Mongolia

Budget Note Series

Highlights of the 2013 Budget

and the Fiscal Outlook

December 2012

This Budget Note was prepared by a team from the World Bank’s Poverty Reduction and Economic

Management (PREM) Sector Unit in the East Asia and Pacific Region Vice-Presidency, consisting of

Taehyun Lee (Team Leader, Senior Country Economist) and Altantsetseg Shiilegmaa (Economist) under

the guidance of Chorching Goh. Copies can be downloaded from http://www.worldbank.org.mn. For

further information, comments and questions, please contact Tina Puntsag (tpuntsag@worldbank.org).

- Executive Summary –

The 2013 budget approved by the Parliament on November 15 has an important implication as the first

annual fiscal plan prepared under the fully effective Fiscal Stability Law (FSL). The budget proclaims

that the Government will be committed to the FSL by setting the structural fiscal deficit at 2 percent.

While this is a progress toward a more sound fiscal policy, the budget also has significant potential risks

of undermining the goal of the FSL with optimistic revenue projections and expansionary spending plans.

Total revenue is projected to increase by 28.9 percent from the 2012 budget, reaching MNT 7,258

billion. However, the rate of increase in total revenue is likely to reach 40 percent compared to

the 2012 revenue outturn. The revenue projections are potentially over-estimated, given the

revenue shortfalls in 2012 and the inclusion of controversial extra revenue (MNT 445 billion)

expected from re-negotiating the 2009 OT (Oyu Tolgoi mine) investment agreement. Potential

revenue shortfall may reach up to 6 percent of GDP.

Total expenditure and net lending is planned to rise by 17.9 percent from the 2012 budget,

reaching MNT 7,444.6 billion. Much of the increase relates to a sharp increase in capital

expenditure of 44.7 percent. Despite the large increase in capital expenditure, a reduction in

capital repairs adds to concerns about maintaining the quality of the new and existing capital

investments. The spending plan of the current budget is yet to include two new spending elements

that could have significant adverse impact on the fiscal outlook: (i) Price Stabilization Program

(MNT 718 billion) and (ii) the use of proceeds from the sovereign bond issue of USD 1.5 billion.

The structural balance is projected to reach 2 percent of GDP, the maximum level set by the FSL.

This is clearly a progress to be noted. However, the fiscal target is likely to be hard to achieve,

given the potential revenue shortages and the two new spending components that will eventually

have to be added to the budget. Exact fiscal impact from the additional spending components

remains uncertain at this stage. However, we expect that the fiscal deficit may reach over 6

percent and the magnitude could be larger depending on how the extra spending plans unfold.

The fiscal imbalance would be much higher if off-budget financing operations were included in the fiscal

outlook of the budget. The fiscal burden from off-budget financing through the Development Bank of

Mongolia (DBM) announced in 2012 is estimated to be over 4 percent of GDP in 2013. Large scale off-

budget financing operations will significantly undermine the effectiveness of prudential rules of the FSL

and likely add to the overheating pressures from the on-budget fiscal activities.

The recent involvement of the BoM in the Price Stabilization Program and the ambiguity on the use of

sovereign bond proceeds are adding to concerns on growing tendency to bypass the FSL. Participation of

the BoM in the Government’s price stabilization measures through providing a subsidized financing is

beyond the traditional role of monetary authorities. Clear plan for the exit of the central bank needs to be

drawn up to disconnect the possibility of it turning into another off-budget financing vehicle. While it is a

sign of growing interest from global financial markets in Mongolian economy, the new bond issue could

become a significant fiscal risk without prudent plans to use the proceeds. It must be noted that the recent

bond issue cannot be an off-budget financing channel and that the receipt and the use of the proceeds need

to be properly recorded in the budget. The Government also needs to take adequate time and extra caution

to select and appraise projects to be financed by the proceeds, considering the financial cost of the

external borrowing and economy’s capacity constraint.

1

I. Context

The 2013 budget was approved by the Parliament of Mongolia on November 15 amidst growing

concerns about an overly expansionary fiscal policy. The recent approval of the budget has an

important implication as it is the first fiscal plan to be prepared under the monumental Fiscal Stability

Law (FSL) that will guide fiscal policy from January 2013. In the wake of continuing external and

internal imbalances of the economy, there has been an increasing concern on off-budget financing

operations bypassing the fiscal rules of the FSL, particularly through the Development Bank of Mongolia

(DBM). Weak budget credibility has also been a concern as the 2012 budget were repeatedly amended

throughout the year. Against this background, this note summarizes the key features of the 2013 budget

and outlines the fiscal outlook and highlights risks.

