MONGOLIAN ECONOMIC UPDATE: ALL THAT GLITTERS IS GOLD (AND

UNCLAS SECTION 01 OF 05 ULAANBAATAR 000228 SIPDIS SENSITIVE SIPDIS STATE PASS USTR, PEACE CORPS, OPIC, EXIMBANK, AND FEDERAL RESERVE STATE FOR EAP/CM, EAP/EP, AND EB/TPP USAID FOR DEIDRA WINSTON LONDON AND MANILA FOR USEDS TO EBRD, ADB TREASURY PASS WORLD BANK, IMF USEDS E.O. 12958: N/A TAGS: ECON PREL EAID EMIN SOCI MG SUBJECT: MONGOLIAN ECONOMIC UPDATE: ALL THAT GLITTERS IS GOLD (AND COPPER)! REF: A) Ulaanbaatar 119 B) Ulaanbaatar 123 C) 06 Ulaanbaatar 773 D) Ulaanbaatar 158, E) Ulaanbaatar 216 F) 06 Ulaanbaatar 621 SENSTIVIE BUT UNCLASSIFIED - NOT FOR INTERNET DISTRIBUTION. ¶1. (SBU) SUMMARY: Preliminary figures for 2006 from the Government of Mongolia's (GOM) Statistics Office show that Mongolia is experiencing unprecedented economic growth. Reaching US$2.7 billion in 2006, nominal GDP increased 8.4%. Mongolia has averaged 7% growth in GDP since 2002 (a low base point following a major weather disaster-driven economic downturn),spiking at 10.6% in 2004. (Note: These figures do not count Mongolia's sizable and active shadow economy, which, by some estimates, may be as much as 40-50% of GDP.) GDP per capita now stands at US$1,036. Gross Industrial Output grew by 9%, led by textiles and base metals production. ¶2. (SBU) Tax and non-tax government revenue increased 62%. Government spending kept pace, rising 61%. The controversial windfall profits tax on gold and copper has added US$152.3 million to government coffers despite efforts by dealers to evade the gold tax through hoarding or smuggling gold. In the financial sector, broad money (M2) grew 31.1% and average lending interest rates fell 3.8% points (although the sustainability of this number is questionable) to the 24.2% to 29.5% range. However, interest rates for deposits remained high at 19.4%, dropping a mere 0.2%. Inflation remained in the mid-single digit range, and the Mongolian Tugrug (MNT) slightly appreciated against the dollar (currently Tugrug 1162=US$1). Higher commodity prices due to skyrocketing trade with China helped Mongolia post its first trade surplus since 1997. Per Mongolian statistics, the 2006 U.S. trade deficit with Mongolia shrank by 33% to US$75 million, with Mongolian exports to the U.S. of US$119 million exceeding imports of US$44 million. Mongolia's growth has been impressive but brittle, in post's view. To summarize post's comment (see next two paras),Mongolia's growth has been impressive, but it is brittle, shallow, and mineral commodity price sensitive. END SUMMARY. COMMENT: Mongolia's Growth: Impressive but Brittle -------------- -------------- ¶3. (SBU) COMMENT: Rich with mineral deposits and positioned between two large, fast-growing economies, Mongolia could achieve solid, sustainable growth. Nevertheless, the economy remains exposed to external shocks, including the possibility of lower copper prices over the medium term. The high copper prices that propelled the recent expansion are projected to decline through 2007 and onwards. Recent GOM cuts in non-minerals taxes only serve to heighten budget sensitivity to mineral sector fluctuations. Meanwhile, new welfare benefits such as cash subsidies for newlyweds and newborns and increased monthly child allowances already strain the budget. Weak central bank governance and banking supervision as well as sometimes speculative management of international reserves are seen as potential risks to Mongolia's financial stability. Of course, Mongolia has routinely periodically experienced climate-related natural disasters such as too much snow or too little. ¶4. (SBU) Overcoming these obstacles to sustained growth will require, among others,: 1) policies that contribute to maintaining economic stability, 2) improving infrastructure, 3) introducing needed reforms that remove impediments to private sector development, 4) effectively utilizing the strong natural resource base, and, 5) improving the efficiency and effectiveness of government. A recent IMF report advised the Bank of Mongolia to rein in the rapid pace of monetary growth to bolster confidence in the financial system and prevent an upturn in inflation. The IMF encouraged the GOM to save most of the large revenue windfall from high commodity prices to keep public debt on a sustainable path. It also recommended that child allowance increases provided in the 2007 ULAANBAATA 00000228 002 OF 005 budget be scaled back significantly, and noted that further reductions may be needed in the future. But the upcoming 2008/2009 