the border frictions remain. We envisage the headline budget deficit to increase to around 5 percent of GDP in 2022 driven by increases in capital spending, the continuation of some COVID-related stimulus measures, and a discretionary pension increase (of around 1.5 percent of GDP), before narrowing to 4.6 percent of GDP in 2023-24. Fiscal consolidation is needed to stabilize public debt which is expected to increase further to 94 percent in 2022 (including the BoM’s swap line with the PBOC). The monetary policy stance is expected to tighten further amid the sharp rise in inflation and the buildup in external pressures. External pressures are expected to build as global financing conditions tighten, large external debt payments fall due, and the current account deficit is projected to remain elevated during 2022-23. With inflation running well above the central bank’s tar get, widening external imbalances, and still-negative real interest rates, further monetary policy tightening is warranted to restore price stability in 2022. Uncertainties surrounding the baseline forecast remain large and are tilted to the downside. In a downside scenario, economic growth could fall to 0.7 percent in 2022 if border restrictions with China persist throughout the year and the war in Ukraine leads to persistently higher energy prices and tighter global liquidity. In this case, the fiscal deficit would widen further due to revenue shortfalls. Moreover, tighter global financing conditions could make it more challenging for Mongolia to refinance large external bonds due in 2023. 4 MONGOLIA ECONOMIC UPDATE – April 2022 Mounting instability and heightened risks call for adjustments in macroeconomic policies. Monetary policy needs to return to a credible inflation anchor. Further policy rate hikes are needed, but should be accompanied by steps to wind down quasi-fiscal operations and strengthen the operational independence of the central bank. While Mongolia’s fear of floating the exchange rate is understandable given its import dependence and high pass-through to inflation, the current rate of intervention and FX restrictions are not sustainable and risk a loss of confidence and growing dollarization. Fiscal consolidation is needed to stabilize debt and ensure external and public debt sustainability. Better targeting fiscal measures to the poor would help contain fiscal imbalances while sustaining support to the most vulnerable households. Structural reforms would help lay the foundation for more diversified and hence more resilient growth in the medium term. Key priorities include measures to reduce trade and transport costs, facilitate foreign investment and domestic entrepreneurship, and encourage private investment in renewable energy through tariff reforms. Finally, financial sector reforms should focus on assessing the underlying capital position of banks for the upcoming IPOs, and mitigate risks associated with new financial instruments (e.g., virtual assets). Special topic: Fiscal sustainability of the Mongolian pension scheme Mongolia’s pension scheme has high levels of coverage but is fiscally unsustainable given current contribution rates and retirement benefits. The current pay-as-you-go pension scheme already requires substantial state subsidies of 2.8 percent of GDP to pay for current benefits not financed from contributions. Without reforms to key parameters of the system, projections suggest a rapid and unsustainable level of growth in the state subsidy, rising to 6.8 percent of GDP in 2030 and 11.3 percent of GDP in 2050. A series of parametric reforms would help improve the financial sustainability of the current pensions system. These include (i) adopting automatic indexation of regular and minimum pension benefits to inflation, which would make benefits more predictable, increase confidence, and avoid the need for ad hoc discretionary adjustments as in early 2022; (ii) gradually increasing the normal retirement age to 65 de- linked from the vesting period and applying an actuarially fair benefit reduction for early retirement; (iii) gradually increasing the contribution rate to its pre-2008 level of 19 percent of gross wages; and (iv) extending the wage base used to calculate benefits from the current seven years to a worker’s lifetime wages. Finally, the proposed Funded Defined Contribution (FDC) scheme should be initiated as voluntary and supplemental, or funded with additional contributions rather than by earmarking funds from the current scheme. Table ES.1. Selected macroeconomic indicators 2019 2020 2021 2022f 2023f 2024f Real GDP growth, at constant market prices 5.5 -4.4 1.4 2.5 5.8 6.8 Inflation (CPI, period average) 7.3 3.7 7.1 10.5 7.5 6.8 Current account balance (% of GDP) -15.2 -4.3 -12.7 -15.6 -13.8 -11.6 Fiscal Balance (% of GDP) 1.4 -9.4 -3.1 -4.8 -4.8 -4.4 Public Debt (% of GDP) 68.4 77.3 79.5 83.6 81.7 80.0 Source: World Bank staff estimates. Note: Public debt does not include the BoM’s swap line with the PBOC (12 percent of GDP in 2021) and the contingent liabilities under the DBM (5 percent of GDP). 5 MONGOLIA ECONOMIC UPDATE – April 2022 Figure ES.1. Key indicators Mining sector contracted sharply in H2 as coal inventories … aggregate demand was supported by gross capital built up and … formation, while border frictions hampered net exports Year-over-year growth of mining sector real GDP and production of Demand-side contribution to GDP growth (y/y, percentage points) key commodities Final consumption GFCF 150% Coal 50% EX&IM Change in inventories Exports Copper restrictions 40% Gold Imports GDP 100% since late 30% Mining real GDP growth (RHS) 30% Q2 20% 50% 20% 10% 7.6% 5.5% 0% 10% 1.4% 0% -10% -4.4% 0% -50% -20% -10% -30% -100% -40% -20% -30% 2018 2019 2020 2021 Sources: NSO; World Bank staff estimates. Sources: NSO; World Bank staff estimates. Note: GFCF = gross fixed capital formation. Rising inflation weighed on real incomes, and households increased precautionary saving amid persistent uncertainty Annual growth of HH deposits and consumption Domestic goods 20% Imported goods 16.6% Real deposit growth Income 15.8% Headline inflation (Ulaanbaatar) 14.8% HH real consumption support 15% Real rate on existing deposits (RHS) programs 30% IMF & GoM reached staff launched 15% 9% 8% 8% 10% level agreement on EFF 20% 10% 5% 10% 5% 7% 8% 8% 0% 0% 0% -0.4% -10% -5% Mongolia closed borders amid COVID-19 (Mar 2020) -8% -5% -20% -10% Source: NSO; World Bank staff estimates. Sources: NSO; BoM; World Bank staff estimates. Fiscal policy will remain expansionary despite eroding fiscal space and … … sizable external bonds maturing during 2023–24 Budget balance indicators in percent of GDP Payment schedule of key sovereign bonds (million US$) Overall balance Sovereign bonds DBM bond 6% Primary balance 1400 3% Structural balance 1200 Structural balance excluding FHF 0% 1000 -3% 800 -6% -3.0% -3.7% 600 -5.1% -9% -7% -8.2% 400 -12% -9% 200 -12% -15% 0 2019 2020 2021 2022 prelim. supp. 2022 2023 2024 2026 2027 2031 Source: MoF; World Bank staff estimates. Sources: MoF; BoM; World Bank staff estimates. 6 MONGOLIA ECONOMIC UPDATE – April 2022 Figure ES.2. Key indicators (continued) Negative real interest rate calls for monetary policy to return to a credible inflation anchor, raise interest rates and allow the exchange rate to absorb negative external shock Real interest rates, per annum In US$ million 5 5500 FX supplied to the market (per week, RHS) 250 3 Gross international reserves (LHS) 1.3 5000 200 0.6 0 4500 150 -0.5 -1 4000 100 -2.7 -5 3500 50 -5.2 3685 U.S. -7.4 3000 0 -10 2500 -50 Malaysia China Mongolia Philippines Vietnam Thailand Indonesia 2021 Source: BoM; EAP Economic Update, 2022. Source: BoM. Capital buffers and liquidity of banks appear broadly adequate, but are likely to deteriorate amid rising uncertainties and as forbearance measure expire 20% Tier 1 ratio (proxy measure) 40% Gearing ratio 30% 16% 20% 12% 10% Reserves / Core Deposits Liquid Assets / Total Liabilities 8% 0% Source: BoM; World Bank staff estimates. Source: BoM; World Bank staff estimates. Parametric reforms will help improve the financial Projected fiscal costs of a full conversion to FDC and one sustainability of the pension system hybrid option Financing Gap under baseline and reform options 0% (PAYG Current Balance as a share of GDP) 2040 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2042 2044 2046 2048 2050 2052 2054 2056 2058 Baseline Inflation indexation -2% 2060 Contribution rate Retirement age Current Balance - No FDC Combined -4% Current Balance All Contributions to FDC 0% 3% of 17% Contributions to FDC -2% -6% -4% -6% -8% -8% -10% -10% -12% -12% Source: PROST Projections, 2019. Note: Scenarios exclude the implications of the 2022 pension hike (1.5 percent of GDP), which could add to the cost under all scenarios. In an FDC scheme, the funds contributed and accumulated are invested in securities to back up future benefits of members. A hybrid scheme either partly converts the Pay-As-You-Go (PAYG) Defined Benefit (DB) scheme to an FDC scheme or adds an FDC scheme while leaving part of the pension formula through the existing or reformed DB scheme. 7 MONGOLIA ECONOMIC UPDATE – April 2022 8 I. Economic Performance and Prospects MONGOLIA ECONOMIC UPDATE – April 2022 I. ECONOMIC PERFORMANCE AND PROSPECTS A. Recent Economic Developments A1. A sluggish recovery in 2021 Mongolia’s economic recovery in 2021 was weak. largely underpinned by a substantial buildup of Following a contraction of 4.4 percent in 2020, mineral inventories (figure I.1). Gross capital the economy grew by only 1.4 percent in 2021, fixed investment (mostly private) recovered from supported largely by the recovery of mining- a steep contraction in the previous year, related investment and improvements in the reflecting robust FDI (foreign direct investment) quality of OT (Oyu Tolgoi) mining output. COVID- inflows and accelerated domestic credit growth, 19 related interruptions in the bilateral trade especially in H1 2021.1,2 In H2 2021, however, with China in H2 2021 hampered mining exports gross capital formation was increasingly driven and the import of vital inputs for domestic by a large buildup of mining inventories, production, preventing Mongolia from reaping reflecting weak coal exports following COVID-19 the benefits of improved terms of trade. Although related border disruptions that impeded exports a series of fiscal and quasi-fiscal stimulus to China (figure I.2). In fact, the accumulation of measures supported employment and incomes, inventories reached 13.4 percent of GDP in 2021. household consumption remained depressed Meanwhile, consumption and net exports were reflecting COVID-related restrictions and higher negatively affected by the lingering impact of the uncertainty. pandemic on household labor income and border frictions. On the demand side, gross capital formation was the key driver of growth, but investment was Figure I.1. Gross capital formation supported the Figure I.2. … and was increasingly driven by large coal aggregate demand … inventories buildup amid border frictions in H2 2021 Demand-side contribution to GDP growth (y/y, percentage Decomposition of gross capital formation points) Change in inventories (% of GDP) Final consumption GCF Gross fixed capital formation (y/y, %) Exports Imports 40% Real exports (y/y, %) 30% GDP 30% 20% 20% 14.0% 7.6% 5.5% 10% 1.4% 10% -4.4% 0% 0% -10% -10% -20% -20% -14.5% -21.1% -30% -30% 2018 2019 2020 2021 2016 2017 2018 2019 2020 2021 Sources: NSO; World Bank staff estimates. Sources: NSO; World Bank staff estimates. Note: GCF = gross capital formation. 1 The change in inventories accounted for 12 percentage points of GDP growth while GFCF only contributed 3.6 percentage points to growth in 2021. The government’s capital expenditure declined in real terms, while private investment increased notably, especially in H1 2021, on the back of a strong rebound in FDI and domestic credit growth under the MNT 10 trillion program. 2 In particular, gross inflow of FDI reached US$2 billion (up by 16 percent y/y), close to the level of 2018. 10 Economic Performance and Prospects – April 2022 Private consumption contracted in 2021, price inflation averaging 7 percent [last year], reflecting diminishing real income and a real household incomes are estimated to have higher propensity to save. Final consumption contracted by 1 percent.4 Rising food prices— is estimated to have contracted by 4 percent in which increased by over 20 percent in 2021— 2021, mainly driven by a 6.6 percent have weighed on consumption, especially of contraction in household consumption—the poorer households. Real household first contraction since the economic crisis in expenditure contracted mostly driven by 2009 (figure I.3). A series of factors account for declining expenditure on non-food items weak private consumption in 2021: (figure I.5).5 First, persistent labor market pressures Third, despite declining real interest rates the weakened nominal household incomes despite household savings rate increased between Q1 generous government support. Households’ 2020 and Q2 2021, amid mobility restrictions nominal income growth decelerated to 6 and persistent uncertainty related to the percent (y/y) in 2021 from 10 percent (y/y) in pandemic.6 For example, while the monthly 2020 as the contribution of salaries and wages allowance benefit of the Child Money Program to incomes turned negative and partially offset (CMP) was raised substantially since mid-2020 the impact of larger social transfers (figure as part of the government income stimulus I.4).3 measures, a recent survey revealed that half of Second, real incomes eroded rapidly as the non-poor households saved their inflation accelerated sharply in 2021, further allowances (figure I.6) (World Bank, 2021).6 curtailing consumer spending. With consumer Figure I.3. Household consumption contracted, dragging Figure I.4. … as elevated inflation eroded real incomes down final consumption … despite government income support to compensate pandemic-stricken households’ labor income Real consumption (y/y) Contributions to HH nominal income (y/y, percentage points) 16% Other income Pension & social welfare Final consumption HH consumption Salary and wage HH nominal income 12% Average annual inflation 8% 9.6% 20% 16% 14% 7.0% 10% 4% 8% 4.5% 10% 7% 4.0% 2.9% 0% 6% 1.8% 1% -4.0% 0% -4% -8% -8% -6.6% -10% 2016 2017 2018 2019 2020 2021 2016 2017 2018 2019 2020 2021 Sources: NSO; World Bank staff estimates. Sources: NSO; World Bank staff estimates. 3 Survey results point to reduced working hours for the majority of surveyed households, lower pay, and temporary and permanent work stoppages (World Bank, 2021). 4 Inflation accelerated in H2 and reached 13.4 percent at the end of the year from 2.4 percent in January 2021 (see section on inflation for more details). 5 Even so, nearly 3 in 10 of the poor or those with income reductions due to the COVID-19 crisis were continuously worried about not having enough food in the near future. 6 This story is consistent with accelerating household bank deposits in H1 2021, despite declining deposit interest rates. Historically, a similar trend in individuals’ saving-consumption behavior was observed in 2016, when the economy faced nearly a recession and uncertainties were building. 