II. Key Features of the Budget

Macro-economic Assumptions of the Budget

The 2013 budget projects the economy to expand by 18.5 percent in real terms with the nominal

GDP reaching MNT 17.6 trillion. The high economic growth in 2013 is expected to be driven by the

significant increases in total export of 78 percent and the mineral extraction of 60 percent. Inflation is

targeted to be contained at 8.1 percent in 2013 as part of monetary policy guidelines. The budget provides

the following brief explanation on key assumptions underlying the growth projection:

Rising mineral production and export. OT (Oyu Tolgoi mine) gold-copper deposit will start

its production early 2013 as scheduled. OT is expected to produce 382 thousands of tons of

copper concentration, 424 thousands of ounces of gold and 802 thousands of ounces of silver in

2013. Coal extraction by ETT (Erdenes Tavan Togoi LLC) is also projected to double in 2013.

Improved trade balance. Total exports are expected to increase by 78 percent whilst imports are

expected to increase by only 17 percent. As stated above, mineral production from OT and ETT

will drive the increase in exports: the export of copper concentration will reach to 1.1 million tons

and coal export is projected to reach 30 million tons in 2013 with washed coal accounting for

about one-third. Total import are expected to grow in 2013 following increased demand for

construction materials and machineries, including for the expansion of ETT production and the

launch of large scale infrastructure projects.

Non-mineral sectors are projected to show relatively robust growth. The agriculture sector is

forecasted to grow by 4.5 percent due to larger production of wheat and livestock thanks to

increased number of young livestock born between 2010 and 2012. Processing industry is

expected to grow 12.3 percent due to the expansion of meat-processing, flour mill and factories.

Transportation, trade and service sector is projected to grow by 10.5 percent in line with growing

production of the mining sector and the expansion of construction/maintenance work. Wholesale

and retail business is projected to grow by 13 percent.

Overview of the Budget

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Under the macro-economic assumptions, the 2013 budget provides the following revenue projections and

corresponding expenditure plans, as summarized in Table 1. For more detailed composition of the budget,

see the Annex.

Total revenue is projected to increase by 28.9 percent, reaching MNT 7,258 billion. Total

mineral revenue including CIT, royalties and dividends is expected to account for about 24

percent (MNT 1.7 trillion) of total revenue.

Total expenditure and net lending is planned to rise by 17.9 percent, reaching MNT 7,444.6

billion, largely due to the sharp increase in capital expenditure by 44.7 percent.

The structural balance is projected to reach two percent, meeting the ceiling (two percent of

GDP) set by the Fiscal Stability Law. However, it remains highly uncertain whether the

projected fiscal deficit can be actually met, given the optimistic revenue projections and

ambitious expenditure plans. MNT 169 billion (equivalent to one percent of GDP) is planned to

be deposited in the Fiscal Stability Fund (FSF).

Table 1. Summary of the 2013 Approved Budget

2012 Amended 2013 approved

Billion MNT

% of GDP Billion MNT % of GDP % change

A. TOTAL REVENUE AND GRANTS 5,631.7 34.9% 7,258.1 41.1% 28.9%

B. TOTAL STRUCTURAL REVENUE AND GRANTS 5,530.3 34.3% 7,088.3 40.2% 28.2%

Tax revenue 4,925.6 30.5% 6,461.5 36.6% 31.2%

Non tax revenue 602.9 3.7% 626.0 3.5% 3.8%

C. TOTAL EXPENDITURE AND NET LENDING 6,312.2 39.1% 7,444.6 42.2% 17.9%

CURRENT EXPENDITURE 4,606.3 28.6% 4,906.1 27.8% 6.5%

Wages and salaries 1,220.9 7.6% 1,406.2 8% 15.2%

Subsidies and transfers 2,363.1 14.6% 2,028.4 11.5% (14.2%)

CAPITAL EXPENDITURE 1,719.7 10.7% 2,488.9 14.1% 44.7%

Domestic investment 1,409.0 8.7% 2,008.2 11.4% 42.5%

D. STRUCTURAL BALANCE : B-C (781.9) (4.8%) (356.3) (2%)

E. OVERALL BALANCE: A-C (680.5) (4.2%) (186.5) (1.1%)

F. STABILIZATION FUND: E-D 101.4 0.6% 169.8 1%

Source: MOF 2013 Budget, WB staff calculation

Key Features of the Revenue Projections

Total revenue is projected to reach MNT 7,258.1 billion (41.1 percent of nominal GDP), up by

about 40 percent from the 2012 revenue outturn and by 28.9 percent from the final 2012 budget.

Tax income constitutes 91 percent of total structural revenue in 2013 with VAT, PIT and other taxes and

fees as major revenue sources for the government. Mineral revenue (MNT 1.7 trillion) is projected to

increase by 62 percent due to the increased mineral export from the OT and TT mines (including extra

revenue expected from the renegotiation of the 2009 OT Investment Agreement). Non-mineral revenues -

accounting for 76 percent of total revenue - are projected to increase by 21 percent in line with the pace of

3

expected economic expansion. Figure 1 illustrates the composition of the total tax revenue and Figure 2

shows the trends of mineral and non-mineral revenues.