election cycle probably makes such retrenchment unlikely, exposing the GOM to some hard choices in the mid-term. END COMMENT. Industrial Output Up, But Mining Sector Sluggish -------------- -------------- ¶5. (U) Up some 21.2% from 2005, the Mongolian manufacturing sector was a major contributor to GDP growth in 2006. Textiles drove the sector's resurgence, increasing a surprising 40% from 2005's MNT 91.8 billion to MNT 128.5 billion in 2006 (US$ 115 million). The 40% increase covers all textile industry sub-sectors, and is explained by rising prices for semi-processed hides, skins, wool and cashmere, as well as some value-added manufacturing of finished products. (Comment: Oddly, textile exports fell 1%, suggesting a possible up-tick in domestic demand for locally made products.) Benefiting from a scrap metal export ban, as well as evidence of better management practices, basic metal production grew 35%. (Note: Having some questions about the relationship of this ban to Mongolia's WTO commitments, USTR in March asked the Mongolian Ministry of Industry and Trade to provide more details on this trade policy as well as associated laws and regulations in advance of the May CTG meeting.) ¶6. (U) Other factors have buoyed growth, including favorable weather conditions (important to herders),surging residential and commercial construction, and rapid expansion in financial services. The transport, storage and communication sector rose 14.3%; agriculture, hunting, forestry and fishery 9.7%; wholesale/retail trade 6.9%; and construction 5.0%. The IMF predicts Mongolia to continue to register average growth of 7% in 2007. (Note: See ref F for a description of Mongolia's shadow economy, which is not reflected in the GOM's statistics and which may be as much as half the size of the official economy. Also, post notes some unexplained anomalies in Mongolia's statistics, such as increased mineral production and prices not being meaningfully reflected in GDP growth, as one would expect, for example. ) ¶7. (SBU) Despite record high prices, mining sector GDP, according to the GOM's statistics, rose an underwhelming 2.7%, apparently hampered by poor infrastructure and uncertainties surrounding last year's amended mining law. Protracted investment agreement negotiations between the GOM and mining giant Rio Tinto and their junior partner Ivanhoe Mines have raised industry perceptions that the GOM may be too fickle a partner in any endeavor. (NOTE: The GOM and Rio Tinto/Ivanhoe just last week concluded an investment or stability agreement, although it will require an estimated three years for the copper mine to start production. See ref E.) Another drag is the windfall profits tax, considered oppressive by local and foreign mining firms, which has lead to a likely underreporting of output (refs A, B and C). However modest growth aside, the mining sector still dominates Mongolia's economy, and by extension its political landscape. When calculated against current prices, mining accounts for 30% of the country's GDP, and 67% of Mongolia's total exports. Tax Revenues Up; Too Sensitive to Commodity Prices -------------- -------------- ¶8. (SBU) The impact of growing mining exports is certainly reflected in the growth of tax revenues. The GOM posted a budget surplus of US$186.6 million, or about 7% of GDP. Overall government revenue rose 62%, bolstered by increases in tax revenue - up 63% percent over 2005 figures (US$966 million in 2006, US$594 million in 2005),and non-tax revenues, which rose 58% (US$190 million in 2006 over US$120.5 million in 2005). Across the board, tax revenues rose impressively in 2006 with corporate, personal, and value added taxes up 84%, 34%, and 31%, respectively. However, many local analysts attribute these increased tax revenues to higher prices for gold and ULAANBAATA 00000228 003 OF 005 copper, and the impact of tax cuts enacted in 2006 on revenue inflows in 2007 has yet to be fully understood (ref D). ¶9. (SBU) The GOM raked in US$152.3 million from the controversial windfall profits tax (WPT) on copper and gold passed with great speed and little consultation or transparency last May (ref C). The WPT reportedly accounts for 34% of the overall increase in revenues to the GOM last year. The balance of the receipts come from the state-owned Mongolia-Russia joint venture copper mine at Eredenet and not from local gold production, which largely disappeared from the market, perhaps reflecting tax avoidance related to the WPT. The Customs General