11 MONGOLIA ECONOMIC UPDATE – April 2022 Figure I.5. Households cut their non-food expenditure to Figure I.6. Consumption contracted despite decelerated preserve food expenditure saving, as saving is concentrated mostly among non- poor HHs with a lower propensity to consume Household real expenditure (y/y) Household deposits and consumption (y/y) 15% Real deposit growth Income 10.9% HH real consumption support 9.4% Real rate on existing deposits (RHS) programs 10% launched 6.3% IMF & GoM reached staff 30% 12% 4.4% 4.2% level agreement on EFF 5% 3.6% 25% 10% 20% 8% 0% 15% 6% 10% 4% 5% 2% -5% Total expenditure 0% 0% -6.1% -5% -0.4% -2% -10% Food Mongolia closed borders -8.7% -10% -4% -9.5% amid COVID-19 (Mar Non-food -15% 2020) -8% -6% -15% 2019 2020 2021 Sources: NSO; World Bank staff estimates. Sources: NSO; BoM; World Bank staff estimates. Note: Nominal expenditures are deflated by respective CPIs. Due to COVID-related border closures and coal exports, which account for about 40 percent bilateral trade disruptions with China, the of the total. Consequently, coal export volumes contribution of net exports to aggregate demand contracted by 44 percent (y/y) in 2021 (figure turned negative. Net exports pulled down overall I.8).7 In addition, while the mining sector recovery growth in 2021 by 6 percentage points as real and private sector investments boosted imports exports contracted by 15 percent (y/y) relative to of fuel and other intermediate goods, COVID a 10 percent (y/y) growth in real imports (figure outbreaks created logistical problems associated I.7). While exports grew strongly in the first with the delay of cargo clearance and a complete quarter, the surge in COVID-19 cases in late April closure of border activities in Q4 2021. Real 2021 in the main exporting region prompted the imports increased by 10 percent in 2021 from a Chinese authorities to tighten public health contraction of 15 percent in 2020. requirements for Mongolian truckers, hampering Figure I.7. Net exports contracted … Figure I.8. … as exports weakened and imports recovered 100% Net exports (ppt contribution to GDP growth) Real imports (y/y, %) 82% 80% Exports (y/y growth) Real exports (y/y, %) 60% 40% Imports (y/y growth) 40% 11% 14% 13% 20% 20% 10% 0% 0% -20% -8% -5% -14% -13% -15% -19% -20% -20% -40% -25% -15% -15% -39% -60% -40% 2016 2017 2018 2019 2020 2021 Source: NSO. Source: NSO. 7 Real exports contracted by 28.4 percent in the last three quarters of 2021 as border frictions severely affected commodity exports, mainly coal and crude oil. 12 Economic Performance and Prospects – April 2022 On the supply side, growth was driven mainly by one-off collection of sizeable tax arrears. After a the services sector (figure I.9). The services sector strong recovery in Q1 2021, output in the mining accounted for 1.8 percentage points of GDP sector contracted sharply in the remaining growth in 2021, reflecting the gradual relaxation quarters of 2021, reflecting trade disruptions of domestic COVID-19 restrictions in H2 2021. with China and COVID-19 related restrictions. As Meanwhile, net taxes also contributed 1.3 a result, mining sector growth slowed rapidly, percentage points to growth following larger tax from 39 percent (y/y) in Q1 2021 to a contraction revenues due to higher commodity prices and a of 16 percent in Q4 (figure I.10). Figure I.9. On the supply side, growth in 2021 was Figure I.10. Mining sector contracted sharply in H2 as supported mainly by services and net taxes coal inventories built up Supply-side contribution to GDP growth, percentage points Mining sector real GDP and production of key commodities ... (y/y) Net taxes Services 150% Coal 50% Non-mining industries Agriculture Copper EX&IM 40% Gold restrictions Mining Real GDP 100% 30% Mining real GDP growth (RHS) since late Q2 7.7% 20% 9% 50% 5.6% 10% 6% 0% 3% 1.4% 0% -10% 0% -50% -20% -3% -4.6% -30% -6% -100% -40% -9% 2018 2019 2020 2021 Sources: NSO; World Bank staff estimates. Sources: NSO; World Bank staff estimates. After a strong expansion in Q1 2021, economic shortage of migrant workers due to border activity in non-mining sectors slowed rapidly due closures (figure I.12).8 In addition, the to the wider consequences of disruptions in transportation sector contracted sharply as trade. Despite strong growth of 11 percent (y/y) border frictions limited export and import freight in Q1 2021, non-mining output increased by only volumes. Lastly, the agricultural sector, which 1.4 percent in 2021 following a contraction of 3.7 was the key driver of growth in 2020, contracted percent in 2020 (figure I.11). The slowdown in by 5.5 percent (y/y) due to a greater loss of non-mining output that started in Q2 2021 was livestock and weaker survival rates of offspring broad-based across key sectors. The amid an outbreak of foot and mouth disease and manufacturing sector stagnated during Q2-Q4 harsh weather conditions. Meanwhile, other amid disruptions in the import of intermediate services, including e-trade and information and and capital goods. Construction also contracted, communication technology (ICT), supported non- reflecting import delays, rising costs, and a mining GDP growth in 2021.9 8 Immigrant workers from China are usually employed at construction sites for residential, non-residential, and road construction activities. The Darkhan-Ulaanbaatar road construction was disrupted when borders were closed; the contractors could not return to Mongolia and one contractor actually defaulted. In 2020, some construction activities related to the Tavantolgoi railroad occurred. But it slowed down in 2021, resulting in weaker construction activities. 9 Among services, health, ICT, trade and repair services, hotels and restaurants, and financial services were the top contributors to growth. 13 MONGOLIA ECONOMIC UPDATE – April 2022 Figure I.11. Manufacturing, trade, and services were the Figure I.12. Broad-based contraction in construction main contributors to non-mineral GDP growth in Q1 activities in 2021 Contributions to non-mineral output (y/y, percentage points) Construction activities (nominal y/y change, percentage points) Residential Non-residential ICT Net taxes Other services Transportation Structural (e.g., railroads) Maintenance Trade Construction Construction activities Manufacturing & utilities Agriculture 15% Non-mining GDP growth 20% 15% 10% 10% 5% 5% 0% 0% -5% -5% -10% -10% -15% 2018 2019 2020 2021 Sources: NSO; World Bank staff estimates. Sources: NSO; World Bank staff estimates. A2. Despite slight improvements, labor market conditions remained weak The labor market remained weak throughout kicked in (figure I.14). The unemployment rate 2021. Total employment declined by 5 percent fell from 9 percent in Q1 2021 to 8 percent in Q4, (y/y) in 2021 as about 60,000 jobs were lost. This while the labor force participation rate increased is in sharp contrast to the average annual growth from 55 percent to 58 percent over the same in total employment of 1 percent over the past period. decade. The contraction in total employment was particularly steep in Q1 2021 at about 10 percent (y/y). The hardest-hit sectors, which endured a decline of more than 20 percent (y/y) in Q1 2021, were non-agricultural sectors operating mainly in urban areas, such as transportation, construction, information and communication, real estate, education, health, and social, and entertainment services (figure I.13).10 Conversely, employment in agriculture, energy, water supply and waste management, and administration went up by more than 10 percent in Q1 2021. The labor market improved throughout 2021, as COVID restrictions were gradually lifted and the government’s stimulus measures to secure jobs 10 ICT sector employment increased by 45 percent (y/y) in 2020 as the demand for ICT services soared due to mobility restrictions. In 2021, employment declined by 18 percent (y/y) but remained higher than in 2019. 14 Economic Performance and Prospects – April 2022 Figure I.13. Job loss was significant in the services sector Figure I.14. … however, labor force participation is … starting to recover Decomposition of change in employment (y/y, percentage points) Labor force participation rate (LFPR) by gender and unemployment rate Agriculture Industries Unemployment rate (RHS) LFPR Services Total employment 10% LFPR (male) LFPR (female) 75% 14% 5% 68% 70% 67% 12% 66% 0% 63% 2.4% 2.0% 1.8% 65% 10% 0.2% 59% 8% 60% 9% 8% -5% -3.4% 61% 7% -5.4% 55% 58% 6% -10% -6.7% 50% 55% 4% 54% -9.9% 52% 52% -15% 45% 48% 2% 2020 Q2 Q3 Q4 2021 Q2 Q3 Q4 40% 0% Q1 Q1 2019 Q3 2020 Q3 2021 Q3 Q1 Q1 Q1 Sources: NSO; World Bank staff estimates. Sources: NSO; World Bank staff estimates. There is some evidence that the economic Figure I.15. Total employment could have been lower recovery package initiated in 2021 has protected without the economic stimulus jobs during the pandemic. The stimulus package Total employment in thousand peoples, actual performance vs of MNT 10 trillion (US$3.5 billion), introduced in counterfactuals using different counterfactuals 1,176 March 2021, included among other things, a 1200 1,125 1,136 1,127 subsidized lending program of MNT 2 trillion to 1150 1,106 support firms in retaining workers during the 1100 1,055 1,049 pandemic. The Ministry of Finance (MoF) reported 1050 that with these programs, about 225,000 jobs 982 1000 1,044 959 (around 20 percent of total employment) were protected as of Q3 2021. 11 Our own analysis 950 Approach 1 956 confirms that, indeed, between 168,000 and 900 Approach 2 230,000 jobs were protected in 2021. As shown 850 Actual 897 in figure I.15, counterfactuals constructed for 800 total employment indicate that in the absence of 2020Q3 Q4 2021Q1 Q2 Q3 Q4 the MNT 10 trillion economic stimulus package, Sources: NSO; World Bank staff estimation. total employment could have dropped by 20.4 Note: Both approaches consider seasonality, while approach 2 percent, to about 900,000 by December 2021 considers the stringency of mobility restrictions. (box I.1 provides details of the analysis). 11 The government’s estimate of 225,000 jobs assumes that an employer would have laid off all of the employees had it not been for the subsidized loans as well as the repo loans under the MNT 10 trillion program. Also, subsidized mortgage loans are considered to fully support the construction employment. These three programs represent about 88 percent of the total disbursement (MNT 4.3 trillion) under the MNT 10 trillion program as of end-2021. 15 MONGOLIA ECONOMIC UPDATE – April 2022 Box I.1. Assessing the impact of the recovery package on employment Simple simulation methodologies are employed to understand the impacts of the MNT 10 trillion recovery package on employment. Assuming the labor market shock at the sectoral level in Q1 2021 would have continued between Q2 and Q4 in the absence of the authorities’ MNT 10 trillion recovery package, two labor market counterfactuals are constructed for Q2, Q3, and Q4 2021: one without seasonal adjustment and another with seasonal adjustment. Both of these counterfactuals are differentiated by incorporating an additional correction for the stringency of COVID-19 related mobility restrictions.12 The difference between the constructed counterfactuals and actual employment data provides insights into the likely impact of the MNT 10 trillion package on total employment. The first simulation method indicates that between 170,000 and 281,000 jobs were saved in Q2, Q3, and Q4 of 2021 (panel A of figure I.16). When labor market seasonality is accounted for, the employment counterfactuals are higher than in the first estimation method, particularly in Q2, and therefore the estimation of the number of jobs saved diminishes. The counterfactual with seasonality adjustment indicates that between 168,000 and 230,000 jobs were saved in Q2, Q3, and Q4 of 2021 (panel B of figure I.16). Figure I.16. Employment counterfactuals using different approaches A. Counterfactuals without seasonality adjustments B. Counterfactuals with seasonal adjustment 1,176 1,176 1200 1200 1,125 1,136 1,127 1,136 1150 1,106 1,125 1,127 1150 1,106 1100 1,055 1100 1,055 1,049 1050 991 1050 1000 957 982 942 1000 1,044 950 959 985 900 Approach 1 950 Approach 1 Approach 2 916 Approach 2 956 850 Actual 900 Actual 800 846 850 897 2020Q3 Q4 2021Q1 Q2 Q3 Q4 2020Q3 Q4 2021Q1 Q2 Q3 Q4 Sources: NSO; BoM; World Bank staff estimates. Sources: NSO; World Bank staff estimates. Source: World Bank staff estimates. A3. Rising inflation complicates monetary policy management Consumer price inflation (CPI) accelerated and services carrying about 46 percent of total sharply in the second half of 2021 amid a surge weight in Mongolia’s (CPI) basket, disruptions in in food and energy prices. Headline inflation goods trade and ensuing logistical challenges reached 13.4 percent (y/y) in December 2021 also led to an increase in imported price inflation, from 5.6 percent in April 2021. This increase was contributing about 8 percentage points of the mainly driven by a rapid rise in food and fuel Ulaanbaatar inflation (average) in March 2022 prices.13 It has since continued to soar to 14.6 (figures I.17 and I.18). Core inflation, excluding percent (y/y) in March 2022, the highest level volatile food and energy prices, also accelerated since 2014 and significantly above the official rapidly, reaching 12.7 percent (y/y) in December target of 6 ± 2 percent (y/y). With imported goods 2021 and 15.4 percent in March 2022. 12 Mongolia faced a variety of stringent mobility restrictions during 2020-21. In the counterfactual simulations (approach 2), the linear methodology is adjusted to reflect changes in the stringency of mobility restrictions in order to account for its impact on employment. The stringency index published by the Oxford COVID-19 Government Response Tracker is used for this analysis. 13 Border closures disrupted the supply of key inputs used in the production of coal briquettes, prompting households to switch to wood triggering, higher prices. 16 Economic Performance and Prospects – April 2022 Figure I.17. Food and fuel prices drove headline inflation Figure I.18. … especially imported goods contributed to in Ulaanbaatar … surging inflation Other items 18% Domestic goods Gasoline/diesel 20% 16.6% 15.8% Heating fuel Imported goods 15% Other food 15% Headline inflation (Ulaanbaatar) Meat 12% Headline inflation (Ulaanbaatar) 9% 8% 8% 9% 10% 6% 5% 7% 8% 8% 3% 0% 0% -3% -5% Source: NSO. Source: NSO. Producer price inflation also rose sharply, reflecting an intensification of border frictions reflecting higher commodity prices. The producer with China (figure I.19).14 The gap between CPI price index (PPI) inflation, including in the mining inflation and PPI (excluding mining), which was sector, rose from -0.2 percent in 2020 to 15 shrinking until Q3 2020, increased substantially percent in 2021, reflecting the sharp increase in since Q2 2021, as producers shifted higher costs the price of Mongolia’s key commodities. to end consumers. On the other hand, rising Meanwhile, excluding the mining sector, the PPI export prices indicate that the mining sector exhibited a rising trend similar to headline (export-oriented firms) seems to have been able inflation as the PPI of the trade and to partially pass along the higher costs to foreign transportation sectors accelerated from Q3 2021, importers (figure I.20). Figure I.19. Mining prices, a key driver of PPI inflation, Figure I.20. … meanwhile, non-mining producers exhibited a limited pass-through to CPI inflation … shifted the higher costs to the end consumers ICT Transport Trade Manufacturing Divergence (incl. mining) Divergence (excl. mining) PPI (excl. mining) Headline inflation (RHS) 20% 15% 10% 2.0% 5% 10% 0% -5% -3.0% 0% -10% Source: NSO. Source: NSO. Note: Aggregate PPI was computed based on the individual sector Note: Divergence = CPI growth (y/y) – PPI growth (y/y). PPI provided by NSO, including mining, manufacturing, trade, transportation, and ICT. Sectoral GDP shares of these sectors were used as weights. 14 The producer prices in the mining sector surged by 41.8 percent (y/y) in 2021. The cost increases in road transportation, reflecting rising prices of fuel and car spare parts in addition to border frictions, prompted an increase in the PPI for transportation, affecting wholesale prices in the trade sector. 17 MONGOLIA ECONOMIC UPDATE – April 2022 Accelerated credit growth and the central bank’s trillion-program led to a sharp rise in net quasi-fiscal activities have added to already high domestic credit (NDC) during the second half of inflationary pressures. On the liability side, broad the year. Quasi-fiscal activities under this money (M2) increased by 15 percent (y/y) in 2021, program sparked demand for imports, causing as fiscal stimulus and recovery of the mining NFA to decrease in Q4 of 2021. 15 As a result, sector in early 2021 fueled growth in MNT monetary policy became sharply expansionary, current accounts and deposits (figure I.21). On further exacerbating inflation risks stemming the assets side, broad money growth in 2021 was from imbalances caused by stoking demand and initially driven by Net Foreign Asset (NFA) constrained supply (figure I.22). accumulation, the inception of the MNT 10- Figure I.21. MNT liabilities support M2 growth … Figure I.22. … while NDC is driving on the asset side FX current accounts FX deposits NFA NDC MNT deposits MNT current accounts Other M2 growth COOB M2 growth Nominal GDP growth Nominal GDP growth 40% 40% 30% 30% 20% 20% 10% 10% 0% 0% -10% -10% -20% Source: BoM. Note. COOB – currency outside of banks. Source: BoM. To counteract persistent inflationary pressure the in Ukraine led to eroding confidence, fueling an central bank started to tighten its policy stance at increasing demand for foreign exchange, the end of 2021. While initially keeping its policy prompting banks to ration FX liquidity and rate at a historic low of 6 percent throughout affecting some import payments. The central 2021 (figure I.23), the central bank increased bank also raised the reserve requirement on USD repo rates initially by 50 basis points (bps) to 6.5 denominated current accounts and deposits from percent in December 2021, and the policy rate by 15 percent to 18 percent in December 2021, and 50 bps to 6.5 percent in January 2022. on MNT current accounts and deposits from 6 Subsequently, the Bank of Mongolia (BoM) raised percent to 8 percent in January 2022. Despite the its policy rate by a further 250 basis points to 9 recent hike, Mongolia’s real interest rates are percent in March 2022, as inflation continued to among the lowest in the East Asia region and rise in the first two months of 2022 and the war remain in deep negative territory (figure I.24).16 15 Total disbursement of these activities reached MNT 4.3 trillion (43 percent of initial allocation) by end-2021, which includes (i) MNT 2 trillion program to protect jobs; (ii) MNT 1 trillion to support a subsidized mortgage program; (iii) MNT 464 billion to provide soft loans to the agricultural sector; (iv) MNT 826 billion extended-term repo facility that is intended to facilitate lending activities by banks, and (v) MNT 67 billion to support mega projects. 16 A draft law recently submitted to the Parliament includes provision of soft loans to producers of meat and flour, and FX loans to fuel importers where the interest rate subsidies and the BoM’s potential loss will be covered by the budget until end-2022. 