Source: Ministry of Finance, 2013 Budget, World Bank staff calculation based on the 2013 budget document

Total mineral revenues including CIT, royalties and dividends are expected to account for

approximately 24 percent (MNT 1.7 trillion) of total revenue. Mineral revenue for 2013 is to be

almost 62 percent higher than in 2012 (about MNT 1 trillion), following from the OT renegotiation and

increased exports of gold and coal. Table 2 provides projections for mineral revenues estimated by the

Ministry of Finance.

Table 2. Composition of Mineral Tax Revenues: 2013 Budget

Commodities

Tax Source (billions of MNT)

Total CIT Royalty

Progressive Royalty

Dividend Customs

Tax Others

Gold 15.95 75.1 20.6 - - 9.9 121.5

Coal 72.9 188.9 74.6 16.30 52.2 61.27 466.1

Copper 44.1 115.2 153.6 66.0 79.0 0.95 457.9

Others 26.6 76.9 48.9 - 10.58 7.22 170.3

Sub-total Mineral Revenue 174.1 461.2 298.5 82.30 63.7 177.3 1,252.7

Extra OT Revenue 224.5 - 221.3 - - - 445.8

Total Mineral Revenue 398.6 461.2 519.6 82.3 63.7 177.3 1,702.9

Note: Sub-total mineral revenue excludes the extra revenue from the OT mine expected by the government.

The Government excludes the VAT from mining sector from the mineral revenue calculation.

Source: Ministry of Finance

Mineral revenue projections largely depend on the underlying assumption concerning major

commodity prices and volumes. The FSL requires the Government to define major commodities that

generate three or more percent of fiscal revenues and formulate their structural prices according to the

special rule under the FSL 1

. Table 3 below illustrates the assumption on structural prices of major

1 According to the FSL, the structural prices of major commodities are calculated as the average of: (i) the historical average commodity prices of the past 12 years and (ii) the average of the price projections for four years including the current year.

1994

3122

4162

5632

7258

1594

2217

2980

4585

5556

400

905 1182 1047

1702

0

2000

4000

6000

8000

2009 2010 2011 2012 2013

Total Revenue

Non-minereal Revenue

Mineral Revenue

PIT 6.6%

CIT 13.4%

Social security

contributions

11.4%

VAT 30.2%

Excise tax

9.3%

Customs duties 8.9%

Other taxes, fees

20.2%

Figure 1. Major Components of Tax Revenue

: 2013 Budget

Figure 2. Projections for Total Revenue and Mineral

Revenue: 2013 Budget (billions of MNT)

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commodities of the 2013 budget according to the rule (for example USD 6,328 per ton for copper, and

USD 131.5 per ton for washed coals). Government projections on structural prices of major commodities

seem conservative compared to the structural prices of the 2012 amended budget as they followed the

fiscal rule set in the FSL. The structural prices for major commodities in the 2012 amended budget were

USD 7,970 per ton for copper, USD 166.6 per ton for processed coal, USD 102.6 per ton for coking coal

and USD 72.4 per ton for hard coal. The price of copper at the London Metal Exchange averaged at

around USD 7,700 per ton in November and December. Given these assumptions total exports are

projected to grow by 78 percent (y/y) and total import by 17 percent (y/y) in 2013.

Table 3. Major Commodity Price and Volume Projections of the 2013 Budget

Volume Structural Price Market Price

Copper 945 thousand tons USD 6328.9 /ton USD 8,152 /ton

Processed coal 5.8 million tons USD 131.5 /ton USD 161.2 /ton

Coking coal (above 5500 kkal) 14.4 million tons USD 80.2 /ton USD 96.7 /ton

Hard coal (4000-5500 kkal) 5.7 million tons USD 65.5 /ton USD 83.17 /ton

Source: Ministry of Finance, 2013 Budget

The 2013 budget records the privatization receipts of MNT 20 billion as an above-the-line item in

non-tax revenue category, a different practice from the past budgets. Past budgets have recorded

privatization receipts as a financing component at the below the line, following the guidelines of the 2011

Government Financial Statistics Manual (IMF) which categorizes privatization receipts as a financing

item. While the absolute amount of the privatization receipts is not relatively large, it must be noted that

recoding the privatization receipt as non-tax revenue instead of financing would reduce the fiscal deficit

by the corresponding amount.

The revenue projections underlying the 2013 budget appear overly optimistic. Compared to the

annual revenue outturn in 2012 estimated by the World Bank staff based on the actual revenue data

between January and November, the 2013 revenue projection is expected to be about 40 percent higher.

(For more details of the 2012 outturn estimates, see Box 1.) The budget also includes the controversial

extra revenue from re-negotiating the investment agreement with OT. Given these, the recent IMF staff

report (Nov, 2012) indicates that the potential revenue shortfall of the 2013 budget will likely reach over

6 percent of GDP.

