Fiscal Snapshot: High Mining Revenues a Boon and a Danger

UNCLAS SECTION 01 OF 03 ULAANBAATAR 000660

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E.O. 12958: N/A
TAGS: ECON PREL EAID EMIN SOCI MG
SUBJECT: Fiscal Snapshot: High Mining Revenues a Boon and a Danger

Ref: Ulaanbaatar 576


1. SUMMARY: Buoyed by sharp GDP growth in the last few years,
Mongolia's government finds itself in a time of relative plenty.
However, these large revenue increases have been driven by high
international commodity prices for gold and copper. When the good
times end for copper and gold, Mongolia may be poorly positioned to
cope. Because government expenditures have soared to pay for recent
sharp increases in commitments to fund social welfare programs,
Mongolia's politicians will be hard pressed to rein in spending.
Moreover, recent tax reforms look to sharply cut revenues, at least
in the short term, provoking concern about the fiscal situation
among the IMF and donors. It is hoped Parliament and Cabinet will
work together during the Fall Session to balance anticipated
revenues and expenditures. END SUMMARY.

A Word About the Charts and Tables
--------------


2. This cable is an adapted form of a report by a Treasury
economist who has been on TDY to the embassy the last two months.
The original report made extensive and helpful use of charts and
tables. We have loaded these charts and tables into Yahoo! Photos.
A window with all of the charts and tables can be opened by clicking
on the link below (readers may need to paste the link into their web
browsers).

http://new.photos.yahoo.com/album?c=freemanpj &aid=57
6460762311138245&pid=&wtok=3OE6QM5uMBMgxODw13 nB0Q--
&ts=1156892844&.src=ph#page1

Economic Growth Up Sharply
--------------


3. Buoyed by the lagged returns to market liberalization, as well
as unusually favorable external conditions, Mongolia is experiencing
a strong episode of economic growth. Growth of real gross domestic
product (GDP) reached 5.6% in 2003 (its highest level since 1995)
then shot upwards to 10.7% in 2004, a year marked by a large
expansion in mining as well as the rebuilding of livestock herds,
before returning to 6.2% in 2005. The International Monetary Fund
(IMF) forecasts real GDP growth of 6.5% in 2006, supported in large
part by continued buoyancy in international commodity markets.

Chart 1 (GDP, Total Revenues, Tax Revenues, and Total Expenditures)

Revenues Side: Up High and on Shaky Footing
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4. Large growth in government revenues has accompanied the recent
GDP growth spurt, with central government revenues (including
non-tax revenues and net transfers) expected to have grown by 107%
nominally; and domestically-financed tax revenues expected to have
grown by 136% nominally between 2001 and 2006.


5. Mining Sector's Impact on Growth: The mining sector plays a
large and growing role in Mongolia's economy, accounting for roughly
one-fifth of GDP in 2005. High mining sector profits are playing a
central role in explaining unusually high GDP growth. The departure
from trend in GDP from the mining sector is expected to account for
fully 71% of the departure from trend in overall GDP in 2006, up
from an already large 47% in 2005.

Chart 2 (GDP, Mining GIO, Mining GDP):

Table 1 (Comparing GDP and mining sector GDP trends; billions of
tugrik):


6. External conditions in international commodity markets explain
the recent upsurge in mining sector activity, particularly from
2003-2006. Over this period, a 197% increase in the price of copper
and a 57% increase in the price of gold are expected to be
associated with a 264% increase in GDP from the mining sector.


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Chart 3 (Mining GDP and price of copper)

Chart 4 (Mining GDP and price of gold)


7. Mining Sector's Impact on Revenues: The ratio of tax revenues
from the mining sector to total tax revenues has roughly tracked the
ratio of GDP from the mining sector to total GDP. (Note: We only
have access to official statistics on government revenues from the
mining sector for the period 2002-2005.) Between 2001 and 2005,
total tax revenues grew roughly tugrik-for-tugrik with GDP from the
mining sector - total growth of tax revenues (roughly 360b Tg) was
very close to total growth of mining sector GDP (about 330b Tg).
The contribution of growth in GDP from the mining sector to growth
in overall GDP nearly doubled from 17% in 2001 to 32% in 2005, while
the ratio of total tax revenues to GDP stayed roughly constant at
29-30% over 2001-2005.