18 Economic Performance and Prospects – April 2022 Figure I.23. The BoM belatedly embarked on a tightening Figure I.24. … despite the recent hike, Mongolia’s real cycle but … interest rates remain negative and lowest in the region Annualized rates In percent (annual) Policy rate 5 3 20 Time deposits' rate 1.3 18 0.6 Lending rate 16 0 14 -0.5 -1 12 -2.7 10 -5 U.S. -7.4 -5.2 8 6 4 -10 Malaysia China Vietnam Philippines Thailand Mongolia Indonesia Source: BoM. Sources: EAP Economic Update April 2022; BoM. Note: Values as of Jan 2022, except Mongolia (March 2022). A4. The fiscal deficit narrowed notably in 2021 amid a one-off tax arrears collection but is expected to widen in 2022 Total budget expenditure remained high, driven Government revenue increased, reflecting the by higher social welfare spending. The one-off collection of tax arrears from OT and consolidated budget expenditure increased by 12 improved tax revenues driven by higher percent (y/y) in 2021 to reach 32 percent of GDP, commodity prices and roll back of some COVID- mainly due to higher spending on social related tax exemptions. Nominally, the protection and welfare (figure I.25). Social consolidated budget revenue increased by 36 welfare spending reached 7 percent of GDP in percent (y/y) in 2021, up from a contraction of 13 2021, up from 2.4 percent on average during percent (y/y) in 2020 (figure I.26). Much of this 2017-19, reflecting generous but poorly targeted reflected a strong rebound in tax revenues of 25 government income support measures (box I.2).17 percent (y/y), which was supported by collection Moreover, health expenditure increased to 5.3 of OT’s tax arrears, the expiry of the COVID-19 percent of GDP in 2021 from 3.7 percent in 2020, tax relief measures in mid-2021, higher mineral following the surge in domestic COVID cases in sector revenue due to stronger commodity 2021. While recurrent spending increased to 29 prices,19 modest economic recovery and rising percent of GDP in 2021, capital expenditure inflation.20,21 In addition, higher commodity dropped to 6.9 percent of GDP in 2021 from 8 prices helped Mongolia increase buffers in the percent in 2020, but remained above its average Fiscal Stabilization Fund (FSF).22 during pre-COVID years.18 17 These programs include a top-up on allowances under the Child Money Program (3.1 percent of GDP), a one-time welfare check provided to each citizen (2.3 percent of GDP) during a month-long quarantine, and a one-time cash transfer incentive to boost COVID- 19 vaccination program (for details see box I.2). 18 Capital spending averaged 6.5 percent of GDP in 2018-19. 19 Copper price was up by about 80 percent (y/y) while coal price more than doubled to US$176 per ton from US$74 in 2021. 20 High inflation may have also contributed to VAT and CIT revenues. 21 It could also be argued that the sizable income support provided in 2021 would not have been feasible if the government had not collected tax arrears from Oyu Tolgoi. Although one-off, the tax arrears amounted to about 2.3 percent of GDP and was the top contributor to budget revenue growth in 2021. 22 Accumulation in FSF increased to 1.4 percent of GDP in 2021, up from 0.2 percent in 2020 and an average of 0.7 percent during 2017-19. 19 MONGOLIA ECONOMIC UPDATE – April 2022 Figure I.25. Social welfare spending dominated Figure I.26. Revenue performance was supported by government expenditure OT tax arrears collection and robust tax revenue intake, reflecting expiry of COVID-related exemptions and higher commodity prices Budget spending and decomposition (y/y, percentage points) Budget revenue and contributions (y/y, percentage points) Others Non-tax revenue PIT CapEx Other taxes Social security revenue Social welfare support Direct mineral revenue CIT Goods, services & wages VAT Total revenue & grants Total spending & net lending 36% 40% 30% 26% 26% 30% 19% 20% 20% 20% 12% 9% 10% 10% 2% 9% 0% 0% -10% -10% -20% -13% 2018 2019 2020 2021 2018 2019 2020 2021 prelim prelim Sources: MoF; World Bank staff estimates. Sources: MoF; World Bank staff estimates. Note: Social welfare support includes welfare pension. Note: Tax arrears from OT contributed 10 ppts to revenue growth. Of which, 6.2 ppts are reflected in the CIT, and 3.7 ppts in non-tax revenues. After recording a large budget deficit in 2020, the some COVID-related stimulus measures deficit narrowed visibly in 2021. The headline (including the CMP), and a discretionary pension budget deficit fell sharply in 2021 to 3.1 percent increase (estimated to add around 1.5 percent of of GDP, down from 9 percent in 2020, amid a one- GDP to pension outlays in 2022).24 Total spending off tax arrears collection and larger tax revenues. is planned to increase by almost 3.5 percentage Similarly, the structural fiscal balance (defined as points of GDP, reflecting large increases in overall fiscal balance net of fiscal saving funds) capital spending (table I.1). Although the overall also improved, as its deficit narrowed deficit is set to widen, the planned structural substantially to 7 percent of GDP in 2021 from 12 deficit is expected to narrow, owing to a funding percent in 2020 (figure I.27).23 adjustment of a key welfare program (figure I.27).25 The structural deficit would have widened The 2022 budget envisages the deficit to widen to over 8 percent of GDP in 2022 without such an again. Under the 2022 budget, the fiscal deficit is arrangement, and therefore would violate the set to widen to 3.7 percent of GDP, driven by threshold set in Mongolia’s fiscal rules.26 increases in capital spending, the continuation of 23 The structural fiscal deficit is the fiscal anchor under Mongolia’s fiscal rule articulated in the Fiscal Stability Law. 24 The 2022 supplementary budget assumes that the pension outlays increase (1.5 percent of GDP) is offset by a reduction in capital spending (0.6 percent of GDP) and some reduction in other recurrent expenditures relative to the original budget, resulting in no change in the planned fiscal deficit. Meanwhile, revenues of the social security fund in 2021 were boosted by the liquidation of non- pension related social insurance reserves. The resulting cash surplus of 0.7 percent of GDP is also counted against additional spending in 2022, but it is important to realize that these revenues are one off. 25 The authorities decided to make a temporary top-up on the Child Money allowance (worth 3.1 percent of GDP) permanent and finance it from the Future Heritage Fund (FHF), an intergenerational fund that was previously excluded from the structural revenue. 26 The financing of the CMP through the Future Heritage Fund has weakened the fiscal framework and long-term sustainability. 20 Economic Performance and Prospects – April 2022 Figure I.27. Budget deficit narrowed in 2021, but is Figure I.28. The revenue projections in the 2022 budget expected to widen in 2022 are optimistic Budget balance indicators, in percent of GDP Planned increase in budget revenue, in percent of GDP Overall balance -Ease red tape at borders 7% -Improve infrastructure (x-ray) Primary balance 6% Structural balance 5.7% 6% -Restructuring some SOEs 2.0% 4% Structural balance excluding FHF -Governance reform -Change dividend policy 2% 5% 0% 4% Digitalization of tax 1.9% -2% services & database -4% (e-barimt) -3.0% 3% -3.7% -6% -5.1% -8% -7% 2% 0.8% -8.2% 0.5% -10% -9% 1% 0.5% -12% -12% -14% 0% 2019 2020 2021 2022 Expansion SOE reform Export Recovery of Economic Revenue prelim. supp. of tax promotion imports recovery increase coverage measures measures from 2021 Sources: MoF; World Bank staff estimates. Sources: MoF; World Bank staff estimates. Note: Increase in budget revenue relative to the planned revenue in 2021. Against the background of modest GDP growth in Furthermore, the expected deterioration in the 2022, the revenue projections under the 2022 quality of OT mining output in 2022 is likely to budget seem overly optimistic. Total revenue further weigh on export revenues. While the 2022 planned under the 2022 budget is expected to budget assumes a continued recovery of the labor increase by 3 ppts of GDP relative to actual market, an increase of 32 percent (y/y) in the revenue of 2021. The budget assumes a strong social security revenues seems ambitious. In fact, economic recovery (5 percent growth rate), an social security revenues increased by 24 percent acceleration of mega projects, expansion of (y/y) in 2019, due to higher contribution rates, but foreign trade amid buoyant commodity prices, these were permanently reduced in 2021.29 The resolution of border frictions in early 2022, and 2022 budget also assumes the health insurance reforms to expand the tax base (figure I.28). 27 revenue component of the social security While the assumptions on commodity prices are revenue to nearly double, contributing about 10 broadly in line with the projections of ppts to the social security revenue increase. international institutions, the revenue Again, this seems overly ambitious, considering projections are unlikely to materialize. 28 Coal the modest increase of 17 percent (y/y) in 2021. exports are expected to only recover toward the end of the year and only if border frictions with China ease (see Outlook and Risks section). 27 Total revenue and grants are planned to increase by 15 percent and 19.5 percent relative to the 2021 actual and planned revenue. 28 Planned budget for 2022 assumes economic growth of 5 percent and inflation of 6.7 percent by end of year. 29 Contribution rate of SSC was reduced by 2 ppts starting July 2021 to 17 percent of nominal wage. Nevertheless, social security revenue increased by 42 percent (y/y) in 2021, supported by a 5 percent increase in average wages, buyback offered to herders, and some grants (10.4 ppts). The buyback option was ended in end-2021. 21 MONGOLIA ECONOMIC UPDATE – April 2022 Table I.2. Selected indicators of the consolidated budget 2018 2019 2020 2021 2022 preliminary suppl. A Total revenue & grants 30.9 31.8 27.6 32.3 35.1 Structural revenue 28.3 28.8 25.0 28.8 33.7 Tax revenue 25.2 25.9 22.5 25.5 29.8 B Total expenditure & net lending 28.3 30.8 36.7 35.4 38.8 Recurrent expenditure 22.6 21.7 28.6 28.9 29.1 Social welfare support 2.3 2.1 5.0 7.1 5.2 Capital expenditure 4.9 8.0 8.0 6.9 10.3 C Overall balance 2.5 1.0 -9.1 -3.0 -3.7 D Structural balance 0.0 -2.0 -11.7 -6.6 -5.1 E Primary balance 5.8 3.3 -6.7 -1.2 -1.6 Sources: MoF; World Bank staff estimates. Note: Values are in percent of GDP estimated by the MoF. The repurposed accumulation of FHF is included in the structural and tax revenues starting 2022. Public debt increased sharply in the past two amount of US$1.8 billion. With the headline years, driven by large fiscal support. Following a deficit expected to widen, public debt is drop by almost 20 ppts between 2016 and 2019, projected to increase further in 2022. Public debt public debt rose by 10 ppts to 79.5 percent of risks are further aggravated by sizable contingent GDP in 2020, and is estimated to have further liabilities, including the Development Bank of increased to about 81 percent of GDP in 2021 due Mongolia’s external bond (US$800 million to various COVID-related fiscal and quasi-fiscal maturing in 2023) (figure I.29). Moreover, measures to support the economy. The overall Mongolia’s borrowing costs in international debt debt ratio would be even higher at about 92 markets have increased over the past six months, percent of GDP at end-2021, including the as evidenced by the pickup in Mongolia’s People’s Bank of China (PBOC) swap line in the sovereign bond spreads (figure I.30). Figure I.29. The size of external bonds maturing during Figure I.30. Mongolian sovereign bond yields are on an 2023–24 period is significant increasing trend Payment schedule of key sovereign bonds (million US$) Yields of sovereign bonds, in percent Sovereign bonds DBM bond Chinggis - USD (2022) Gerege - USD (2023) 1400 Khuraldai - USD (2024) Nomad - USD (2026) 1200 Century - USD (2027) Century - USD (2031) 11 1000 10 9 800 8 7 600 6 5 400 4 3 200 2 1 0 2022 2023 2024 2026 2027 2031 Sources: MoF; BoM; World Bank staff estimates. Source: Bloomberg. 22 Economic Performance and Prospects – April 2022 Box I.2. Fiscal Relief Measures The government’s COVID-19 relief package, supported by fiscal and quasi-fiscal measures, increased in 2021. To cushion the impact of the COVID-19 crisis on households and firms and prevent job losses, relief measures were introduced. These include tax and non-tax relief, support to direct income, waiver of payments of monthly utility bills, and issuance of subsidized loans. While the relief on tax and social security contributions expired in mid-2021, the total cost of these measures reached 11 percent of GDP (MNT 4.7 trillion) in 2021, up from 7 percent in 2020, mainly dominated by the one-time check provided in May 2021 during the month-long quarantine (figure I.31). More specifically, the government program included: • A top-up on the allowance under the Child Money Program for all children, introduced in April 2020, accounted for 3.1 percent of GDP in 2021, on the budget. The temporary top-up was made permanent starting 2022. • A waiver on income taxes and social security contributions during April 2020 –June 2021 (representing about 1 percent of GDP in 2021, on the budget). • A one-time allowance of MNT 300,000 to each citizen during the month-long quarantine of May 2021 (representing about 2.3 percent of GDP, on the budget). • A one-time cash incentive to reward those who received two doses of the COVID-19 vaccine starting May 2021 (about 0.2 percent of GDP, on the budget). • A waiver of monthly payments of housing utility bills combined with subsidizing the price of coal briquettes for households and firms during December 2020–December 2021 (accounting for 3.8 percent of GDP in 2020-21, but financed by state owned enterprises) (quasi-fiscal activity). The waiver on household electricity bill payments and a discount on the price of coal briquettes have not yet expired. The income support measures were considered effective and timely for households. The National Statistics Office (NSO) and the World Bank jointly conducted a series of household surveys, which revealed that the income support measures (e.g., the CMP), were timely and effective in supporting the households during the crisis. In fact, based on surveys conducted in April and June 2021, about 20 percent of the poor respondents reported that the CMP was effective in fully mitigating the impact of the COVID-19 crisis on household income. Meanwhile, 80 percent of these households reported that the CMP was somewhat effective. Furthermore, 73 percent of the poor households indicated their CMP allowance was used for immediate consumption, while 50 percent of the non-poor respondents saved it for the future (World Bank, 2021). Figure I.31. COVID-19 Fiscal relief measures Tax relief measures 5% Providing exemptions on SSC payments Interest subsidy on subsidized loans Top up of CMP 0.8% 4% Top up on social welfare pension Other allowances Allowance during the quarantine 3% Bonus for vaccination Quasi-fiscal (exempting utility bills and coal price) 2.3% 0.3% 2% 0.8% 1.0% 1.0% 1% 0% Q1-20 Q2-20 Q3-20 Q4-20 Q1-21 Q2-21 Q3-21 Q4-21 Source: MoF; World Bank staff estimates. Note: Values are in percent of GDP. Sources: Summarized from budget documents published at http://forum.parliament.mn/projects/11228. 23 MONGOLIA ECONOMIC UPDATE – April 2022 A5. Rising external pressures amid widening current account deficit External pressures have intensified in 2021 due higher FDI inflows, which increased to US$2 to a widening current account deficit. Following billion in 2021, up from US$1.7 billion in 2020, a surplus of US$787 million in 2020, the balance the balance of payments position weakened, of payments (BOP) recorded a deficit of US$222 reflecting a widening current account deficit million (1.4 percent of GDP) in 2021—Mongolia’s (figure I.33). first BOP deficit since 2018 (figure I.32). Despite Figure I.32. Widening current account deficit led to a Figure I.33. … as the import bill and profit repatriation BOP deficit … increased Balance of payments and its components, in percent of GDP Current account and its components, in percent of GDP CA KA & FA (excl. FDI) Imports Services Incomes FDI (net inflow) BOP Exports CA 30% 60% 40% 20% 20% 5.9% 10% 3.2% 0% -1.1% -1.4% 0% -5.1% -20% -5% -17% -15% -12% -11.8% -40% -10% -16.8% -15.4% -60% -20% -80% 2018 2019 2020 2021 2018 2019 2020 2021 Source: BoM. Source: BoM. Note: CA, KA, & FA = current, capital, and financial account of the balance of payments respectively. The current account deficit increased in 2021, higher profit repatriation led to a deterioration in driven by a deterioration in the trade balance and the primary income account, which, together higher profit repatriation. The current account with large service payments due to higher deficit widened to US$1959 million (12.7 percent transport costs, also weighed on the current of GDP) in 2021 from US$675 million (4.3 percent account. of GDP) in 2020. Merchandise imports expanded To avoid a sharp depreciation of the tugrug, the by 32 percent (y/y) (figure I.34), supported by central bank conducted foreign exchange (FX) stronger domestic demand, higher global oil interventions, which led to a gradual loss of FX prices, import leakage from the government’s reserves. As the external position deteriorated stimulus program and rising transportation cost due to border closures, especially in H2 2021, the associated with the border frictions.30 Larger FDI central bank sold foreign exchange on the inflows also supported the import of domestic market and tightened macroprudential intermediate and capital goods (figure I.34). measures to prevent a sharp depreciation of the Meanwhile, although key export commodity tugrug. As a result, gross international reserves prices almost doubled, nominal exports grew by fell from US$4.9 billion in April 2021 (about only 18 percent (y/y) in 2021 due to the border seven months of imports) to US$3.7 billion (fewer frictions (figure I.35). Overall, the merchandise than four months of import coverage) in February trade balance decreased to US$1.3 billion in 2022 (figure I.36). The nominal exchange rate 2021 from US$1.8 billion in 2020. Moreover, remained relatively stable against the US dollar 30 Using interlinkages of the input-output table, we estimated that about 20 percent of the excess liquidity provided through a repo facility, agricultural soft loans, and subsidized loans to support jobs, leaked to finance imports (compounded by rising transportation costs). 