The underlying assumption of 18.5 percent economic growth may be too optimistic, given

the frail global economic outlook and the uncertain prospect of the economic recovery of

China. Recent growth projections for 2013 of the World Bank and the IMF were 16.2 percent

and 16.8 percent respectively, which are also likely to be downward adjusted given the slow pace

of economic growth during the latter half of 2012. Mongolia’s economic outlook will largely

count on China’s economic performance: China accounted for 93.7 percent of total export during

the first 8 months of 2012. China’s economic growth decelerated gradually throughout 2012 from

8.1 percent during the first quarter to 7.4 percent during the third quarter, the lowest level in the

past 14 quarters. Recent monthly data on industrial production and fixed asset investment

indicates that China may be bottoming out thanks to strong investment of public sector. However,

the prospect of China’s economic rebound remains uncertain especially given still looming

downside risk over main trade partners including Europe and the US.

5

The budget revenue projections reflect the renegotiation plan of the 2009 OT investment

agreement, that is expected to yield MNT 445.8 billion or 2.5 percent of GDP (see Table 2).

The additional source of income expected from the re-negotiation includes progressive royalty tax

revenue (MNT 221.3 billion) arising from increased royalty from the current 5 percent under the

2009 investment agreement up to 20 percent depending on the commodity price level. In addition,

MNT 224.5 billion is to be recorded under the CIT (corporate income tax). However, it remains

uncertain from which sources of CIT the budget is expecting to raise additional resources2. The

items may reflect the Government’s rough expectation on extra revenues coming from abolishing

CIT related discounts and exemptions under the Double Tax Agreement with Netherlands which

was recently announced to be invalidated. However, it remains highly uncertain if and how the

operators of Oyu Tolgoi would agree to the Government’s plan, especially given that the extra

income is almost three times the tax payment the OT is supposed to pay under the original

investment agreement. Furthermore, the uncertainty surrounding the OT re-negotiation issue

could add another serious down-side risk to the vulnerable revenue projection as the production

of the OT mine could be further delayed due to the stalemate on the investment agreement.

Key Features of Expenditure Plans

The 2013 budget provides an additional 17.9 percent of total expenditure and net lending when

compared to 2012. Total expenditure and net lending is planned to reach MNT 7,444 billion, equivalent

to 42.2 percent of GDP in 2013. The double digit spending increase is mainly due to the 42.5 percent

increase in domestic investment, expected to account for almost 30 percent of total expenditure.

Source: Ministry of Finance, 2013 Budget, World Bank staff calculation

2 The budget provided the following explanation: “The parliament assigned the Government to take royalty from the Oyu Tolgoi via amending Investment Agreement and to reduce some concessions and exemptions on CIT, which will together generate MNT 445 billion of revenue.”(World Bank translation)

Wages & Salaries 18.9%

Goods & services 14.4%

Interest payment

5.3%

Subsidies 2.5%

Transfers 24.8%

Domestic Investment

27.0%

Others 7.1%

Figure 3. Major Components of Total

Expenditures: 2013 Budget

6.5

15.2

23.1

-17.9

44.7 42.5

-7

6.5

15.2

23.1

-17.9

44.7 42.5

-7

Figure 4. Changes in Major Components of

Expenditures: 2013 Budget vs 2012 Budget (%)

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Current expenditure is planned to increase by 6.5 percent in 2013, a significant slowdown when

compared to the 28 percent increase in the 2012 amended budget. The relatively moderate current

spending increase reflects slower growth or reductions in the two largest current spending items: (i)

wages and salaries will only increase by 15.2 percent compared to an alarming 53 percent in the 2012

budget and (ii) the reduction of transfers by 17 percent. There were noticeable increases in debt-service

payment by 162 percent.

The spending on government wages and salaries significantly slowed down to 15.2 percent

from over 50 percent of the 2012 amended budget. Government wages has been increasing

significantly to keep the civil service wages competitive, however options with less fiscal burden

needs to be considered given its impact on fiscal burden and inflation. A recent World Bank

report3 highlights that civil service wages have been raised through regular 15-30 percent across-

the board salary increases over the past five years but the increases have not kept pace with the

much higher growth in relevant private sector wages. Meanwhile, the nominal wage bill has

increased seven-fold since 2003 and become a significant fiscal burden. Adding to it, a recent

IMF study4 suggests that the government wage hikes are likely to be the most contributing factor

to inflation among major spending items, estimating that the sharp wage increase over 50 percent

in 2012 could have contributed to inflation by around 5 percentage points. Given these findings,

the Government needs to consider a more flexible pay policy, replacing the current across-the-

board salary increases with more targeted market-based salary premiums across different

categories of staff.