Table 2 (Mining sector taxes)


8. The overall impact of mining sector activity on tax revenues is
likely to be even larger than the mining sector's actual tax
payments. In a developing country such as Mongolia, heavily
dependent on mining, a significant increase in mining activity
typically results in a significant increase in exports, as the
majority of minerals are sold on international markets. (Note:
However, it is important to note that most of Mongolia's
commercially exploitable minerals and metals assets have not come on
line. Mongolia remains a small economy, which allows the limited
gold and copper mining currently occurring to have exaggerated
impacts on the year-on-year economic growth.) Because the resulting
positive income shock is denominated in foreign currency, it leads
to a larger increase in the consumption of imports than income
shocks affecting other components of aggregate demand, and this
generates a secondary impact on tax revenues via import duties. In
Mongolia's case, imports are on track to rise by approximately 80%
in nominal dollar terms between 2003 and 2006. (Note: A 2004 World
Bank report, Mongolia's Mining Sector Sources of Growth, provides a
more thorough discussion of this and other secondary fiscal
transmission mechanisms linking mining sector activity to government
revenues.)


9. Mongolia's exposure to external shocks, notably the eventual
downturns in minerals prices, may be even more significant than most
observers perceive it to be. Over 2003-2006, a 197% increase in the
price of gold and a 57% increase in the price of copper are expected
be associated with an 84% increase in tax revenues. Mongolia's
Parliament recently passed a series of major tax reforms that
threaten to sharply cut revenues, at least in the short term; and
further widen Mongolia's exposure to downturns in commodity markets
(reftel). However, reliable estimates of the short- or medium-term
impact of the tax reforms are not publicly available at this time.
As the Value-added Tax, Corporate Income Tax and Personal Income Tax
laws do not take effect until January 2007, time remains for
thorough analyses of the projected fiscal impact of the tax reform.
In addition, Parliament passed a Windfall Profits Tax law in Spring
Session. No companies have pulled out of Mongolia but, if the new
tax and other concerns led to a decrease in mining activity in
Mongolia, budget revenues from the mining sector would be reduced
regardless of the world minerals price trends. Of course,
Mongolia's domestic economy is also subject to climate-related
shocks, including black and white "dzuds" (too little rain/snow or
too much, respectively, causing significant herd reductions
affecting the wealth and well-being of Mongolia's herders).

Chart 5 (Tax revenues, and mining sector GIO and GDP)

Chart 6 (Tax revenues and the price of copper)

Chart 7 (Tax revenues and the price of gold)

Expenditures Side: An Urgent Need to Set Priorities
-------------- --------------


10. Government expenditures have been increasing at roughly the

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same pace as revenues, raising concerns among many observers that
Mongolia is failing to take advantage of a passing opportunity to
secure its fiscal outlook. Between 2001 and 2006, expenditures are
expected to have grown by 100% nominally, roughly tracking the
expected 107% growth in revenues over the same period.


11. Exacerbating Mongolia's lack of fiscal discipline are political
obstacles that will make reversing the recent increases in
expenditures difficult, even as positive shocks to revenues recede.
There has been a dramatic 162% (130 billion Tg) rise over 2001-2006
in the subsidies and transfers component of current expenditures.
Because this increase is closely linked to new government
commitments to fund recurrent expenditures, it is cause for special
concern. Increases in this category of expenditure may prove to be
the most politically difficult type to reverse in the face of
falling revenues. The figures in Table 3 and Chart 8 do not fully
account for the fiscal repercussions of the recent expansion of the
Child Money Program (CMP). Earlier this year, Parliament extended
the coverage of the CMP to all households regardless of wealth or
income. To add to the fiscal burden, Parliament attached a large
new entitlement component to the CMP: a 100,000 Tg lump sum payment
to any household welcoming a newborn child.

Chart 8 (Components of government expenditure)

Table 3 (Growth in government expenditures)

Slutz

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