24 Economic Performance and Prospects – April 2022 and depreciated by only 1.3 percent in 2021, substantial appreciation in the real effective while the tugrug weakened by about 8 percent exchange rate by about 5 percent in H2 2021 against the RMB. Meanwhile, the rapid (figure I.37). acceleration in domestic inflation led to a Figure I.34. Investment, consumption and fuel dominated Figure I.35 … while high commodity prices mainly the imports bill … supported nominal exports Imports bill growth and percentage contributions of key items Export revenue growth and percentage contributions of key commodities Consumer goods Industrial input Gold Copper Investment items Fuel Coal Others Others Total imports (y/y, %) Total exports (y/y, %) Export price (y/y, %) Imports price (y/y, %) 150% 40% 120% 30% 90% 20% 60% 10% 30% 0% 0% -10% -30% -20% -60% -30% Sources: Mongolian Customs; World Bank staff estimates. Sources: Mongolian Customs; World Bank staff estimates. Note: Copper also covers gold content within Oyu Tolgoi’s copper concentrate. Figure I.36. BoM’s supply of FX intensified in the second Figure I.37. Real effective exchange rate (REER) has half of 2021 been appreciating Gross FX supplied to the market, in US$ million Exchange rates (Jan 2019 = 100) 5500 FX supplied to the market (per week, RHS) 250 115 Average nominal exchange rate (MNT/US$) Gross international reserves (LHS) 5000 200 110 REER NEER 4500 150 105 4000 100 100 3500 3685 50 95 3000 0 90 this way is appreciation 2500 -50 85 2021 Source: BoM. Source: BoM. Note: NEER=Nominal effective exchange rate. 25 MONGOLIA ECONOMIC UPDATE – April 2022 Deteriorating market expectations led to some (MNT/US$) which depreciated by 5.5 percent as dollarization of domestic assets resulting in a of April 6, 2022 (relative to end-2021), despite weaker tugrug, FX rationing, and a widening gap the central bank’s gross intervention of US$1.8 between the parallel and official exchange rate in billion since January 1, 2022.31 Banks started early 2022. As external imbalances widened and rationing FX to customers since end of February market expectations shifted in early 2022 amid and the government recently submitted to the war in Ukraine, dollarization increased to 31 Parliament a draft law aimed to limit the amount percent of total current deposits by end of of FX and precious metals that can be carried February 2022, up from 29 percent in January across the border to no more than MNT 20 million (figure I.38). Amid accelerating demand for (about US$6700) per individual. This has resulted foreign exchange, the BoM was challenged to in significant gap between the non-bank and the maintain a stable nominal exchange rate interbank nominal exchange rates (figure I.39). Figure I.38. Dollarization of current account jumped in Figure I.39. FX Rationing amid deteriorating market February 2022 expectations widened the spread between non-bank and interbank exchange rates Estimated dollarization of deposits and current account Mid-point of nominal exchange rate of MNT/US$ 50% FX deposits/total deposits 3200 Interbank FX current account/total current account 3150 40% Non-bank (parallel) 3100 31% 3050 30% 29% 3000 21% 2950 20% 20% 2900 2850 10% 2800 Sources: BoM; World Bank staff estimate. Source: BoM. Note: To avoid the effect of nominal depreciation, a fixed Note: The central bank reports the mid-point of the daily exchange rate is used to estimate the dollarization. nominal exchange rate announced by banks (interbank exchange rate). A6. Conditions in the banking sector have improved but challenges remain Supported by the government’s stimulus performing loan (NPL) ratio (nonperforming loans measures, banks resumed their lending activity in to total outstanding loans) moderated from its 2021. After contracting in 2020, outstanding peak at the end of 2020. While this reflects some loans of banks started to increase rapidly from Q2 progress on NPL resolution, it is largely explained 2021, and credit growth accelerated to 22 by a moratorium on loan classification and percent (y/y) at end-2021, reflecting increased provisioning. NPLs are expected to increase lending to trade, manufacturing, and mining again, as the moratorium on asset classification sectors (figure I.40). The amount of past-due and provisioning expired on March 31, 2022 loans decreased by 26 percent (y/y) and the non- (figure I.41). 31 Prior to the start of the war in Ukraine on February 24, 2022, the tugrug depreciated by 0.5 percent (relative to the end of 2021) against the US dollar. Meanwhile, the depreciation accelerated after the start of the Russian invasion. The central bank’s intervention has amounted to US$700 million since then. 26 Economic Performance and Prospects – April 2022 Figure I.40. Income relief and stimulus program Figure I.41. Problematic loan ratios are converging back supported resumption of bank lending to their pre-pandemic levels Bank lending (y/y, percentage points) Ratio of problematic loans to total loans, in percent 30% Agriculture Mining NPL / Total Loans Overdue Loans / Total Loans Manufacturing Construction 25% Trade Transport 12% 20% Other Total 10% 10% 15% 9% 8% 10% 6% 7% 5% 4% 0% 5% -5% 2% -10% 0% Source: BoM. Source: BoM. Provisioning of loans to risky sectors continues to loans in December 2021. Meanwhile, 64 percent be low. Loan loss provisions for problematic of the value of problematic loans issued to loans for the mining, construction, and individuals is currently covered by provisions manufacturing sectors ranged between 50 and 63 (figure I.43). The erosion in real incomes could percent (figure I.42). Combined, these sectors pose challenges to households in meeting their account for about 56 percent of total problematic debt servicing obligations. Figure I.42. Ratio of problematic loans and provisioning Figure I.43. Ratio of problematic loans and provisioning rate (SME & Corporate Loans) rate (Household Loans) Problematic loans (as % of sector total) Problematic loans (as % of sector total) LLP (as % of problematic loans) LLP (as % of problematic loans) 130% 130% 110% 110% 80% 79% 90% 90% 64% 68% 63% 63% 62% 56% 54% 70% 55% 70% 53% 50% 48% 50% 36% 50% 32% 27% 24% 21.2% 30% 15% 30% 14.9% 15.9% 7% 10% 6% 8.5% 7.7% 10% 10% -10% -10% Source: BoM. Source: BoM. The reported system-wide capital and liquidity decreased by 3 percentage points from 15 position appears broadly adequate. The gearing percent in 2021, it remains above the 9 percent ratio of banks has remained stable throughout minimum requirement imposed by the central the pandemic, and although the Tier 1 capital bank (figure I.44).32 The banking sector also ratio (proxied by the balance sheet items) has displays ample liquidity, as evidenced by a 32 In general, the gearing ratio shows the share of total assets funded by owners’ equity. Based on the BoM’s capital adequacy requirement, Tier 1 capital includes only core equity items such as common shares and retained earnings. 27 MONGOLIA ECONOMIC UPDATE – April 2022 further improvement in the liquidity ratio, economy from the COVID-19 pandemic (figure suggesting adequate buffers to withstand I.45). adverse shocks and support the revival of the Figure I.44. Banks appear adequately capitalized … Figure I.45. … while overall liquidity remains high 20% Tier 1 ratio (proxy measure) 40% Gearing ratio 30% 15% 20% 10% 10% Reserves / Core Deposits Liquid Assets / Total Liabilities 5% 0% Source: BoM. Source: BoM. With large foreign currency denominated assets (figure I.46). The large gap between liabilities, bank balance sheets continue to be foreign assets and foreign liabilities could expose exposed to currency mismatches. Although the bank balance sheets to currency risk, especially share of foreign currency denominated liabilities in an uncertain external environment. This risk is in total liabilities has fallen from about 33 partially mitigated through off-balance sheet percent at end-2020 to around 28 percent at end- contingent assets and liabilities (e.g., letters of 2021, the share of foreign liabilities in the credit, stand-by facilities, tender guarantees, and banking system is almost triple the size of foreign hedging instruments) (figure I.47). Figure I.46. Net open position-to-capital ratio improved, Figure I.47. Balance sheet FX risk is partially-hedged by indicating mitigation of FX risk off-balance sheet contingent assets Net Open Position (balance sheet items only) Net Open Position (including off-balance sheet items) FX Assets / Total Assets 20% 15% FX Liabilities / Total Liabilities 15% 50% Net Open Position / Capital (RHS) 0% 11% 10% 40% -50% 5% 30% -100% 0% 20% -150% -2% -5% -2% 10% -200% -10% 0% -250% -15% -15% -20% TDB Khan Golomt Xac State Source: BoM. Source: Websites of systemically important banks. The financial intermediation of the non-banking economic turbulence, as their loans reached 4.6 financial sector has significantly increased percent of GDP by December 2021 (figure I.48). recently. Activities of non-bank financial Driven by Mongolia’s blue-chip companies institutions (NBFI) expanded despite the benchmark stock index, the MSE Top 20 gained 28 Economic Performance and Prospects – April 2022 more than 130 percent in 2021 and reached a has seen a surge in virtual coins issuance, adding market capitalization of more than 14 percent of to financial sector risks (box I.3). GDP for the first time (figure I.49). Mongolia also Figure I.48. Role of NBFI increased in recent years Figure I.49. The stock market is also booming 7% 6.1% 16% 45 Total assets to GDP Market Capitalization as % of GDP 14% 40 6% Total loans to GDP Top 20 Index (RHS) 12% 35 5% 30 10% 4% 4.6% 25 2.7% 8% 3% 20 6% 15 2% 4% 10 1% 1.7% 2% 5 0% 0% 0 2015 2016 2017 2018 2019 2020 2021 2015 2016 2017 2018 2019 2020 2021 Source: Financial Regulatory Commission (FRC). Source: Mongolian Stock Exchange (MSE). Box I.3. Mongolia’s Market for Coins and Other Virtual Assets The foundations of the Mongolian market for coins and other virtual assets were established in 2017. While the number of market participants was limited initially, the number of Initial Coin Offerings (ICO) and Virtual Asset Services Providers (VASPs) increased sharply in 2021. The Financial Regulatory Commission (FRC) indicates that 18 coins/tokens are traded, six coins/tokens are going through the ICO stage, while four coins/tokens are in the preparation stage. In December 2021, the total market capitalization (MC) of traded coins/tokens reached MNT 1.23 trillion (close to 3 percent of GDP). Comparatively, equity trade on the Mongolia Stock Exchange (MSE) also improved, as market capitalization increased by 97 percent in 2021, representing more than 14 percent of GDP. The breakdown of the market capitalization by coins/tokens and VASPs is presented in figures I.50 and I.51 below: Figure I.50. Market capitalization (Coins) Figure I.51. Market capitalization (VASPs) Other Other COREX 12% 1% 3% COMPLEX TRD 11% DAX 5% 33% SPC 6% TRADE MNFT 20% 7% IHC 61% ARDX 9% COINHUB 32% Source: FRC. Source: FRC. Several factors may have contributed to the fast expansion of the Mongolian market for virtual assets. First, a loose monetary policy stance prompted banks to reduce their deposit rates rapidly. In fact, with the real return on MNT deposits already negative by August 2021, investors were nudged to search for alternatives, including virtual assets. Second, several coins/tokens demonstrated extraordinary performance with high capital gains and returns. For example, IHC, currently the largest coin in terms of MC, was trading around MNT 0.3 on September 13, 2021, but the price reached MNT 28.76 within a few days. However, in December 2021, the IHC coin experienced significant adjustments and corrections as its price dropped to about MNT 4.3, bringing an unrealized gain to 1,333 percent for 29 MONGOLIA ECONOMIC UPDATE – April 2022 buyers who invested at the early stage. ARDX, the second largest coin in terms of MC, also exhibited a trajectory with substantial volatility. Its current capital gain is still above 300 percent for early investors. FRC indicates that close to 550,000 investors, of which around 75 percent are active participants, have registered with the VASPs. The number of investors is likely to be overestimated due to double counting, as the possibility of an individual or firm registering on more than one VASP is not excluded. Considering the potential risks associated with highly volatile coins, the authorities have recently established two working groups, led by the Parliament and FRC, to develop the legal and regulatory frameworks necessary for investor protection on Mongolia’s market for coins and other virtual assets. Joint efforts of the two working groups facilitated approval of the Law on Virtual Asset Service Providers in December 2021. Source: Summarized by World Bank staff based on FRC presentation. B. Outlook and Risks Economic growth in 2022 is projected to remain will provide short-term support to the modest at 2.5 percent. This forecast reflects the construction and services sectors and expand impact of the war in Ukraine on Mongolia’s mining capacity in the long run. Lastly, our economy through higher prices of imported food, baseline forecast assumes a strong recovery of fuel, and fertilizers, coupled with lingering the agricultural sector in 2022, after a border frictions with China (see also box I.4).33 contraction in 2021 supported by relatively Coal exports are expected to recover modestly favorable weather conditions and an ensuing toward the end of the year, assuming border higher survival rate of livestock (table I.2).35 frictions with China ease toward the end of the Over the medium-term, economic growth is year. Although labor market conditions will expected to accelerate to above 6 percent in gradually improve with the reopening of the 2023-25, as the underground mining phase of OT economy, the recovery of domestic demand is becomes operational during H2 2023. The expected to be modest as household recently approved New Recovery Policy (NRP) consumption growth is weighed down by high targets improvements in private investment in inflation and a slow improvement of real 2023-25, although the extent to which this is incomes.34 In addition, gross fixed capital realized will depend on improvements in the formation will rise only moderately relative to its macro environment and on the consistent pre-COVID average. The recent agreement with implementation of key legislative reforms, for Rio Tinto over Mongolia’s largest copper mine, example the new PPP law (box I.5).36 Private OT, will continue to support investment amid consumption will also support growth in the steady FDI inflows. While an anticipated drop in medium term. the quality of OT mining output—following last year’s improvement—will weigh on mining output this year, the acceleration of investments 33 Infrastructure projects are expected to help Mongolian exports fulfill the hygiene requirements at the border. Under this scenario, coal exports will accelerate in late 2022 and could reach 18 million tons in 2022 relative to the target of 37 million tons. 34 Although real private consumption is projected to grow by 8.9 percent, its recovery is actually modest considering the base effects following a substantial contraction of 6.6 percent in 2021. The average growth of private consumption was 7.3 percent in 2017-19. 35 In 2021, agricultural output contracted significantly, by 5.5 percent (y/y), as 2020 rough weather conditions affected the survival rate of offspring hit by animal disease in 2021. However, preliminary estimates suggest that the stock of animal forage remains sufficient as of mid-February, indicating less severe winter months relative to previous years. 36 A draft PPP law prepared by Ministry of Finance was recently submitted to Parliament aims to establish a legal environment that: (i) provides a clear, predictable investment environment in infrastructure assets; (ii) gives the private sector assurance that the public sector will honor its commitments; (iii) clarifies roles and responsibilities across different public entities; and (iv) provides adequate checks and balances to ensure fiscal and fiduciary governance. 30 Economic Performance and Prospects – April 2022 Table I.3. Key macroeconomic indicators 2019 2020 2021 2022f 2023f 2024f Real GDP growth, at constant market prices 5.5 -4.4 1.4 2.5 5.8 6.8 Private Consumption 5.8 2.1 -6.5 8.9 7.6 7.0 Government Consumption 12.3 14.6 5.3 5.3 5.8 6.1 Gross Fixed Capital Formation 14.0 -21.1 14.0 16.3 17.5 16.2 Exports, Goods and Services 12.0 -5.3 -14.5 4.0 18.0 17.1 Imports, Goods and Services 8.6 -15.5 9.6 5.7 17.5 17.8 Real GDP growth, at constant factor prices 5.1 -3.9 0.0 2.5 5.8 6.8 Agriculture 5.2 5.8 -5.5 3.0 4.1 5.5 Industry (incl mining) 3.1 -4.4 -2.8 1.2 7.9 6.1 Services 6.4 -6.5 3.6 3.0 5.1 7.6 Inflation (CPI, period average) 7.3 3.7 7.1 10.5 7.5 6.8 Current account balance (% of GDP) -15.2 -4.3 -12.7 -15.6 -13.8 -11.6 Financial and Capital account (% of GDP) 19.7 10.3 11.9 11.6 8.6 7.6 Fiscal Balance (% of GDP) 1.4 -9.4 -3.1 -4.8 -4.8 -4.4 Primary Balance (% of GDP) 3.6 -6.9 -1.1 -2.8 -1.9 -1.1 Public Debt (% of GDP) 68.4 77.3 79.5 83.6 81.7 80.0 Source: World Bank staff estimates. Note: Public debt does not include the BoM’s swap line with the PBOC (12 percent of GDP in 2021) and the contingent liabilities under the Development Bank of Mongolia (DBM) (5 percent of GDP). Box I.4. Global and Regional Outlook and Risks According to the January 2022 edition of the World Bank Global Economic Prospects report, global growth is expected to decelerate markedly, from 5.5 percent last year to 4.1 percent this year. The war in Ukraine is expected to accelerate this slowdown and contribute to higher global inflation. The OECD, for example, estimates more than 1 percentage point lower global growth and at least 2.5 percentage point higher global inflation than pre-conflict projections. Financial market volatility has also increased, contributing to a sharp tightening of global financial conditions, as the war in Ukraine soured risk appetite. Meanwhile, citing a tight labor market and elevated inflation, the Federal Reserve increased policy rates by 25 basis points and signaled another six rate hikes for 2022 at its Federal Open Market Committee meeting in March (figure I.52.A). The dollar strengthened more than 2 percent against a basket of major currencies from mid-February to mid-March amid elevated geopolitical risk. The war and associated severe economic sanctions imposed on Russia contributed to a further increase in commodity prices, especially commodities for which Russia and Ukraine are key exporters, including fertilizers, fuels, metals, and wheat. Natural gas prices in Europe more than doubled in the aftermath of the invasion, amid supply uncertainty, as Europe remains heavily reliant on Russian imports of natural gas. Gas prices have fallen back lately but remain 40 percent higher than in mid-February. Coal prices also rose sharply as several European countries announced plans to increase coal-powered electricity generation and build stockpiles. Several metal prices reached all-time highs in March, including aluminum, nickel, and palladium, due to concerns over the metal supply. Wheat prices increased by 40 percent, reaching record highs (figure I.52.B). The war in Ukraine is having a large negative impact on the Europe and Central Asia region due to tight regional economic and financial linkages; Russia alone accounts for about 40 percent of regional GDP. The war is also expected to adversely affect other EMDEs (Emerging Market and Developing Economies), particularly commodity-importing economies, which have experienced a rapid increase in sovereign spreads since the war started. As central banks in advanced economies begin to reduce monetary accommodation, capital flow volatility and currency depreciation may pose additional challenges to EMDE policy makers. Higher prices could weigh on consumer confidence and erode real earnings. Protracted high inflation could lead inflation expectations to rise above central bank objectives and require sharper-than-expected tightening of monetary policy, aimed at re-anchoring expectations. 