Macroprudential Foreign Exchange Policy in Mongolia

Abstract

Mongolia is a country with a large mineral wealth and great growth potential. As the Mongolian economy heavily depends on the production and export of minerals, it is inevitable for Mongolia to be vulnerable to external shocks. The changes in the demand for minerals and the associated changes in the prices of minerals in the global market directly affect the mining sector and ultimately the balance of payments, the government budget balance, and the growth rate of the Mongolian economy.

External shocks to the economy also directly affect the capital flows. The volatile capital flows, along with the swings of commodity prices, generate a boom-bust cycle, and given the mineral-centric structure of the Mongolian economy, small shocks in the world commodity market may have substantial impacts on the Mongolian economy following the changes in external conditions. Indeed, the Mongolian economy witnessed a decrease in the net capital inflows between 2012 and 2016. In particular, the net capital inflows of direct investments were USD 5.2 billion in 2012, but the direct investments turned into the net capital outflow of USD 4.4 billion in 2016. The crash of the foreign direct investments mainly resulted from the delay of the second phase development of the Oyu Tolgoi (OT) after the end of the first phase. In fact, the sudden fall of the foreign direct investments caused an economic turmoil in the Mongolian economy.

In response to these adverse external shocks, the Mongolian government and the Bank of Mongolia conducted expansionary fiscal and monetary policies to support growth. These expansionary policies, however, also caused side effects such as a rapid credit growth, deterioration of bank balance sheets, and an unsustainably high public debt.

The large mining investments required external financing, leading to a large current account deficit and a deterioration in the net international investment position. In 2012 and 2013, when the investment rates were high, the current account deficit recorded at –43% to -44% of GDP. The cumulative current account deficits resulted in a rapidly growing external debt. The external debt to GDP ratio, in fact, increased from 99.1 percent in 2010 to 220.9 percent in 2019. At the same time, the foreign exchange reserves decreased sharply from USD 4.1 billion in 2012 to USD 1.3 billion in 2015 and 2016. This large external debt and small international reserves require immediate policy responses.

Given the large external imbalances and weak prudential regulations in Mongolia, a sound management for external debts and capital flow should be the primary policy goal for the Mongolian goverment. The basic premise is to accumulate a financial buffer in order to strengthen resilience of the economy by conducting counter-cyclical macroprudential foreign exchange policies. For Mongolia to achieve this goal, several recommendations are suggested.