Administration reports that exports of copper concentrates increased by 96% over the previous year, making up 67% of the total increase in exports. Exports of gold, on the other hand, fell by 18% even though average world market prices for gold during this period increased by 35%. ¶10. (SBU) Gold producers are reportedly hoarding gold supplies, hoping the WPT will be repealed, or they employ tax-evasion scams, such as smuggling, supposedly resulting in movement of substantial if unknown quantities of gold out of the country. Some estimates suggest that some 12 metric tons of gold (worth US$260 million) have simply "disappeared" from the economy. Hypothetically, if 2006's quantity of extracted gold matched 2005's numbers, for example, actual 2006 gold exports could be as high as US$434 million. Practically speaking, this means Mongolia's total exports might have equaled US$1.693 billion and Mongolia's trade balance would have registered a surplus of US$203.4 million instead of the lower official figure of US$39.6 million (ref C). Faced with these facts, GOM interlocutors tacitly acknowledge the adverse affects the WPT might have had on both foreign and domestic currency flows. But so far, they show no enthusiasm to alter, let alone repeal, the WPT, despite calls from the mining industry to do so. Government Expenditures Booming -------------- ¶11. (SBU) Government expenditures climbed 61% last year, consuming 31.5% of GDP. Government expenditures for goods and services rose 30% as did wages and salaries. Expenditures for social assistance funds, such as the quarterly child subsidies, rose 44%. In all, government expenditures for subsidies and transfers rose 40% (US$66.3 million). Government capital expenditures increased by 98%, led by a 160% increase in domestic investment expenditures (US$48.2 million in 2005 to US$125.4 million in 2006). The Ministry of Finance has budgeted some US$300 million in projects for 2007, or another 140% increase, with the increase largely financed by proceeds from the windfall profits tax. ¶12. (SBU) At a budgeted 40.9% of GDP (up from 31.7% in 2005), government expenditure in Mongolia accounts for a higher share of GDP than in many other low income countries. According to resident reps of the international finance institutions (IFIs),some spending, particularly social welfare payments, will strain the budget, especially if commodity prices decline, as some predict. Unfazed by these warnings and unwilling to admit the cyclic nature of commodity markets, some Mongolian economists point to Chinese counterparts who claim that copper consumption in China will continue to grow 5%-10% year on year before peaking in 2015-2020. What if these rosy predictions do not happen? Mongolian politicians tell us that they will simply lower expenditures, canceling public spending on pork barrel projects and cutting back on transfer payments to children and young couples. Fiscal Performance: -------------- ¶13. (SBU) Broad money, as measured by M2, within Mongolia grew 31.1% during the year. The share of domestic currency deposits and current account in M2 has been expanding constantly since 2000 while ULAANBAATA 00000228 004 OF 005 the share of currency outside the banking system has been shrinking. Foreign currency deposits present a mixed picture. IFI reps note that rapid monetary growth is an indication of improving confidence in the banking system. But the IMF warns that this pace of monetary growth could eventually create higher inflation. ¶14. (U) According to the National Statistics Office, weighted average annual interest rates for short-term domestic currency loans dropped 3.8 percentage points during 2006. But this number is deceptive, because December 2006 alone saw a drop of 2.7%. The interest rate offered by banks for short-term (up to 1 year) domestic currency deposits ranges widely from 7.56% to 19.4%. When compared to 2005 figures, the top rate dropped 0.2% and the bottom rate is up by 1.56%. ¶15. (SBU) The Mongolian Central Bank has reported that nonperforming loans (NPLs) of the banking system were brought down from 23.5% of total loans at the end of 2000 to 9% at year's end 2005, with the ratio remaining relatively stable in 2006. However, some in the banking sector and independent accountants doubt the veracity of these NPL numbers, telling post that most banks chronically under-report their NPL portfolios. One well-respected accountant unequivocally stated that, with the exception of one or two financial institutions, almost all