Interest payment from outstanding government debt is projected to increase by 162 percent

from MNT 153 billion to MNT 398 billion. The debt-service includes MNT 140 billion for the

global sovereign bond issue of USD 1.5 billion made on Nov 28, 2012 with the following two

tranches: USD 0.5 billion of five-year bond at 4.125 percent and USD 1 billion of ten-year bonds

at 5.125 percent. Interest payment for the external borrowing (USD 580 million) by the DBM is

planned to be MNT 97.5 billion.

Transfers are planned to be reduced to MNT 1.8 trillion by 17.9 percent in 2013 from MNT

2.2 trillion due to the significant reduction of the cash transfers in the Human Development

Fund (HDF). Transfers include local government transfers, social welfare contributions and the

HDF; together accounting for 24.8 percent of total expenditure in 2013. Total transfers from the

HDF in 2013 will decline by 67 percent from MNT 866 billion to MNT 284 billion as the

universal transfer scheme is replaced by the Child Money Transfer5. The HDF budget includes

the new Child Money Transfer (MNT 240 billion) and the remainder of universal cash-handouts

(MNT 32 billion) to be given only to those6 who did not receive their entitled transfers during the

period 2010-2012 due to administrative problems. The HDF receives revenues according to the

3 The World Bank, Policy Note, October 2012, Mongolia: Civil Service Reform Options

4 International Monetary Fund, Working Paper WP/12/192, July 2012, Inflation Dynamics in Mongolia 5 Child Money program plans to give MNT 20,000 monthly to every child between 0-18 years old. 6 Under the universal transfer program, MNT 1 million was originally planned to be given to every citizen. As part of the scheme, MNT 500,000 was given to every citizen during 2010-2012. The MNT 32 billion in 2013 targets those who did not receive MNT 500,000 due to administrative reasons.

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Human Development Law including: (i) royalty7, (ii) dividend, (iii) progressive royalty from OT

renegotiation. See Table 4 for the breakdown of the HDF budget.

Table 4. 2013 Human Development Fund (billions of MNT)

Expenditure 2013 Revenue 2010 2011 2012 2013

Cash Transfer 305.0 721.3 751.3 272 Royalty 396.4

Dividend 70

Progressive Royalty 155

Health Insurance Contribution

10.9 15.8 12.2 12.2

Others 0 66.8 102.6 0

Total 315.9 803.9 866.0 284.2 621.4

Source: Ministry of Finance, 2013 Budget, World Bank staff calculation

Total capital expenditure is planned to be raised by 44.7 percent, driven by significant increases in

domestic investment of 42.5 percent. The domestic investment spending envelope (MNT 2,488 billion)

for 2013 is almost twice the level of 2011, increasing from 20 percent of domestic spending in 2011 to 27

percent in 2013. Despite the increase in capital expenditure, a seven percent reduction in capital repairs

adds to concerns about maintaining the quality of the new and existing capital investments.

Increasing significance of domestic investment spending underscores the importance of

efficient and effective planning and implementation of development budget. The Integrated

Budget Law (IBL) represents a significant step in strengthening the regulatory framework for

project preparation and appraisal, and in improving the coordination between planning and capital

budgeting. However, operationalization of the IBL is very much a work in progress. Given the

increasing size of domestic investment and the current capacity of the Ministry of Economic

Development (MED) and Ministry of Finance (MoF), the recent split of responsibilities for

capital and recurrent budgets between

the ministries is likely to jeopardize

efficient project preparation and

supervision. A more pragmatic and

realistic approach is needed to make

best use of available resources within

the Government given the capacity

constraint, including having the MoF

retain the current capital budget

function for smaller projects and the

MED be responsible for large projects.

A recent World Bank report8 provides

in-depth discussion and various policy

recommendations on how to improve

7 According to the Integrated Budget Law, royalty from minerals are distributed as the following rules: 70% for HDF, 25% for central government budget, and 5% for Local Development Fund. 8 The World Bank, October 2012, Improving Public Investment to Meet the Challenge of Scaling Up Infrastructure

35

9

0

5

10

15

20

25

30

35

40

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

New Investment

Capital Repairs

Figure 5. Growth in New Investments and Capital Repairs (2003 level = 1)

Source: Ministry of Finance, World Bank staff calculation

8

public investment in Mongolia’s.

Reduced capital repairs (down by seven percent) adds to the concern on under-allocation of

resources on capital maintenance and repair. The recent World Bank Infrastructure8 report

suggested that the neglect of capital maintenance is approaching crisis proportions, especially in

the energy and roads service. For example, costs of immediate capital repair needs in the

electricity sector alone reached almost two percent of GDP and 60 percent of the national paved

road network is in need of repair and rehabilitation at an estimated cost of roughly seven percent

of GDP. However, the 2013 budget puts heavy priority on new investments with the ratio of

capital repairs to new investment declining over the past five years. The neglect in maintenance

and repairs is both fiscally and economically costly, reducing the life-span of existing

infrastructure that will result in a significant future increase in the fiscal burden due to larger

rehabilitation cost down the line. Given the rapidly growing investment, proper allocation for

capital maintenance and repair is essential to keep the exiting capital functioning and providing

intended benefit.