31 MONGOLIA ECONOMIC UPDATE – April 2022 Figure I.52. Global developments A. CPI and 10-year treasury note yield in US B. Commodity prices (nominal index, 2010=100) Percent CPI 10-Year Treasury Note Yield (RHS) 170 Energy 8 3.0 Agriculture 2.5 140 Metals&Minerals 6 2.0 110 4 1.5 1.0 2 80 0.5 0 0.0 50 20 Mar-13 Mar-16 Mar-19 Mar-22 Sources: Haver Analytics; World Bank. Rising borrowing costs, combined with high debt levels and the rapid rise in non-concessional debt across many EMDEs increase the risk of financial stress. The pandemic has exacerbated an unprecedented debt boom across EMDEs, with debt of all types rising to multi-decade highs. The composition of debt compounds the challenges this will pose, with many EMDEs borrowing externally or at short maturities. Looking forward, EMDE policy makers will need to balance macroeconomic support with bolstering fiscal sustainability. As EMDEs have limited policy space to provide additional support if needed, these downside risks heighten the possibility of a hard landing —a much sharper slowdown in growth than currently envisioned. Source: Summarized from Global Economic Prospects January 2022 and EAP economic update April 2022. Box I.5. The New Recovery Policy The Parliament of Mongolia approved on December 30, 2021, an action plan for the New Recovery Policy (NRP), which is a 10-year strategy aimed to reduce the negative impacts of the COVID-19 pandemic, create enabling environment for effective implementation of Mongolian long-term Vision 2050, and address binding constraints to medium-term economic development. The NRP envisages 94 projects worth MNT 100 trillion (US$33 billion) to strengthen six major pillars: (i) recovery of operations of border ports; (ii) energy sector recovery; (iii) industrial sector recovery; (iv) urban and rural development; (v) green development; (vi) improving public sector productivity. The NRP indicates that the government will reduce the fiscal burden by mobilizing and financing significant portions of these projects through private sector funding (e.g., PPP). While aiming to support Mongolia’s path to economic revival, the NPR still lacks critical details. There is large uncertainty as to whether private sector financing as envisaged by the government will materialize to carry out the planned investments. In the absence of private sector participation, drawing on state resources might not be viable given Mongolia’s limited fiscal headroom and could further undermine efforts to reduce public debt. The NRP could also set measurable outcomes before engaging in expensive PPP schemes, especially considering the size and implications of the existing Build-Operate-Transfer (BOT) arrangements on fiscal sustainability. Lastly, the NRP could be clearer on the prioritization and selection of projects and the role and responsibilities of different government agencies in implementing the NRP. Source: Summarized from https://legalinfo.mn/mn/detail?lawId=16390082532431&type=3 We project the fiscal deficit to widen more than outlays, the government’s fiscal projections are envisaged in government budget. Against the overly optimistic. Even with higher global background of modest growth and rising pension commodity prices, the path to fiscal 32 Economic Performance and Prospects – April 2022 consolidation will be difficult as long as the swap line of US$1.8 billion with the People’s border frictions remain. In the absence of further Bank of China maturing in 2023 could also add spending cuts, including on capital expenditure, more pressure to the external sector unless it is and further revenue-enhancing measures extended. (including restoring social security contribution From 2024, however, the external balance may rates), the structural deficit would worsen by at improve rapidly as exports rise. By the end of least 1.5 percent of GDP in 2023 and onward, 2024, the current account deficit is projected to preventing Mongolia from reaching the statutory narrow to 11.6 percent of GDP as the limit on structural deficit until 2026.37 development and expansion of mining will Considering the pressure on budget revenue and increase production and exports. The investment the pattern of expenditure consistent with drive in the mining sector will generate higher election cycles, we envisage the headline budget demand for capital goods and other intermediate deficit to increase to around 5 percent of GDP in goods and, as a result, also increase imports. 2022, before narrowing to 4.6 percent of GDP in 2023-2024. Moreover, the government debt-to- The monetary policy stance is expected to GDP ratio (excluding the BoM’s swap line with tighten further amid the sharp rise in inflation the PBOC) is expected to reach 84 percent in and the buildup in external sector pressures.39 2022, and gradually decline to 80 percent in With inflation running well above the central 2024, amid a narrowing primary deficit and the bank’s target band of 6 ± 2 percent, widening use of Future Heritage Fund to finance the CMP. external imbalances and still-negative real Fiscal consolidation is needed to stabilize debt interest rates, further monetary policy tightening consistent with the requirements in the Fiscal is likely required to restore price stability in Stability Law. 2022.40 While additional policy rate hikes would help lower inflationary expectations, they should External sector pressures are expected to build be accompanied by steps to wind down quasi- further as global financing conditions tighten, fiscal operations and strengthen the operational large external debt payments fall due, and the independence of the central bank (see box I.6). current account deficit is projected to remain While Mongolia’s fear of a floating exchange rate elevated until end-2023. The current account is understandable given its import dependence deficit is projected to widen to 15.6 percent of and high pass through to inflation, the current GDP in 2022, as exports are only expected to rate of intervention and FX restrictions are not recover toward the end of 2022 when border sustainable and will likely exacerbate a loss of frictions with China are expected to ease. confidence and dollarization. Instead, monetary External sector pressures are further policy needs to return to a credible inflation compounded by tighter global financing anchor, raise rates and allow the exchange rate conditions, which could make it more to absorb negative external shock. challenging for Mongolia to refinance large external bond payments of around US$1.5 billion that are due in 2022-23. 38 Similarly, the BoM’s 37 The MTFF, approved by the Parliament by June 1 of each year, is a three-year budget document that specifies the targeted budget structural revenue, ceilings on budget expenditure, structural deficit, and net present value of sovereign debt in the upcoming three calendar years. 38 Recently, it was revealed that 58 percent of the DBM’s loans were classified as non-performing and another 25 percent as past due. While its external debt obligations do not have a sovereign guarantee, it is highly likely that the government would assume the bank’s debt obligations in 2023 to avoid its default. Default of a major SOE in the international market would be detrimental to Mon golia’s reputation and could hurt the successful refinancing of a sovereign bond (Khuraldai bond worth US$600 million) maturing in 2024. 39 Section A.3 provides a detailed discussion of the inflation dynamic of the last 14 months. 40 The approved monetary policy guideline indicates that BoM’s inflation target rate for 2021-23 is 6 percent with ±2 percentage points band. 33 MONGOLIA ECONOMIC UPDATE – April 2022 Box I.6. Why Central Bank Independence Matters Numerous studies have validated the importance of central banks’ independence. Indeed, central bank legislation in many countries contains “anchors” in one form or another, for central bank independence (CBI). Generally, the laws tend to recognize that political interference could undermine central banks’ goals—such as stable inflation over time, and, in some countries, maximum employment—and potentially create long-term risks to economic and financial stability. Since the global financial crisis, many central banks pursued strategies that significantly expanded their balance sheets. In some cases, governments tasked them with new or additional financial stability functions on top of their mandate of price stability. In some quarters, concerns about the expanded activities of central banks led to skepticism about the necessity or appropriate degree of central bank independence. Regardless of the type of reform enacted, operational independence in monetary policy must be safeguarded, in light of all the evidence. However, CBI in many countries remains limited, including in Mongolia. The extent of Mongolia’s legal (de jure) CBI is marginally lower than the average among all countries included in the sample (figures I.53 and I.54). Furthermore, Mongolia’s measure of legal CBI is lower than the average among lower-middle income countries in the sample. Since legal measures of CBI do not indicate the degree of actual independence. Cukierman, Webb, and Neyapti (1992) argue that the turnover rate (TOR) of central bank governors is a better proxy for actual (or de facto) central bank independence. By that standard, Mongolia’s de facto measure of CBI is also limited. Since 1991, BoM has seen a succession of nine central bank governors, implying that most governors were replaced before the end of their six-year terms. In contrast, based on central bank TOR from Dreher, Sturm, and De Haan (2010), a five-year average TOR around one implies that central bank governors in most countries are able to complete a full term. Figure I.53. Mongolia’s CBI in 2012 was below average Figure I.54. Similarly, the measure for Mongolia in in terms of legal measure 2014 was below the average Source: World Bank staff illustration based on measure of legal central bank independence from Garriga C. (2016) and Bodea and Hicks (2014). Note: The data coverage from Garriga C. (2016) expands to 182 countries between 1970 and 2012. Data from Bodea and Hicks (2014) covers 144 countries between 1972 and 2014. The importance and benefits of central bank independence from political interference are undeniable. For one, more independent central banks tend to deliver and maintain a lower level of inflation compared to less independent ones (Bade and Parkin, 1988; Garriga and Rodriguez 2020; Brumm, 2002, 2011; Klomp and de Haan, 2010; and Berger, De Haan, and Eijffinger, 2001). Second, more independent central banks are less subject to political pressure and interference and are less prone to finance the government’s fiscal deficit, thus contributing to debt sustainability (Masciandaro and Tabellini, 1988; Sikken and De Haan, 1998; Lucotte, 2009). They also tend to accumulate more international reserves (Samano, 2021). Fixed-effect model estimations indicate that an improvement in Mongolia’s CBI index from 0.55 to the average among lower-middle-income countries (0.6), could be associated with a 3.3 ppts decline in the inflation rate and a marginal decline of 0.1 ppt in the budget deficit. Sources: Compiled by World Bank staff. 34 Economic Performance and Prospects – April 2022 Risks Uncertainties surrounding the baseline forecast could trigger instability through the erosion of remain large, mostly on the downside. In a public confidence in banks, especially in the face downside scenario, economic growth could fall to of the upcoming initial public offerings (IPOs). 0.7 percent in 2022 if border restrictions with Indeed, there is a risk that rushing forward with China persist throughout the year and the war in the IPOs without adequate preparation could Ukraine leads to persistently higher energy prices worsen financial sector risks, as investors lack and tighter global liquidity. In this case, the fiscal information and hence confidence on the deficit would widen further due to revenue underlying capital position of banks. shortfalls. While border disruptions would limit Rising food price inflation could prompt poverty imports as well, the current account deficit would to remain above the pre-COVID level as urban nonetheless increase, exacerbating external poor households spend nearly 40 percent of their financing pressures. consumption on food. Additionally, weather- The Russia-Ukraine conflict poses a significant related shocks could adversely impact the downside risk for Mongolia. Given Mongolia’s income of poor and vulnerable herders. Risks to large dependence on fuel imports from Russia— growth could also stem from new severe COVID- about 90 percent of total fuel imports originate 19 variants that could further prolong the border from Russia—the ongoing conflict and ensuing closures, suppress exports, and stall the economic sanctions against Russia are likely to envisaged recovery in consumption. complicate Mongolia’s fuel supply (for details see Mounting instability and heightened risks call for box I.7). adjustments in macroeconomic policies. Downside risks also stem from Mongolia’s l arge Monetary policy needs to return to a credible off-budget liabilities, which could further inflation anchor, raise rates, curtail quasi-fiscal undermine fiscal sustainability. These include activity, and allow the exchange rate to absorb the commercial debts of the DBM, which is facing negative external shocks. Fiscal consolidation is an external bond payment of US$800 million in needed to stabilize debt and ensure external and 2023. Risks associated with the DBM’s solvency public debt sustainability. Better targeting fiscal could affect Mongolia’s sovereign credit rating, measures to the poor would help contain fiscal increase financing costs, and threaten fiscal imbalances while sustaining support to the most sustainability. Similarly, given Mongolia’s high vulnerable households. Restoring long-term level of government debt and the erosion of fiscal sustainability and building buffers to existing fiscal space, failure to gradually restore manage commodity price volatility is critical. In fiscal discipline could weigh on investor and this regard, pension reforms could help stabilize consumer confidence and derail the recovery in the medium-term fiscal outlook (see the next growth. chapter). Although conditions in the banking sector Structural reforms would help lay the foundation improved, vulnerabilities remain. End-2021 for diversified and hence more resilient growth in financial disclosures by systemically important the medium term. These reforms include banks indicate high levels of capital adequacy measures to prioritize transport investments and liquidity. However, a moratorium on loan along critical corridors while improving customs classification and provisioning masks the true and logistics to reduce trade costs, and improve financial conditions of banks. A potential rise in the business climate and economic governance NPLs following the expiration on March 31, 2022, to attract investment. Moreover, enacting of the moratorium on loan classification and electricity tariff reforms and transparent power provisioning could reduce bank lending and purchase agreements will encourage private weigh on investment and consumption. If investment, including in renewable energy. unaddressed, undercapitalization in some banks Meanwhile, Mongolia will also need to mitigate 35 MONGOLIA ECONOMIC UPDATE – April 2022 the risk of climate change associated to its coal accelerate monetary policy tightening. Finally, heavy energy sectors.41 In addition, the financial sector reforms should focus on authorities should scale down quasi-fiscal assessing the underlying capital position of activities under the MNT 10 trillion program and banks for the upcoming IPOs. Box I.7. Preliminary assessment of the impact of the war in Ukraine on Mongolia The war in Ukraine could not have come at a worse time for the Mongolian economy. The recovery from COVID-19 has been weak amid prolonged border closures with China. Inflation has surged substantially, to almost twice the central bank target, while sizable contingent liabilities, including the