Fitch Ratings has affirmed Mongolia’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDR) at ‘B+’ with Stable Outlook. The agency also affirmed the Short-Term Foreign-Currency IDR at ‘B’, and the Country Ceiling at ‘B+’.
It also said that Mongolia emerged from a banking crisis and IMF-supported adjustment programme in 2009-2011 with a framework for strengthened economic and macro-prudential policies. Recovery has been buoyed by the booming natural resource sector: growth is expected to average 14.1% over 2011-2012, while international reserves doubled to USD2.5bn in August 2012 from end-2009. However, Mongolia’s macroeconomic policy stance has been mixed, and the vulnerabilities that were exposed in 2009 remain substantially unaddressed.
Mongolia enjoys bright economic prospects. The country is richly endowed with natural resources, while five-year average annual GDP growth of 8.3% has far outpaced the ‘B’ median of 5.9%. At USD3,056 in 2011 income per head at market exchange rates was exactly aligned with the ‘B’ median and should increase further given rapid economic development, while the country’s governance standards are a relative strength in the ‘B’ range. However, managing the macroeconomic volatility associated with a resource boom will remain a major challenge.
Mongolia is heavily dependent on minerals exports with China as its main export destination. Mongolia’s “basic balance” (the current account plus net FDI) weakened to 3.6% of GDP in August 2012, on a 12-month rolling basis, from 21.3% in 2011. Softer commodity prices weighed on exports while strong growth in government spending boosted import demand. FDI eased as some key mining projects near the production stage. Fitch expects structural improvement in the balance of payments after the Oyu Tolgoi mine comes on stream. However, any unexpected delays in major mining projects could exert pressure on Mongolia’s already stretched external finances.
Pro-cyclical fiscal policy has led to overheating in Mongolia. Inflation has remained stubbornly in double-digits since the beginning of 2012, fuelled by a surge in government spending. Although the Bank of Mongolia has tightened policy rate twice this year, these actions have been insufficient to rein in inflationary pressures.
The fiscal balance has deteriorated to 8.9% of GDP in September 2012, on a 12-month rolling basis, from a deficit of 3.6% in 2011. Expenditure growth outstripped revenue ahead of parliamentary election in June 2012 and the inception of a Fiscal Stability Law (FSL) in 2013. On paper, the FSL should strengthen Mongolia’s policy framework, setting a clear path to fiscal consolidation and the build-up of windfall mineral revenues in a Fiscal Stabilisation Fund (FSF). However, Fitch notes that there is a high risk of the Development Bank of Mongolia (DBM) being used for off-budget financing, thereby circumventing the FSL, while the FSF is still in its infancy with funds amounting to just 2% of GDP.
Mongolia’s external public debt is rising sharply. Outside the narrowly-defined government budget, DBM has borrowed heavily (USD600m) under explicit sovereign guarantee. Moreover, the government intends to raise USD1.5bn-2bn (17-23% of GDP) of sovereign bonds within this year, which would add significantly to the public debt stock. These sizable borrowings will increase Mongolia’s external vulnerability and give rise to refinancing risk in the event of sharp deterioration in balance of payments.
Domestically, the financial sector remains a source of potential vulnerability. Fitch’s macro-prudential risk indicator assigned to Mongolia is ‘MPI3′, reflecting the agency’s unease with the rapid credit growth, strong asset-price growth and appreciation of real effective exchange rate. The fast expansion of credit (35.7% yoy in September 2012), fueled by replenished foreign-currency funding raised offshore, could give rise to bank asset quality problems. Banks’ buffers against losses – profitability and capital – are both under pressure. Mongolia’s supervisory framework is weak and regulatory forbearance raises concern, particularly for small-to-medium sized banks. Any strong downward pressure on the currency could see banks facing losses on dollar-denominated lending to borrowers with limited or no dollar income streams, as in 2009.
Strong adherence to the FSL, including the build-up of external buffers, would help to shield the budget from commodity price volatility, ease the pressure on Mongolia’s external finances and facilitate a reduction in inflation and would support a case for an upgrade. Conversely, policy slippages, including strong fiscal spending beyond the ability of the economy, would exert negative pressure on the ratings. Re-emergence of problems in Mongolia’s banking system requiring extensive sovereign support would also be negative for the ratings.