The budget is yet to include recently announced Price Stabilization Program that is expected to cost

MNT 718 billion (four percent of 2013 GDP) over the next three years. The program was launched by

the Government to stabilize prices of major consumption goods including staple food, fuel, imported

consumption goods and housing price. Under the agreement with the Government, the central bank will

temporarily provide discounted loans to suppliers of selected goods through commercial banks until the

Government issues bonds to replace the central bank’s loan. The objective of the Government program is

noble in a sense that it aims to address supply side factors pushing inflation, however the implementation

and financing schemes of the program include several potential problems, including:

The price stabilization program involves the central bank excessively in the fiscal

operations, including supervision and implementation monitoring. The program is a typical

Government operation to address supply side bottlenecks including transportation, distribution

and storage of strategic goods. The role of the central bank stipulated under the agreement with

the Government is clearly way beyond the traditional role of central bank.

The financing scheme includes new central bank loans, which would inevitably create new

money injection (equivalent to base money supply of 4 percent of GDP). This is an

inflationary measure adopted to curb inflation. The central bank currently does not have a plan to

sterilize the supply of new money. While the new money supply could be temporary should the

Government eventually replace it with new bond issue, there is high likelihood that the central

bank will stay as a main financier of the program through purchasing the government bond. The

Government and the central bank have to make sure that the central bank does not finance the

program once the Government replaces the central bank loan through the proceeds of government

bonds, as announced by the MoU.

Cost of the program need to be properly reflected in the budget in order to: (i) have the

fiscal plan account for all policy operations creating fiscal burden; (ii) disconnect even the

remote possibility of the central bank’s functioning as another channel for off-budget

financing. While the program is planned to have three-year horizon of implementation, most of

the lending from the central bank is likely to be implemented upfront in 2013.

9

Financing Plan

The 2013 budget projects the structural fiscal deficit to be two percent of GDP to meet the ceiling

under the FSL. The budget plans to finance 55 percent of the financing gap through domestic bond

issues and borrowings and deliver 45 percent from external financing. The gross new domestic bond

issuance in 2013 is planned to be MNT 812 billion and MNT 421.8 billion will be used to repay

principals of outstanding bonds. The budget plans to deposit about MNT 169.7 billion of mineral

revenues in the Fiscal Stability Fund (FSF), equivalent to one percent of GDP. The sources of mineral

revenues for FSF will be composed of the CIT (MNT 38 billion), royalty (MNT 55.3 billion) and

progressive royalty (MNT 76.4 billion).

The financing plan is yet to reflect the recent bond issue of USD 1.5 billion and the new external

financing should be recorded in the below the line part of the budget since this is a government

financing operation. The huge sovereign borrowing is equivalent to over 11-12 percent of 2013 GDP

and will be a significant fiscal burden going forward. The 2013 budget currently reflects only the interest

payment expected for the newly issued bond. Its effect on the 2013 fiscal deficit will depend upon how

the government uses the proceeds: (i) if the government deposits the proceeds in its Bank of Mongolia

account, it will only be a below-the-line operation, not affecting the fiscal deficit; (ii) however if the

government spends the proceeds to finance government programs including infrastructure investments,

the use of the proceeds should be recorded in the above-the-line of the budget either as a capital

expenditure (if directly used to finance government infrastructure projects) or a net-lending component (if

lent to the DBM). In the latter case, the fiscal deficit would increase by corresponding amount, thereby

posing a significant risk of breaching the ceiling of the structural fiscal deficit of the FSL.

III. Fiscal Outlook and Risk

Despite the commitment of the budget to the 2 percent ceiling of the FSL, the fiscal target is likely

to be hard to achieve. The revenue projections are potentially over-estimated, given the revenue

shortfalls in 2012 and the inclusion of controversial extra revenue (MNT 445 billion) expected from re-

negotiating the 2009 OT (Oyu Tolgoi mine) investment agreement. Potential revenue shortfall may reach

up to 6 percent of GDP9. The spending plan of the current budget is yet to include two new spending

elements that could have significant adverse impact on the fiscal outlook: (i) Price Stabilization Program

(MNT 718 billion) and (ii) the use of proceeds from the sovereign bond issue of USD 1.5 billion. Exact

fiscal impact from the additional spending components remains uncertain at this stage. However, we

expect that the fiscal deficit may reach over 6 percent and the magnitude could be larger depending on

how the extra spending plans unfold. (See Box 1 for more details.)

The fiscal imbalance would be much higher if off-budget financing operations were included in the

fiscal outlook of the budget. Plans for the Development Bank of Mongolia (DBM) to finance large

infrastructure projects through borrowing up to USD 5 billion have raised a serious concern on fiscal

sustainability and macro-economic stability. While not covered under the rule of the FSL, the DBM is

becoming a major source of public financing for infrastructure projects. Financing projects with poor

prospect of cost recovery, the DBM operation will become significant fiscal burden that has to be

9 It is based on the amount of extra revenues from OT renegotiation and the projected revenue estimates by the IMF Staff Report.