DBM’s external bond (US$800 million), have further exacerbated large public debt risks. This note analyses the preliminary impact of the war in Ukraine on Mongolia’s economy through trade, cost of production and inflation, and financial channels. Trade channel. Mongolia has some direct exposure to Russia through trade channels, especially energy imports. While about 1 percent of Mongolia's exports is directed to Russia, about 28 percent of imports originate directly from Russia, of which more than half are fuel and energy imports (figure I.55). About 90 percent of Mongolia's fuel imports originate from Russia (figure I.56). In addition, it is estimated that about 10 percent of Mongolia's imports from European countries transit through Russia. The significance of the Russian border for external trade increased in 2021, amid the prolonged border frictions with China, which caused delays in imports and increased transport costs through the main border with China. Since frictions on the border with China are unlikely to ease before the end of 2022, trade disruptions with Russia would have significant implications on the supply of imported food, fuel, and fertilizers, compounding already elevated inflationary pressures. So far, there is no indication of physical barriers to imports from Russia, however. Figure I.55. Fuel imports constitute more than half of Figure I.56. Mongolia relies mainly on imports of fuel imports from Russia and fertilizers from Russia Imports from Russia as a share of total imports (average of Imports of selected goods from Russia within each category 2019-2021) (average of 2019-2021) 30% 27.9% 100% 88% 90% 25% 20% 15.3% 75% 15% 8.3% 10% 50% 3.2% 5% 0.5% 0.5% 27% 0% 20% 25% Food Fertilizer Fuel Electricity Others Total imports from 0% Russia Food Fertilizer Fuel Electricity Source: Mongolian Customs. Source: Mongolian Customs. Note: Wheat import is included in food imports. Note: Wheat import is included in food imports. Cost of production and inflation. Rising fuel and food prices negatively affect Mongolia's current account balance, economic growth, and inflation through rising costs of production and consumption. Mongolia is a net importer of oil, as its import bill averaged US$1 billion during 2019-21. A surge in global oil prices would have significant implications for the current account balance, which already recorded a deficit of 12.7 percent of GDP in 2021. In addition, rising global fuel prices could quickly translate into higher domestic consumer prices and substantially raise the cost of production (figure I.57). Our estimates indicate that a 10 percent change in fuel prices could push food prices up by 1.2-1.4 percent (see box A.1 in annex).a Furthermore, with 24-28 percent of its wheat supply (100 percent of wheat imports) and 88 percent of fertilizers originating from Russia, war-driven supply constraints in 41 Encouraging sustainable herding practices through for example livestock tax will help mitigate Mongolia’s climate change risk associated with overgrazing by its large size of livestock. 36 Economic Performance and Prospects – April 2022 Russia could add to already high food price inflation, and further weaken growth and the livelihood of the population. Figure I.57. Global prices of key imported goods spiked Figure I.58. BoP pressure led to a shortage of FX and banks’ FX rationing Price index Jan 2021 = 100 Nominal exchange rate of MNT/US$ 350 Fertilizer (Urea) Wheat Oil 3200 Interbank 300 3150 Non-bank (parallel) 250 3100 200 3050 3000 150 2950 100 2900 50 2850 0 2800 Sources: Markets Insider; Bloomberg Source: BoM. The impact of the war on domestic confidence adds to pressure on the balance of payments. The war in Ukraine has eroded confidence and added to uncertainties, fuelling an increase in the demand for foreign exchange (FX). Given declining gross international reserves, commercial banks are rationing FX liquidity, further weakening growth as firms will limit their purchase of key imported capital and intermediate goods. The divergence between official and parallel market exchange rates has recently increased (figure I.58). Finally, the war in Ukraine and ensuing sanctions on Russia could put at risk a joint project between Russia Figure I.59. The growth forecast in 2022 was and Mongolia, with significant economic and downgraded due to several factors Percentage contributions to change in GDP growth forecast environmental implications. Mongolia has been trying in 2022 for at least a decade to serve as a transit territory for the gas pipeline connecting Russia with China. The project 6 is expected to have significant positive economic and 3 environmental implications for Mongolia, such as 5.1 2.5 easing air pollution in Ulaanbaatar. Significant progress 0 -0.1 0.5 was made on deals at the higher levels, and Mongolia -1.7 -1.3 recently signed an agreement with Gazprom (Russian -3 SOE) to initiate the preparatory work. While construction is slated to start in 2023, if sanctions are expanded to energy-related activities, Mongolia could see a delay of an important source of growth and opportunity for cleaner energy. Source: World Bank staff estimate. We downgraded our initial 2022 growth forecast for Mongolia from 5.1 percent to 2.5 percent. The downgrade takes into account the impact of rising prices of food, fuel, and fertilizers on Mongolia’s terms of trade, lowering growth by 1.7 ppts. Continued border disruptions with China also reduce growth by 1.3 ppts compared to our October 2021 assumptions. Moreover, a 0.1 percent downgrade in China’s economy could translate into a 0.09 ppt reduction in Mongolia’s GDP, given strong trade and investment flows with China. Some additional fiscal support, specifically to the agricultural sector will partially offset these negative shocks (0.5 ppt) (figure I.59). Source: World Bank staff. Note. a. Estimates vary with the estimation method (ordinary least square or simultaneous equations). However, the effect on food prices can be as high as 8.23 percent if extreme fluctuations are considered. 37 MONGOLIA ECONOMIC UPDATE – April 2022 38 II. Fiscal Sustainability of the Mongolian Pension Scheme MONGOLIA ECONOMIC UPDATE – April 2022 II. FISCAL SUSTAINABILITY OF THE MONGOLIAN PENSION SCHEME This chapter assesses key challenges facing the Pension Insurance Scheme and suggests options to enhance its financial sustainability. The following key challenges were identified: • Substantial real increases in minimum pension benefits including the February 2022 increase has resulted in more than three quarters of retirees receiving the minimum resulting in weak links between contributions and benefits. • Without reform, the Pension Insurance Scheme is unsustainable, given that fiscal costs are projected to escalate. Costs are projected to increase from 2.8 percent of GDP in 2020 to 6.8 percent in 2030 and to grow further thereafter. • The Notional Defined Contribution scheme (NDC) will result in substantial reductions in replacement rates for cohorts born after 1978. This abrupt reduction in benefits will shortly affect some new retirees. • Proposals to establish a Funded Defined Contribution (FDC) scheme would require additional fiscal transition costs of up to 2.5 percent of GDP per year for about 30 years in addition to challenging institutional requirements. From a worker’s perspective, replacement of the current scheme with an FDC scheme under most scenarios would reduce, rather than increase, retiree benefits. The following reform options are suggested: • Parametric reforms can reduce the anticipated growth in fiscal costs. Adoption of automatic indexation of pension benefits, including the minimum, linked to the growth of the consumer price index, can both protect retirees and reduce costs. Similarly, increases in the contribution rate and the retirement age can reduce costs without affecting benefits. It is also possible to reduce the level of benefits accrued for service after a reform date. • A smoother transition in the implementation of an NDC scheme could be achieved by applying the scheme to contributory service after a reform date rather than retroactively applying it to all retirees born after a specific date. • The fiscal and institutional challenges in establishing an FDC scheme appear to outweigh the limited benefits. One means of beginning to address the institutional challenges while limiting fiscal costs is to adopt a national framework for voluntary, supplementary FDC contributions. 40 Fiscal Sustainability of the Mongolian Pension Scheme A. Mongolia has a relatively generous pension scheme with high levels of coverage and unsustainable fiscal costs A1. The Pension Insurance Scheme is effectively universal for retirees with generous replacement rates and modest contribution rates The Pension Insurance Scheme has very high data suggests that more than 80 percent of the levels of both labor force and elderly coverage. labor force contributed to the scheme during Coverage of workers has been high in Mongolia, 2020-21 (figure II.1). Moreover, coverage of the owing to some growth in payroll-based elderly is effectively universal for men ages 60 employment during 2008-12 and increased and older and women who are 55+, which is close participation in the voluntary scheme following to coverage in former Soviet countries (figure buyback facilities offered in 2012 and 2017. 42 The II.2). Figure II.1. Coverage of the labor force by pension Figure II.2. Mongolia’s coverage of elderly is effectively contributors has been high universal as in former Soviet countries Share of contributing workers within the labor force Share of population above statutory pensionable age receiving a pension in 2020 Mandatory Voluntary Total 81% EAP average 64 90% 73% 80% 70% 17% 9% OECD average 88 60% 51% 50% 6% 40% Former Soviet countries 96 30% 64% 64% 20% 45% 10% Mongolia 100 0% 0 20 40 60 80 100 Source: NSO. Source: OECD: Pensions at a Glance 2021: OECD and G20 Note: Value in 2021 is estimated based on monthly indicators. Indicators. Note: Social welfare pensions are included. The benefits provided by the Pension Insurance half of their wage, assuming that the benefit was Scheme are relatively generous by regional and larger than the minimum pension. 43 For instance, international standards, especially considering a full-term worker who works for 35 years would the relatively low retirement age and modest receive a benefit of about 68 percent of their contribution rate. Relative to OECD countries, individual wage (see box II.1 for details of current Mongolians enjoy higher replacement rates pension scheme). Similarly, the gross (figure II.3). Under the current scheme, a worker replacement rate for Mongolia remains high with an average number of years of service at considering the effective contribution rates retirement would receive a benefit equal to over (figure II.4). 42 The discounted service credit offered was heavier in 2012 relative to 2017. 43 As of end-2018, the average contribution density (defined as the average number of pensionable years of service) at retirement was 26 years for men and 24.6 years for women, with a total contribution density for all workers at retirement of about 25.3 years. A worker with either a low contribution density and/or lower applicable wage base from which to determine benefits may receive the minimum pension and therefore have a higher individual replacement rate. 41 MONGOLIA ECONOMIC UPDATE – April 2022 Figure II.3. Replacement rates in Mongolia are among Figure II.4. … characterized by lower contribution rates the highest relative to comparators … Gross replacement rate and retirement ages in select Gross replacement rate and contribution rates in 2020 countries44 90 Denmark Gross replacement rate Retirement age 80 Mongolia Italy 70 80 Gross replacement rate Turkey 70 60 50 OECD 60 50 40 USA 40 30 Korea 30 20 20 Lithuania y = 0.6584x + 34.467 10 R² = 0.0729 0 0 10 20 30 40 Effective contribution rate Source: OECD: Pensions at a Glance 2021: OECD and G20 Source: OECD: Pensions at a Glance 2021: OECD and G20 Indicators. Indicators. Box II.1. Description of the Pension Insurance Scheme of Mongolia The state-mandated and managed defined benefit scheme hinges on a variety of parameters. Under this scheme, introduced in 1994, workers and employers with labor contracts are mandated to contribute 17 percent of covered wages, while workers without contracts, including herders and the self-employed, can voluntarily participate with a 13.5 percent contribution rate. Old-age benefits can be received at age 60 for men and 55 for women, with workers in specified professions or conditions entitled to benefits as early as 10 years prior to regular retirement age.45 A benefit equal to 45 percent of the pensionable wage base is provided after the first 20-25 years of service. The accrual rate thereafter is 1.5 percent per year. Workers meeting the vesting requirement of 20-25 years are entitled to a full pension for which the minimum is set at no less than 75 percent of the minimum wage. A lower “partial” minimum benefit, of no less than 50 percent of the minimum wage is provided for workers with 10-20 years of contributory service. The scheme also provides permanent disability and survivorship benefits (see table II.1 for a detailed description of the nexus between vesting requirements, the retirement age and the minimum pension as well as table A.II.1 for a detailed description of all of the parameters of the scheme). A Notional Defined Contribution (NDC) scheme was established in 1999 to reduce the fiscal burden and better align contributions and benefits. While the scheme was applied to cohorts born after 1960, the 2015 State Policy on Pension Reform changed its coverage to cohorts born after 1978. Cohorts born between 1960 and 1978 receive the better of either the defined-benefit (DB) pension or the NDC pension, which is almost always the DB pension. Despite being widely perceived as offering better benefits, the NDC scheme has substantial design flaws, including: • Due to the lack of a transition mechanism policy between cohorts, an abrupt reduction in benefits is expected for cohorts born after 1978. For example, workers retiring in 2039 (when men born in 1979 reach the retirement age of 60) would see average benefits decline from about 55 percent of the projected average covered wage in that year to about 42 percent, a decline of 13 percentage points or a reduction in the pension by almost a 44 Gross replacement rate refers to the individual replacement rate at retirement for an average wage worker who works continuously from age 22 to retirement age. The retirement age refers to the higher of men or women for countries that have distinct ages for each gender. 45 See Table II.1. for a more detailed explanation. In 2018, the retirement age and vesting requirements were changed as follows: Workers were required to complete a total of 20-25 years of service to receive a full pension and full minimum pension at the regular retirement age of 55 for women and 60 for men. The required years of service was legislated to increase at a rate of three months for each year. However, for workers with only 20 years of contributory service, the retirement eligibility age increases at a rate of three months per year until it reaches age 65 for both men and women. Workers in special professions, herders, and mothers with four or more children have earlier retirement ages, which are five to 10 years below the normal retirement ages. 42 Fiscal Sustainability of the Mongolian Pension Scheme quarter (figure II.5). Not only it is inequitable, the abrupt decline in the replacement rate would also increase the already high proportion of retirees entitled to the minimum pension. • There are technical issues over the valuation of accrued rights and calculations of notional interest rates and annuity factors. Notional balances may be underestimated, particularly since wage data was not available for work prior to 1994. • The scheme does not set aside a sufficient proportion of contributions for disability and survivorship benefits. • The Mongolian NDC scheme has no provisions for the separate accounting and state financing of the minimum benefit. Benefits provided by NDC or FDC schemes are a function of contributions, so any minimum needs to separately finance the difference between the pension derived from an individual account accumulation and the minimum. There also is a contradiction in the legislation between the NDC pay-as-you-go financing and aspirational funding targets in the legislation. In neither the PAYG DB scheme nor the NDC scheme will there be surpluses generated to somehow fund or fill individual accounts. • There is ongoing confusion between the objectives of the NDC scheme and the concept of a Funded Defined Contribution (FDC) scheme (see part B). Table II.1. Parameters of the minimum pension Years of Qualifying Service Age of Qualification for Benefit Benefit < 10 55 (women), 60 (men) Social Welfare Pension (Non- contributory social assistance) 10 - < 20 55 (women), 60 (men) Calculated partial pension or partial minimum pension (>50% of minimum wage) 20 + 55 (women), 60 (men) gradually increasing to age Calculated full pension or full 65 at a rate of 3 months per year, for those retirees minimum pension (>75% of who do not meet the rising vesting requirements or minimum wage) lower ages for herders, women with 4 or more children, hazardous and special professions 20 rising to 25 years at phased-in 55 (women), 60 (men) Calculated pension or full at a rate of 3 months per year minimum pension (>75% of minimum wage) Source: World Bank staff assessment. Figure II.5. Replacement rate is expected to be significantly lower for the cohort born after 1978 Replacement rates between Pay-As-You-Go Defined Benefit (orange line) and Notional Defined Contribution Schemes (blue line) as percent of average covered wage 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2052 2054 2056 2058 2060 Source: PROST Projections, 2019. Note: The vertical lines are the projected drops in the replacement rates for men and women, respectively. For purposes of presentation, we have eliminated the small number of pre-1979 cohorts retiring after 2042 and the small number of early retiree post-1979 cohorts retiring before 2032. 