Asia's Wild Frontier for Investors

If there is any place in Asia that can still be considered the wild frontier, it is Mongolia, wedged between China and Russia and uneasy with both of them. To give some idea of the size of the economy, the amount of T-bills and other assets the US Fed buys about every three and a half days is the equivalent of Mongolia's entire 2012 GDP.

"Mongolia is a reality check for the modern economist," said Dr Jim Walker, the founder and managing director of the Hong Kong-based independent research firm Asianomics. "Here is a real economy with a population of 2.8-2.9 million, untold mineral wealth and traffic jams in its major city like most of the rest of Asia. It is a real, live place."

It is also a suspicious one. Its geopolitical relationship with its two giant neighbors -- China and Russia -- is not good. With regard to China in particular there is traditional animosity. As an example, Mongolian coal miners recently refused to supply Chinese companies with coal at prices below what they felt were reasonable. China retaliated, with Mongolian shipments to China falling by 8.6 percent annually. "Nationalist feelings run deep and populism based on these nationalist tendencies strikes a chord with the young electorate. But putting these two together -- nationalism and haste -- can lead to bad, often downright bizarre, policy decisions," Walker wrote after his visit to the country.

In a subscribers-only report to his clients, Walker pointed out that in 2011, real GDP soared upwards an annual 17.5 percent pace, followed at 12.3 percent in 2012. GDP is expected to grow by another 13 percent in 2013 at a time when global GDP is forecast to hit 3.9 percent and the advanced economies are expected to make only a 1.9 percent pace. Three-year nominal GDP growth unadjusted for price changes -- zoomed upward by an average 29.8 percent, with the government's 2013 fiscal deficit projected to reach 9 percent of GDP.

There are obvious economic problems. Government spending is running at over 40 percent of GDP annually, not bad compared with, say Greece, one of the world's basket cases, at just over 50 percent per annum. Consumer price inflation is another story, with the 2012 figure at 14.2 percent. The Bank of Mongolia, in an attempt to bring inflation down to single digits, has set its current policy rate at a whacking 13.25 percent.

Given that inflation rate, the government increased the minimum wage by 36.7 percent on Sept. 1 to the equivalent of US$114 per month. Civil servant salaries were increased by 50 percent earlier this year ahead of the June 26 general election. As a result, the tughrik, as the currency is known, was the worst performer in Asia this year, tumbling 17.4 percent against the US dollar since Jan. 1, just slightly worse than the Indian rupee at 17 down against the dollar.

The civil service and minimum wage increases, along with other means, allowed the incumbent President Tsakhiagliin Elbegdorj to squeak in with 50.9 percent of the popular vote, keeping the Democratic Party in power in both the Presidency and the legislature, known as the State Great Khural.

In an economy as small as Mongolia's it doesn't take much to blow it on or off course, according to the report. Rampant 2010 money supply growth at more than 60 percent was directly associated with the beginning of the first phase of the Oyu Tolgoi copper and gold mine, out in the middle of the Gobi Desert, which cost more than 60 percent of annual GDP to develop. Thus the resulting growth, inflation and current account deficit are not surprising in the context of the gigantic size of the project relative to the economy. But the swings in money supply, inflation, government spending and the currency were exacerbated by government policies when they should have been damped by them.

The overwhelming conclusion one arrives at when reading official assessments of Mongolia by the IMF and the World Bank, as well as speaking to economists, journalists and bankers, Walker said, is that this is an economy "in a hurry to make up for lost time under communist rule (1921-1990), in a hurry to provide a good standard of living for its people, in a hurry to grow and in a hurry to take advantages of its natural resources."

The government has ramrodded through a striking series of important laws since 2010, including on fiscal stability, an integrated budget and social welfare.

"Taken together these seem like sensible moves and adopt sensible policies," Walker says. "However, on-budget and off-budget accounts have not been integrated and the position of the Development Bank of Mongolia and the central bank, Bank of Mongolia, with respect to fiscal policy and funding is questionable to say the least. In short, fiscal responsibility is a pipe dream."

The parliament also passed a Strategic Foreign Investment Law (prepared and passed within one month and now under review with the help of the World Bank), a Mining Law (also in the process of revision), a Mortgage Financing scheme and a Price Stabilization Program.

"The last two of these call into question the independence of the central bank and prospects for truly containing inflation. All-in-all, Mongolia stands accused -- not least by people within the economy -- of trying to do too much, too fast and without thinking through the consequences of their actions. As one commentator put it to us, "The government will elicit four opinions on a particular piece of legislation -- and then take option number five. Policy making is not predictable."

One contact, Walker said, bemoaned the government's short-termism and, at the same time, berated the advice given by international financial institutions as regards monetary management. In his view classical monetary policies applied to Mongolia were part of the problem, not the solution. Mongolia suffered from supply side issues, not demand problems. These supply side issues could be addressed by the government and central bank identifying preferred sectors and providing loans at preferential interest rates to entrepreneurs and the private sector in these sectors.

Mongolia, Walker concluded, "badly needs more fiscal discipline. It also needs to let the central bank take care of what should be its primary focus; controlling the amount of money and credit in the system ie, inflation. In addition to fiscal discipline, the government needs some legislative discipline. Bouncing from one bad solution to the next less bad solution to the next is not a legislative process, it is just a mess."