10

eventually repaid by the budget and has to be properly contained under the rules of the FSL. The fiscal

burden from off-budget financing through the Development Bank of Mongolia (DBM) announced in

2012 is estimated to be over 4 percent of GDP in 201310

.

The recent involvement of the BoM in the Price Stabilization Program and the ambiguity on the use

of sovereign bond proceeds are adding to concerns on growing tendency to bypass the FSL.

Participation of the BoM in the Government’s price stabilization measures through

providing a subsidized financing is beyond the traditional role of monetary authorities. The

ambiguity on the role of the central bank in the program points to the possibility that it will

eventually turn into a government program relying on cheap central bank financing. If the

financing of the program were to be implemented up front next year, the total fiscal burden from

the program would reach up to 4 percent of GDP. A clear exit strategy of the central bank from

the role of financier of the government program needs to be announced and the cost of the

program needs to be properly included in the budget.

While it is a sign of growing interest from the global financial market in Mongolian

economy, the new bond issue could become a significant fiscal risk without prudent plans to

use the proceeds. The lack of concrete plans on how to use and record the use of the proceeds of

the recent USD 1.5 billion sovereign bond issue (equivalent to 11-12 percent of GDP) also raises

concern that the Government may seek ways to use it as an off-budget financing vehicle. During

the road-show on the sovereign bond deal, the Government announced that the proceeds will be

used to finance infrastructure projects (via debt and/or equity injections). The Government also

announced that the proceeds will not be used to fund the general budget nor social welfare

programs. The Government is likely to explore ways to use the fund to finance infrastructure

projects through the DBM. As noted in the previous section, the receipts and use of the proceeds

should be properly accounted in the budget no matter how the government plans to use it: either

as a direct expenditure to government operations or for lending to the DBM.

In planning for the use of the sovereign bond proceeds, the Government needs to take

adequate time and caution to select and appraise projects, considering the absorptive

capacity of the economy and the management capacity of the government. Strong political

pressure to facilitate the spending is almost certain. However, front-loading the use of the

proceeds in a hasty manner will likely: (i) add to the expansionary fiscal stance and escalate

internal/external imbalances of the economy; (ii) include poorly prepared and politically-

motivated projects. . If all the proceeds were to be used for investment in 2013, it would make the

domestic investment almost double from the 2012 level and the GDP share of domestic

investment would reach over 23 percent. Given the significant fiscal and macro-economic

implication, any new projects to be included should be subject to rigorous project selection and

appraisal process. The projects to be financed by the proceeds need to be bankable/revenue-

generating projects with sufficient cost recovery, especially given the size and financial cost of

the foreign currency borrowing to be repaid by the budget.

10 Annual spending plan for 2013 of the DBM is not clear yet. This estimates follows the assumptions of the IMF Staff Report (Dec, 2012) that the DBM will spend USD 500 million from government guaranteed bonds issued every year during 2013-2016.

11

Box 1. The 2012 Outturn and the 2013 Fiscal Projection

The projection of the 2012 outturn based on the Jan-Nov outturn data of the budget (National Statistics Office) indicates that even the revenue projections of the second amendment budget in September 2012 were optimistic. During the first eleven months, the revenue receipts reached 78 percent of the budget projection and the expenditure execution reached 80 percent of the budget plan. Should the revenue and expenditure in December follow the past outturn trend during the 2007-2011 period, total revenue for 2012 would fall short of the budget by 2.7 percent of GDP. Assuming that the expenditure outturn reaches 95 percent of the 2012 budget, the overall deficit of the general government is projected to reach around 5% in 2012.

In 2013, the total revenue is expected to fall short of the budget by about 6 percent of GDP while the spending envelope of the current budget is projected to be adjusted downward due to the revenue shortage. However, the inclusion of two additional spending components (Price Stabilization Program and the use of the proceeds from the recent USD 1.5 billion) will likely offset the spending adjustment: the extra spending from the two components is projected to be over 4 percent of GDP in 2013, assuming that only one-third of the total cost of Price Stabilization Program is implemented in 2013 and one-quarter of the bond proceeds are used either for new direct investment by the Government or are lent to the DBM. Under these assumptions, the overall fiscal deficit is projected to reach over 6 percent and the structural deficit over 7 percent, breaching the ceiling set by the FSL. This projection is indicative as the actual fiscal outlook will depend on the decision of the Government on how to re-prioritize or adjust downward the spending envelope and how much of the new spending components to be implemented in 2013.