43 MONGOLIA ECONOMIC UPDATE – April 2022 A2. The current pension scheme requires substantial state subsidies and faces escalating projected fiscal costs The pension insurance scheme is projected to GDP in 2020 to 6.8 percent of GDP in 2030 and absorb an increasing proportion of fiscal 11.3 percent of GDP in 2050 (figure II.6). revenues unless there are reforms to key Assuming that fiscal revenues as a share of GDP parameters. The Scheme in 2020 required a state remain constant, the projections suggest that the subsidy of 2.8 percent of GDP to pay for about 45 state subsidy to pensions would grow four-fold, percent of benefits that were not financed from from 9.2 percent of total revenues and grants in contributions. Projections in 2019 suggested a 2019 to 37.2 percent by 2050, crowding out other rapid and unsustainable level of growth in the essential public expenditures. state subsidy, rising from about 2.8 percent of Figure II.6. Financing gap is expected to increase under the current system Financing gap under PAYG Current Balance as a share of GDP 0% 2042 2057 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 2056 2058 2059 2060 -2% -4% -6% -8% -10% -12% Source: PROST Projections, 2019. Note: Under current system (baseline), growth of minimum and regular pension are indexed to growth in average covered wage; the Defined Benefit scheme applies to all cohorts including cohorts born after 1978. The simulated results were close under NDC. A series of reasons explain the escalating • The retirement age is relatively low and has projected fiscal costs of pensions: not increased in Mongolia even though life • The contribution rate of 17 percent (13.5 expectancy at retirement age has been percent for self-employed) is far from increasing. Furthermore, in 2017 the sufficient to support the promised benefits. 46 authorities reduced the retirement age for • The authorities have enacted multiple herders and have retained early retirement increases in benefits, in minimum benefits, ages for workers in hazardous and dangerous and two buyback arrangements which professions as well as for women with four or heavily subsidized future pensions for a large more children (figure II.7). number of participating workers. 46 As a part of COVID-19 relief measures, the authorities subsidized employer and employee contributions during 2020 and 2021, which is unlikely to have a long-term impact on pension costs. From April 1, 2020 to September 30, 2020, all contributions for social insurance for private sector workers in the mandatory scheme were paid by the state. Between October 1, 2020 and June 30, 2021, there was a partial relief, with the state paying for all non-pension social insurance contributions and 7 percent of the contribution rate of 17 percent (for voluntary participants from 3 percent to 6.5 percent from contribution rate of 11.5 percent). 44 Fiscal Sustainability of the Mongolian Pension Scheme Figure II.7. Retirement age in Mongolia remained unchanged despite increasing life expectancy Retirement age Life expectancy at retirement age 90 19.2 18.9 22.9 22.3 23.9 23.6 15.6 25.3 15.6 27 19.1 19.8 21 60 Years 30 66 65.7 65 64.5 62 60 61.5 60 55 56.5 55 58 57 0 Source: OECD: Pensions at a Glance 2021: OECD and G20 Indicators. A3. Recent increases in minimum pensions further erode the contributions-benefits nexus as well as fiscal sustainability Recent increases in the minimum pension have II.6 under the baseline scenario. Such abrupt reduced the linkage between contributions and increases have become the norm in Mongolia, benefits. As a result of the ad hoc changes in instead of a relatively steady and predictable cost pension benefits, introduced in February 2022, adjustment associated with automatic the proportion of retirees receiving the full indexation, which could be linked to a commonly minimum pension is estimated to have increased accepted index. For instance, the minimum from 52 percent to 78 percent of those qualifying pension was raised by over 70 percent and the and the partial minimum pension from 85 partial pension by over 100 percent in 2012. In percent to 98 percent. This suggests that most several developed countries, indexation of retirees will receive the minimum, regardless of pensions, including the minimum, are often their contributions based on reported wages. Ad automatically adjusted by inflation or wage hoc adjustments have in effect resulted in a flat growth or some combination thereof. This pension for about three-quarters of workers, reduces uncertainty related to pension benefits, irrespective of their contributions based on maintains the purchasing power of benefits, varying levels of salaries. eliminates the need for annual review, and de- politicizes the adjustment process. Ad-hoc adjustments in indexation and the Moreover, retiring workers can qualify for one of minimum pension create unprogrammed and the three minimum benefits according to the abrupt fiscal costs along with uncertainty for years of qualifying service. 47 The full minimum workers and retirees. The 2022 increase in the and partial minimum are adjusted on an ad-hoc minimum pension and the 15 percent increase in basis. Moreover, full retirement benefits total pensions are estimated to have a budgetary (including a full minimum) are linked both to the cost of about 1.5 percent of GDP in 2022, years of qualifying service and the age of resulting in a further increase in costs in the retirement. This multiplicity of vesting periods, future. These costs exacerbate the already retirement ages and minimum pensions creates unsustainable pension costs illustrated in figure 47 These benefits include: (i) social welfare pension (non-contributory social assistance) with less than 10 years of service; (ii) calculated partial pension or partial minimum pension (>50% of minimum wage) with 10-20 years of service; and (iii) calculated full pension or full minimum pension (>75% of minimum wage) with 20+ years of service. For details see table A.II.1 in annex. 45 MONGOLIA ECONOMIC UPDATE – April 2022 fragmented incentives to work and contribute toward Mongolia’s pension insurance scheme. A4. Fiscal costs could be reduced by changes in parameters A series of parametric reforms would help wages. Although automatic inflation indexation improve the financial sustainability of the current would make benefits more predictable, inflation pensions system (figure II.8). The following indexation would lead to reduced replacement reforms are projected to reduce the growth of rates over time, explaining the reduction in the public expenditures while also making the overall deficit. pensions system more equitable and benefits Second, gradually increasing the normal more predictable: retirement eligibility age to 65, applying an First, the adoption of an automatic indexation for actuarially fair benefit reduction for early regular and minimum pension benefits consistent retirement, and eliminating the linkage between with inflation is projected to reduce costs by the retirement age on the one hand and the almost 6 percent of GDP by 2050 when compared vesting period on the other could reduce fiscal with a baseline projection based on indexation to costs by over 3 percent of GDP by 2050. Figure II.8. Parametric reforms will help improve the financial sustainability Financing Gap under baseline and reform options Details of scenarios: (PAYG Current Balance as a share of GDP) Baseline – Growth of minimum and regular pensions are indexed to growth in average covered wages. The DB formula was applied Baseline Inflation indexation to cohorts born after 1978 as the simulated results were close to Contribution rate Retirement age Combined those under the NDC. 0% Inflation indexation – The minimum and regular pension is adjusted by CPI inflation in the previous year. -2% Retirement Age – The retirement eligibility age is increased at a -4% rate of three months per year until age 65 for men and women and an actuarially fair penalty applied to those retirees retiring -6% prior to the prevailing eligibility age. Contribution rate – The contribution rate is increased by 2 -8% percent for the mandatory scheme over a period of 2 years starting 2022. Same is assumed for the voluntary scheme. -10% Combined – This is a composite scenario of all the reforms above, -12% as well as an extension of the period for determination of benefits extended from seven to 10 years, according to the same parameters and transition periods. Source: PROST Projections, 2019. Note: Scenarios exclude the implications of recent pension hike (1.5 percent of GDP), which could actually add to the cost under all scenarios starting 2022. Third, gradual increases in the contribution rate This would improve incentives, equity between could also reduce fiscal costs. Returning to a workers, and reduce the tendency of some combined contribution rate of 19 percent, as it workers to increase their wages seven years was between 1994 and 2008 could also before retirement, especially in the voluntary somewhat reduce costs once Mongolia’s scheme. economy stabilizes and returns to pre-COVID Fifth, establishment of a linear accrual rate could growth. improve incentives. The current parameters Fourth, gradual extension of the wage base for provide for a higher accrual rate for earlier determining benefits from seven years to lifetime service; the first 20-25 years of service yield a and indexation of the wage base would improve replacement rate of 45 percent (about 2.25 fairness, though have almost no effect on costs. percent per year accrual rate) while subsequent 46 Fiscal Sustainability of the Mongolian Pension Scheme service is at a rate of 1.5 percent per year. A more parametric reforms such as to the retirement age continuous set of incentives could be established and contribution rate to address the challenge to by adopting a linear accrual rate of perhaps 2 fiscal sustainability. The legislation also percent/year of service. introduces substantial discretionary provisions, including the notional interest rate, the rate of The authorities have introduced reforms to return on funded pension assets, and the pensions and other social insurance legislation parameters for an additional “Basic Benefit.” The submitted to Parliament (see box II.2). Automatic legislation also fails to address the abrupt price indexation in the draft bill would help to reduction in replacement rates for post-1979 mitigate some of the projected increase in costs. cohorts under the NDC scheme. However, the draft bill fails to offer sufficient Box II.2. Draft Pensions Legislation Submitted to Parliament The draft legislation submitted to Parliament includes the following: • The contribution rate remains unchanged and is specified in the proposed General Law on Social Insurance. • Automatic price indexation is provided for pension benefits, although the minimum remains ad hoc. • The current dual criteria for retirement age and vesting is maintained. There is no change in the retirement age for those who meet the gradually increasing vesting period. • The retirement age for some special and hardship professions, which had been 10 years earlier than the normal retirement age, is to be gradually increased to five years early. No changes are proposed to the criteria for professions subject to early retirement. • The wage base for determining benefits would gradually increase from the current seven years to 10 years. • A linear accrual rate of 2 percent/year would replace the current non-linear benefit formula (for cohorts born prior to 1979). • A “Basic Benefit” is introduced in the legislation though there are no parameters indicated for determining the benefit. • The abrupt reduction in replacement rates for post-1979 cohorts to which the NDC scheme would be applied is not addressed (figure II.5). • The interest rate on notional accounts is removed and replaced by a rate determined on an ad hoc basis. The current notional interest rate is the average rate of covered wage growth over the past three years. • The draft legislation introduces the funding of individual accounts with 1 percent of contributions yet fails to articulate the framework for funding, linking benefits to funding. B. Benefits and pitfalls of the new proposed scheme: A Funded Defined Contribution Scheme B1. Potential Objectives of an FDC scheme – lessons for Mongolia A Funded Defined-Contribution scheme (FDC) is for establishing an FDC scheme, bearing in mind a retirement savings scheme whereby the fiscal costs, risks, and institutional contributions go into a fund that accumulates requirements. until retirement (box II.3). Enactment of an FDC Several countries that have migrated their scheme is a complex and important public policy pension system from PAYG DB schemes to either decision with important fiscal dimensions, which FDC or hybrid schemes have since modified the can materially impact the adequacy of pension FDC pillar or have reverted entirely to a PAYG DB benefits.48 It is important to have clear objectives 48 The authorities are exploring options for establishing a National Provident Fund, including using such a fund as the basis for an FDC design (see box A.2). 47 MONGOLIA ECONOMIC UPDATE – April 2022 scheme. In Eastern Europe and Central Asia, most Transitioning from a PAYG Defined Benefit countries adopted a “hybrid” approach whereby scheme to an FDC scheme will result in an they either converted part of the existing PAYG increase in fiscal costs. In fact, the government DB scheme to an FDC scheme or added on an will need to continue paying benefits to current additional FDC scheme while leaving part of the pensioners and older workers while suffering a pension formula through the existing or reformed loss of revenues related to the diversion of DB scheme. Before and during the global contributions to FDC accounts.49 Such transition recession of 2008-11, while several countries had costs could last for over three decades as the full or partial reversals of their FDC schemes, government tries to offset forgone contributions. others substantially modified the rules. Notably, Using these assumptions, the fiscal costs of the Hungary and Argentina closed their FDC funded scheme would be higher than those of the schemes, Poland has largely removed the Funded PAYG DB scheme and only be less than the PAYG pillar, and seven countries in Central and Eastern DB scheme when it begins to fund itself in about Europe have made substantial changes to their 2055. Transition costs are often financed through FDC schemes (see table A.II.2). (i) earmarking anticipated fiscal surpluses, (ii) a tax-financed transition, offsetting the fiscal A key challenge for maximizing individual returns losses through tax increases or expenditure cuts (and thus pensions adequacy) is to find a (parametric reforms to the PAYG DB scheme can diversified portfolio for FDC investments. This offset some of such transition costs), and/or (iii) a will be challenging for a country like Mongolia, debt-financed transition.50 considering its small domestic market for debt and equity securities. Box II.3. Principles of an FDC Scheme and its Applicability to Mongolia What are key features of an FDC design? In an FDC scheme, the funds are invested in securities either by a single agency or by fund managers. Although there can be many variants, generally all of funds contributed and accumulated in an FDC fund are invested to back up future benefits of members. Individuals often bear the risk and receive the return on pension fund assets during the accumulation phase (net of management and administrative costs).51 There are several different arrangements for the payout phase, such as phased withdrawals or annuities. What determines an individual’s benefits in an FDC scheme? An individual’s replacement rate depends upon the history of contributions, the return their pension assets (net of costs) as well as their retirement age. If the net rate of return on an individual’s pension assets are less than the growth of wages, the replacement rate will be lower than the replacement rate under an equivalent DB scheme, assuming the contribution rate fully finances the DB benefits. In addition, in Mongolia the contribution rate under the DB scheme is substantially less than the sustainable PAYG contribution rate, so that the replacement rate under an FDC scheme would be lower for this reason. Countries with thin, small, and/or poorly developed financial markets often find it difficult to achieve strong real rates of return by investing domestically. However, placing investments abroad requires a capacity to manage the pension flows in investments overseas. Also, minimizing administrative costs has been challenging in many countries. Is it desirable for Mongolia to establish an FDC scheme? When compared with the current PAYG DB scheme in Mongolia, an FDC offers the opportunity to link benefits to the rate of return on investments, pre-fund some of the future pension obligations, and offer workers a more diversified set of risks associated with their pension benefit. When viewed from a worker’s perspective, however, an FDC scheme will most likely lead to a reduction in an individual’s income replacement rate when compared with the PAYG DB scheme. 49 Several countries facing steep transition costs have, instead, established FDC schemes by requiring additional contributions to funded schemes over and above the contributions to the existing PAYG DB and NDC schemes. This, therefore, results in no additional transition costs. 