banks are virtually insolvent. (NOTE: These figures do not/not include the perennially risky and, until last year, largely unsupervised, savings and loan sector, suggesting still further financial vulnerability.) Inflation in Check, Food Prices Stable -------------- ¶16. (U) Core inflation increased by 7.3% over the course of 2006. Core inflation calculations exclude prices for consumer such products as meat, milk and vegetables that fluctuate seasonally. The general consumer price index (CPI) rose 6% over 2006. Unlike previous years, food price increases were among the lowest of the sub baskets in consumer price index calculation (up 3%),largely because of stable prices for meat, which comprises the largest share in the Mongolian consumer basket. Stable food prices helped offset a 12% increase in communication and transportation costs, which included a 6-15% rise in gas prices and a 20% jump in coal prices. ¶17. (SBU) The Mongolian Tugrug (MNT) appreciated by 4.6% against US dollar over 2006. This owed much to the dollar's global depreciation and the Chinese mild relaxing of the dollar-Yuan rate, but increased export income and remittances from abroad also factored into the MNT's rise. The MNT depreciated 6% against Euro. The average MNT-Yuan rate in 2006 was 147.8, only slightly higher than 2005's 147.3. First Trade Surplus in a Decade! -------------- ¶18. (U) Reportedly driven by surging Chinese demand, continued high world market prices for copper and gold helped Mongolia post a trade balance surplus for the first time since 1997. Mongolia registered a modest trade surplus of US$39.6 million in 2006, shifting from a deficit of US$119.5 in 2005. Exports increased by 43.5% in 2006 to US$1.528 billion (from US$1.064 billion in 2005) while imports increased by 25.7 % to US$1.489 billion, resulting in a total trade turnover increase of 34.2%. Some 67% of the US$463.9 million export increase stemmed from price and volume increases of the country's 16 major export products, which accounted for 77.7% Mongolia's total exports. ¶19. (U) The value of exports to China more than doubled over 2005 (US$1.036 billion in 2006 compared to US$512 million in 2005),aided by surging copper exports. Mongolian analysts note that China is now the world's largest copper consumer, and its northern neighbor is ULAANBAATA 00000228 005 OF 005 proving a ready and willing supplier. Overall, minerals accounted for 83% of Mongolia's increase in exports to China. Exports to Russia and Canada also increased by 64% and 40%, respectively. ¶20. (U) Conversely, exports to the U.S. fell by 22% from US$152 million in 2005 to US$119 million in 2006, as did trade turnover. The U.S. trade deficit with Mongolia shrank by 33% in 2006 to US$75 million. The drop in gold exports to the US accounted for 63.4% of the total decline in Mongolia's exports. Apparel exports to the U.S. dropped 29.3%, continuing the decline that began after expiration of the Multi-Fiber Agreement in 2005. In addition, Mongolian exports to another key partner, South Korea, steeply declined, dropping 67%. ¶21. (U) As with the U.S., the decline in Mongolia's exports to the European Union (down 20%) is attributed to the shift of gold exports to the non-EU market. However, excluding gold, exports to the EU actually increased US$15.2 million. Gold comprised 39% of total exports to the EU in 2006 as against to 62.7% in 2005. Exports of some animal origin products and apparel to the EU increased slightly, but it is too early to tell whether these increases are related to Mongolia's accession to the EU's GSP+ system of tariff preference because the increases were only incremental. Imports Increase, Much of it Energy -------------- ¶22. (U) Mongolia increased imports from just about all its major trading partners with the exception of Canada, which saw exports to Mongolia drop to US$10.1 million in 2006 from US$17.3 million in ¶2005. Imports from Russia increased by 30.5% to US$545.4 million. With a 36.6% share of Mongolia's total imports, Russia remains the largest exporter to Mongolia. Petroleum products comprise 68.8% of Russia's exports. Imports from China increased by 35.1% to US$103.6 million, while imports from the U.S. rose by 10% from US$40.1 million in 2005 to US$44.1 million in 2006. The rise in imports of energy products accounted for 60.7% of the increases in total imports, and energy products command the largest share in total imports (28%),followed by machinery and equipment (11%),and durable consumer goods (9%). Goldbeck