Table 5. Outlook for Key Fiscal Indicators

2012 2013

Budget Outturn

1

(Staff projection) Budget

(Trillions MNT) Staff Projection (Trillions MNT)

Total Revenue 5.6 5.2 7.3 6.12

Structural Revenue 5.5 5.1 7.1 5.9

Government Expenditure 6.3 6.0 7.4 7.23

Structural Balance(% of GDP) (4.8%) (5.6%) (2.0%) (7.6%)

Overall Balance(% of GDP) (4.2%) (5.0%) (1.1%) (6.6%)

Source: Ministry of Finance, World Bank Staff Projection, IMF Staff Report (Nov, 2012)

1 The 2012 outturn was estimated based on the actual outturn from January through November 2012 and the past

trends of revenue and expenditure in December during 2007-2011. 2 The staff revenue projection for 2013 is based on the IMF staff projection of the Staff Report (Nov, 2012) and assumes

the extra revenues from the OT renegotiation will not be materialized. 3 The projection for government expenditure assumes that the current spending envelope the 2013 budget will be

under-executed by 10 percent but the Price Stabilization Program and the use of the bond proceeds of USD 1.5 billion will add extra spending. The projection assumes that the total cost (718 million MNT) of the Price Stabilization Program will be evenly distributed for three years and only a quarter of the proceeds from the USD 1.5 billion will be used for new government spending programs or net-lending in 2013. In an alternative scenario, If the current spending envelope of the 2013 budget is 100 percent executed, the overall deficit is projected to reach 12 percent of GDP under the same assumption of extra spending from the two additional spending components.

12

Annex: Key Components of the 2013 Budget

Billions of MNT Percentage Share of GDP 2013

Budget (%

Change)

2011 actual

2012 amend

2013 2011

actual 2012

amend 2013

TOTAL REVENUE AND GRANTS 4,468,198.0 5,631,686.9 7,258,092.4 40.3 34.9 41.1 28.9

TOTAL STRUCTURAL REVENUE AND GRANTS

4,227,178.1 5,530,336.9 7,088,333.7 38.1 34.3 40.2 28.2

Tax revenue

3,668,307.8 4,925,603.9 6,461,531.6 33.1 30.5 36.6 31.2

Income Tax 833,738.9 950,859.7 1,261,481.6 7.5 8.2 5.9 32.7

PIT 232,257.3 292,182.2 397,727.5 2.1 1.8 2.3 36.1

CIT 545,631.1 658,677.5 863,754.0 4.9 4.1 4.9 31.1

Social Security Contribution 473,351.3 591,565.0 732,018.1 4.0 4.7 3.7 23.7

Sales Tax and VAT 1,114,382.5 1,734,053.0 1,940,163.9 11.0 11.0 10.7 11.9

Excise Taxes 293,967.0 376,367.5 595,227.5 3.0 2.9 2.3 58.2

Foreign Trade Taxes 337,422.6 565,955.9 575,299.6 3.5 3.3 3.5 1.7

Other Taxes 662,859.7 1,296,310.9 633,451.2 5.1 5.6 4.1 95.6

Royalty 204,921.7 291,646.4 367,329.4 1.8 1.8 2.1 26.0

Progressive Royalty 177,785.2 193,365.1 199,035.1 1.6 1.2 1.1 2.9

Non tax revenue 545,366.5 602,915.0 625,986.5 4.9 3.7 3.5 3.8

TOTAL EXPENDITURE AND NET LENDING

4,997,040 6,312,220.3 7,444,625.0 45.1 39.1 42.2 17.9

CURRENT EXPENDITURE 3,236,403 4,606,347.5 4,906,137.0 29.2 28.6 27.8 6.5

Wages and salaries 802,465 1,220,856.9 1,406,241.5 7.2 7.6 8.0 15.2

Purchase of other goods and services

702,040 870,752.0 1,072,066.4 6.3 5.4 6.1 23.1

Subsidies and transfers 1,694,577 2,363,149.3 2,028,389.1 15.3 14.6 11.5 (14.2)

Subsidies 122,881 119,232.8 185,993.3 1.1 0.7 1.1 56.0

Transfers 1,571,697 2,243,916.5 1,842,395.8 14.2 13.9 10.4 (17.9)

CAPITAL EXPENDITURE 1,280,920 1,719,710.4 2,488,859.6 11.6 10.7 14.1 44.7

Domestic investment 1,020,970 1,408,993.0 2,008,220.0 9.2 8.7 11.4 42.5

Capital repairs 50,139 55,776.9 51,875.4 0.5 0.3 0.3 (7.0)

STRUCTURAL BALANCE (%) (769,862) (781,883.4) (356,291.3) (6.9) (4.8) (2.0) (54.4)

OVERALL BALANCE (%) (528,841.8) (680,533.4) (186,532.6) (4.8) (4.2) (1.1) (72.6)

STABILIZATION FUND 241019.89 101350.00 169,758.7 2.2 0.6 1.0 67.5

Source: Ministry of Finance (2013 Budget), World Bank staff calculation