50 An option of earmarking resources from the FHF had been proposed earlier by the authorities and requires separate study. It is important to note that the authorities have earmarked resources from the FHF to finance the Child Money Program. 51 Some FDC schemes establish minimum return guarantees and/or risk limits. 48 Fiscal Sustainability of the Mongolian Pension Scheme Is it sensible for Mongolia to establish an FDC scheme? An FDC scheme involves substantial additional fiscal transition costs that the Mongolian Treasury will need to finance continuously for over 30 years. The benefit from the FDC scheme of being self-financing will be realized only after several decades. Although it is possible that assets under management may earn rates of return after fees that exceed wage growth (and thus partially finance benefits through market instruments), this is particularly challenging in small countries with imperfect and shallow financial markets, as is the case in Mongolia. Is it feasible for Mongolia to establish an FDC scheme? The scheme’s feasibility depends, among other things, on its design and financing strategy. Feasibility could be improved by meeting certain institutional conditions before introduction. For example, the scheme could be initiated as voluntary and supplemental, or funded with contributions in addition to current contributions rather than by earmarking funds from the current scheme. Another possibility would be to establish a hybrid scheme that is limited to a small proportion of current contributions, restricts participation to younger cohorts, and, possibly, builds on the existing infrastructure for collections, data management, and disbursement. It is therefore essential to have a sound strategy pension scheme. This includes a strategy for the for financing transition costs regardless of the development of the government debt market, size and design of the FDC pillar. Projections of including the development of a yield curve that an FDC scheme in Mongolia suggest that the provides the necessary benchmark for private additional fiscal costs (state subsidy) would instruments, including mortgage-related average about 2.5 percent of GDP if the entire securities (mortgage bonds, mortgage-backed PAYG DB scheme were replaced with an FDC securities) and corporate bonds. Supplementary scheme for all cohorts. This is in addition to the FDC schemes, such as proposed in draft projected fiscal costs for the PAYG DB scheme. legislation in Mongolia, can provide important experience before launching mandatory FDC A well-considered strategy of public debt schemes (see box II.4). management is integral to introducing an FDC Box II.4. Mongolia needs a regulatory framework for private, voluntary supplementary pensions Regulated, supplementary pension arrangements can play an important role in old age income protection but are not in place in Mongolia, which lacks a regulatory framework for these instruments. Supplemental arrangements can provide an important means for workers to set aside additional savings for retirement as well as a voluntary arrangement which can have more lenient withdrawal conditions. Supplementary pensions need to be well- regulated and supervised to sustain the public trust while their savings are illiquid, which can be for decades. Many countries provide some tax exemptions either for contributions or benefits up to a cap, in part as an incentive to overcome the illiquidity. Regulated, supplementary pensions can also support regulatory and institutional framework for funded defined- contribution (FDC) schemes and can provide important experience before launching mandatory FDC schemes. Legislation is now pending before the Mongolian Parliament which would establish a regulatory framework for supplementary pensions. A pensions financing strategy also needs to contributions to an FDC scheme would reduce finance the projected sharp increase in public the projected transition costs in 2022 from about expenditures for the existing PAYG DB scheme 2.8 percent of GDP to 0.5 percent. For example as while also financing projected transition costs illustrated in Figure II.9 below, suppose that 3 associated with the introduction of an FDC percent of the 17 percent contribution rate was scheme. Adopting a hybrid scheme would require earmarked for FDC accounts, meant to be used smaller incremental fiscal transition costs. For entirely for old age, and the remaining 14 percent example, earmarking 3 percent of the 17 percent contribution to the PAYG scheme, including 49 MONGOLIA ECONOMIC UPDATE – April 2022 disability and survivorship benefits. In such case, earmarked to funded individual accounts (figure the accrual rate should be reduced from the II.9). currently proposed 2 percent/year of service to The gap between contribution revenues on the 1.6 percent per year, proportional to the one hand and promised benefits under the reduction in the contribution rate to the DB existing scheme means that contributions under scheme. This option would have the benefit of the current parameters will not generate any only subjecting the government in the short term surpluses to finance FDC accounts. On the to additional transition costs of about 0.5 percent contrary, the gap between contributions and of GDP per year, as compared to up to 2.8 percent benefits is projected to keep increasing, requiring of GDP per year if all contributions were an escalation of the size of the state subsidy. Figure II.9. FDC Scheme - Projected fiscal costs of a full conversion to FDC and one hybrid option 0% 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044 2045 2046 2047 2048 2049 2050 2051 2052 2053 2054 2055 2056 2057 2058 2059 2060 -2% Current Balance - No FDC Current Balance All Contributions to FDC -4% 3% of 17% Contributions to FDC -6% -8% -10% -12% Source: PROST projections in World Bank (2020). It is worth noting that the projected baseline deficit for 2020 was based on 2018 data. B2. An optimal pensions scheme should balance risks and benefits and curb escalating fiscal costs The authorities will need to weigh the risk and contribution rate, and reducing the accrual benefits of different design choices and rate for benefits accrued after the reform. parameters while addressing the pressing • Amendments to the NDC scheme. One challenge of escalating fiscal costs in the current means of addressing the sharp reduction in scheme. A comprehensive program of reforms replacement rates is to replace the current should include: design based on birth dates and instead • Parametric reforms to the Pension Insurance apply the scheme to service histories after (DB) scheme. One key reform would be to the reform date. So, for example, a future automatically link the minimum pension retiree with service both before and after and pension indexation to the growth in the the reform date would receive a benefit consumer price index (CPI).52 In addition, the based on the accrued DB rights before the authorities should consider increasing the reform date, and possibly a benefit based on retirement age (both for regular retirees and their notional balance accumulated after special professions), increasing the the reform date. This will seamlessly make 52 In this regard, effective monetary policy would be critical in maintaining a sustainable pension system. 50 Fiscal Sustainability of the Mongolian Pension Scheme for a more feasible transition in replacement important to supplement those from the rates over time. Pension Insurance Scheme. Such a scheme • Any establishment of an FDC scheme, even could be organized on a defined- if by earmarking a nominal proportion of contribution basis and would need to be contributions, needs to have in place the regulated and supervised by the Financial institutions and fiscal resources to support Regulatory Commission. At the same time, a it. strengthened regulatory and supervisory • Establishment of a regulatory framework for framework is needed for all pensions. private voluntary supplementary pensions is 51 MONGOLIA ECONOMIC UPDATE – April 2022 ANNEX Box A.1. Preliminary impact assessment of petrol price changes on food, housing, and transport prices Mongolia produces limited quantities of oil, but it imports all petroleum products from abroad because of the lack of a refinery plant. Recently, COVID-19 related border frictions combined with adverse effects of the war in Ukraine led to substantial increases in the prices of petroleum products. Therefore, the main goals of this box are to (i) investigate the effect of petroleum price increases on the prices of major items in the consumption basket, including food, housing, and transport; (ii) calculate respective pass-throughs on headline inflation; (iii) check whether the traditional methods might be underestimating the effect of extreme prices movements (esp. the ones caused by the war). The figure below indicates that petrol prices have relatively high and positive [Pearson type] correlations with food, housing, and transport prices. Figure A.1. Scatterplots, histograms, and Pearson correlations Source: World Bank staff estimates. Moreover, the left-bottom scatterplots suggest a nonlinear relation between food prices and petrol. In fact, the data indicate positive and statistically significant rank correlation between the two indicators (e.g., Spearman rho = 0.4362, with a p-value = 0.0001). A histogram on the bottom-right of the figure also suggests that petrol prices tend to exhibit heavy-tail phenomena with extreme price fluctuations. In fact, descriptive statistics suggest that annual changes in petrol prices fluctuate in a wide range [-27.75, 53.33] percent. Therefore, to properly quantify the effect of large price movements, we utilise the Generalized Pareto Distribution (GPD) which is commonly used in statistical analysis of extreme and rare events. − 1/ () = 1 − [1 + ] where is the threshold to capture extreme observations; > 0 and ∈ are the scale and shape parameters of GPD. We also assume that the scale parameter is dependent on changes in petrol prices. 52 ANNEX = ( ) = 0 + 1 We compare marginal effects of the GPD model with estimates provided by traditional methods, including Ordinary Least Squares (OLS) and Seemingly Unrelated Regressions (SUR). Estimation results OLS SUR GPD Food 1.19 *** 1.43 *** 8.43 * Housing 2.06 *** 2.06 *** NA Transport 1.09 *** 1.09 *** NA Note: *** - p.value <=0.001; * - p.value <=0. 1 The Table shows that a 10 percent increase in petrol prices leads to 1.19 (OLS) and 1.43 (SUR) percent increase in food items. However, if extreme fluctuations are properly taken into account, the effect on food prices can be as high as 8.23 percent. Changes in housing and transport prices do not exhibit heavy-tail phenomena (NAs in the Table). Therefore, we utilized the SUR estimates to calculate the final effect on headline inflation for these items of the consumption basket. As a result, the pass-through of a 10 percent increase in petrol prices on headline inflation is 0.61 percent under the linear model, and 2.35 percent under the GPD model. Source: World Bank staff estimation. Box A.2. Characteristics of Government Managed National Provident Funds There is considerable variation in the design and parameters of Government-managed national provident funds though they do tend to share the following characteristics: 1. They are mandatory, contributory funds that centralize collections, account management, fund management and disbursement. 2. They have a defined-contribution design. 3. They are fully-funded. 4. They have centrally-managed investment management, even though they may contract with 3rd party investment managers. Many provident funds are heavily invested in government debt. The following characteristics of many government sponsored provident funds: 1. Many provident funds do not mark-to-market some or all of assets held. Capital gains may be held in reserve accounts so that there is a loose relationship between administered returns and the market-based returns on assets under management. The smoothing of returns between years can be employed as a means of avoiding negative returns. 2. There are different forms of payouts including lump sums and phased withdrawals. 3. Provident funds may focus resources on national development objectives though this may conflict with maximizing risk-adjusted returns. 4. They may provide for savings needs beyond retirement such as for financing home purchases or education although these savings objectives may compete with those of financing retirement. Source: Richard Jackson and Evan Inglis, 2020. Asian Provident Funds: Meeting Tomorrow’s Challenges, World Bank. 53 MONGOLIA ECONOMIC UPDATE – April 2022 Table A.II.1. Parameters of Mongolia’s pension insurance scheme Defined-Benefit (DB) Scheme (pre-1979 Cohorts) Notional Defined Contribution (NDC) Scheme Old age insurance Law on Social Insurance and Law on Pensions and Benefits Individual Pension Insurance Contribution Provided by the Fund of Social Insurance 1994 (as amended). Accounts Law of 1999. Applicability All contract employees born before Jan. 1, 1979. All contract employees born after Jan. 1, 1979.53 Contribution rate 17 percent of wages (8.5 percent employer and 8.5 percent Same. employee) for workers with labor contracts and 13.5 percent of wages for the voluntary scheme. Minimum wage National Minimum Wage (revised periodically). Same. subject to contribution Maximum covered 10 times the minimum wage. None. wage Benefits - Accrual rate 45 percent for the first 20-25 years of eligible service Based on the Notional Account balance and (according to transition) + 1.5 percent/year for each year of annuity factor. eligible service after that. Wage base for benefit Best wages for seven consecutive years of all service years Not applicable. determination wages. There is no automatic indexation or “valorization” of the wage base. Valorization is on an ad-hoc basis. Minimum Pension Provided to retirees meeting vesting requirement (20-25 years 20 percent of the national average wage, + 0.5 of qualified service) for a full pension. Benefit is at least 75 percent of the average wage for each additional percent of the minimum wage, adjusted on an ad hoc basis. year beyond the minimum of 15 years of contributory service. Partial Pension Partial pension available after 10 to 20 years of eligible Not applicable. service. Benefit level should be at least 50 percent of the minimum wage, adjusted on an ad hoc basis. Indexation On an ad-hoc basis. Law states that pensions should be “in direct relation to the inflation rate” as increased in “relation to changes in the cost of living.” determined by the Social Insurance National Council based on the suggestion of the National Statistics Office. Taxation of benefits Contributions and benefits are tax exempt. Contributions, accumulations, and benefits are all tax exempt. Qualifying Conditions Vesting requirements • at least 20 years with full pension and full minimum pension • 15 years of service and contributions. (rising to 25 years at a rate of three months/year as legislated in 2018). • 10 to 20 years for partial pension and partial minimum pension. Retirement age (no • 60 for men and 55 for women, not subject to special early retirement rules.54 benefit reduction for • 55 for men w/at least 20 years of service, at least 12 o/w in hazardous conditions. early retirement) • 50 for women w/ at least 20 years of service, at least 10 o/w hazardous conditions. • 50 for men with at least 20 years of service, at least 10 o/w underground or in high heat. • 45 for women with at least 20 years of service, at least seven o/w underground or high heat. • 50 for women who have brought up four or more children. • 55 for qualifying herder men and 50 for qualifying herder women, beginning in 2018. Source: Social Insurance laws currently in effect. 53 The law specifies that cohorts born between 1960 and 1979 have two calculations, one for the Pay-As-You-Go (PAYG) DB scheme and one for the NDC scheme for which the retiree receives the better of the calculation according to each. However, the PAYG DB benefits are sufficiently greater than the NDC calculation, therefore, in effect, it is not applicable. 54 The retirement age increases to age 65 for those retirees who do not meet the vesting requirements which increase from 20 to 25 years by three months each year beginning in 2018. 54 ANNEX Table A.II.2. Establishment, parameters, and reversals of FDC schemes in Central and Eastern Europe Public Enact. Initial Who Participates Revision or Reversals Pension Date Cont. Scheme (PAYG) Hungary DB 1998 6%-8% Mandatory for new entrants, Permanent reversal. Contributions to FDC voluntary for all employed eliminated (2011). Poland NDC 1999 7.3% Mandatory for new entrants Permanent reduction and partial reversal. 7.3% CR and workers < 30; voluntary => 2.3% CR (5/2011) => 2.9% CR (2/2014). Assets for 30-50 in govt. bonds transferred to PAYG scheme (2014); 2019 govt. announced that FDC scheme would be eliminated, and assets transferred to PAYG or NDC scheme. Latvia NDC 2001 2%-8% Mandatory for new entrants Partial reduction. 8% CR => 2% CR (5/2009) => 4% (1998) and workers < 30; voluntary CR (2013) for 30-50 Bulgaria DB 2002 2%-5% Mandatory for all workers < 42. Croatia Points 2002 5% Mandatory for new entrants and workers < 40; voluntary for 40-50 Estonia DB 2002 6% Mandatory for new entrants; Temp. reduction w/off-set. 6% CR shifted to PAYG voluntary for 19-60 scheme (6/2009-1/2009). CR 3% (1/2011), 6% (1/2012). 2014-1017 CR 8% to offset missed contributions. Lithuania DB 2004 2.5%-5.5% Voluntary for current and new Partial reduction. 5.5% CR => 2% CR (7/2009) => workers but no opt-out. 1.5% CR (1/2012) =>2.5% (2013) => 3% (2014), voluntary participation; additional CR 2% 2016- 2019. Slovakia Points 2005 9% Mandatory for those born Permanent reduction. 9% CR => 4% CR (2013). after 1983; voluntary for Since 2017, schedule of gradual increase to 6% those in Social Insurance CR (2024). 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