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THE INTERNATIONAL FINANCIAL SYSTEM AND ITS IMPLICATIONS ON MONGOLIA Dr. SahaMeyanathan BCM, Co-Chair, Education Working Group

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Page 1: Saha lecture updated1

THE INTERNATIONAL FINANCIAL SYSTEM AND ITS IMPLICATIONS ON MONGOLIA

Dr. SahaMeyanathan

BCM, Co-Chair, Education Working Group

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Outline

I. The International Financial System

II. Global Financial Crises

III. Mongolian Financial System

IV. How the International System Affects Mongolia

V. What Can Mongolia Do to Protect Itself from the Boom and Bust Cycles of Commodity Exporting Countries?

Main message: Mongolia is now more than ever interlinked with the global financial developments

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I. THE INTERNATIONAL FINANCIAL SYSTEM

• System depends on structure, structure depends on its parts, and how it all works

• Structure and parts: Banks, capital markets, international multilateral institutions, regulatory framework, why?

• Financial markets are different, because of systemic problems

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History of the International Financial System

• The Gold Standard (1876-1914)• Gold has served as a medium of exchange since the early

B.C. days of Greeks and Romans• In late 19th century, there arose a need for a more formalized

system for settling trade balances• Under this standard:

• Each country set the rate at which its currency could be converted to a weight of gold ($20.67/ounce in the US, £4.2474/ounce in GB)

• Central banks could not issue more currency than its gold reserves

• Worked until the WWII interrupted trade flows

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History of the International Financial System

• War years (1914-1944)• WWI began, need for government spending increased (to

pay for the war), printed large amounts of currency• Many of the trading currencies lost their convertibility into

other currencies. USD was the only currency that continued to be convertible.

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History of the International Financial System

• The Bretton Woods System (1944-1971)• As the WWII drew to a close in 1944, the Allied Powers (the

anti-German coalition consisted of 44 nations) met in Bretton Woods, New Hampshire to create a new system.

• Established a USD-based international monetary system:• USD was the only currency converted into gold ($35/ounce).• Other currencies were exchangeable at a fixed rate against the dollar.

• Also established two institutions: the IMF and the World Bank

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History of the International Financial System

• Collapse of the Bretton Woods (1971)• Inflation in the US

BOP deficits in the US

BOP surpluses around the world

forcing inflation upon other countries

not effective anymore• Break of the link between value of currency and gold• Risks of printing money

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Present System• Institutions:

IMFCentral Banks

Governments

Multilateral Development Banks

Private Institutions(private capital flows)

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The Balance of Payments (BOP)

• Monitors how much money is going in and out of a country during a specific period of time

• Affects important factors of the economy such as the exchange rate, interest rates, inflation, and the GDP

• 3 accounts:• Current Account(trade)• Capital and Financial Account (investments)• Foreign reserves

• Surplus: money in>money out • (ex: KFA surplus: foreign investments>domestic investments in

foreign country)

• Deficit: money out>money in • (ex: CA deficit: imports>exports)

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II. GLOBAL FINANCIAL CRISES

1. Crises of the 1990’s• Mexican Peso Crisis (1994)• The Asian Financial Crises (1997-98)• Russia and Brazil (1998-99)

Similar characteristics:Market liberalization/deregulation Capital mobilitySpeculative attacksInsufficient reservesDevaluation of the currencyStock markets crashing

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II. GLOBAL FINANCIAL CRISES

2. Crisis of 2008, but it has not over• The financial crisis of 2007–2008, also known as the Global financial Crisis and 2008 financial crisis, is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s.•This time originated in the developed markets, Bear Sterns, Lehman Brothers collapse affecting the world

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II. GLOBAL FINANCIAL CRISES

3. The Euro Debt Crisis (now)• Eurozone countries losing control of their

finances and become unable to repay their government debts

• Greece was the first to take a multi-billion pound bailout from other European countries last May, followed by Portugal and Ireland.

• The “contagion effect”—one country’s financial problem spilling over to another country.

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III. MONGOLIAN FINANCIAL SYSTEM

• Banking Sector• Bank dominated about 95% of the total financial system assets• 14 commercial banks• Banks are exposed to credit and market risks

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III. MONGOLIAN FINANCIAL SYSTEM

• Capital Markets• markets are small but financial flows affect

the exchange rate• Market capitalization 2.2 trillion MNT as of

2011 (about 20% of the GDP)• limitations in terms of legal framework,

infrastructure, and liquidity• because MSE is underdeveloped, companies

seek funding from overseas markets

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III. MONGOLIAN FINANCIAL SYSTEM

• Correlation of commodities and government finances• Government finances dependent on commodity exports• First it was Erdenet, now from coal, soon from copper exports from

OT• Decline in exports negatively impacting government finances

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Risks: banks, inflation

• Vulnerability in the banking system• Highly dollarized (more than 1/3 of bank loans and bank deposits

are denominated in USD)• High non-performing loans (NPLs)• Risk management weak

• High inflation • reached 16.7% in April (y.o.y), 14.8% in September (still above the

BoM’s target of a single-digit inflation)

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• Increasing government deficit

expenditures increased 25.6% percentage points more than the revenues (y.o.y)

Source: National Statistical Office, September 2012

Risks: fiscal deficit

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Risks: Fiscal deficit

Mongolia’s fiscal deficit rose to 4.2% of the GDP in April 2012 although the government revenue growth was the highest.

Source: The World Bank, Mongolia Quarterly Update, June 2012

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Risks: Export growth

• Export growth negative for the first time in April

• Further sluggishness likely

Source: The World Bank, Mongolia Quarterly Update, June 2012

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• Widening trade deficit

$2.1bn in March 2012, up from $0.7bn in 2011

Source: The World Bank, Mongolia Quarterly Update, June 2012

Risks: Trade deficit

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• Risks: CA deficit 35% of GDP in March 2012 (was 18% in 2011)

Source: The World Bank, Mongolia Quarterly Update, June 2012

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Risks: Exchange rate

Nominal and Real Exchange Rates

Source: The World Bank, Mongolia Quarterly Update, June 2012

• Depreciation of the MNT

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IV. HOW THE INTERNATIONAL SYSTEM AFFECTS MONGOLIA

The Transmission Mechanisms

1. International Monetary Flows, monetary base increases/decreases• Inflation

• Demand side pressures

government spending• Supply side pressures

MNT depreciation imports more expensive

Supply-food shortages

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The Transmission Mechanisms

2. Foreign Reservesmoney in BOP reserves- exchange rates

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The Transmission Mechanisms

3.Monetary base, money supply• Interest Rate Differentials

• also affects the transmission system

E.g. flows of Korean funds during the 2008-2009 crisis• Real interest rates important for people who live in the

country• With inflation accelerating, real deposit and lending rates

falling.

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Real deposit rate now negative (-6.7%)

Real lending rate barely positive (0.6%)

Source: The World Bank, Mongolia Quarterly Update, June 2012

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The Transmission Mechanisms

• Monetary Policy• Expansionary versus contractionary (tightening)• BoM tightened the policy by raising the benchmark rate to

13.25% and the banking sector reserve requirement ratio to 11%

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The Transmission Mechanisms

• Fiscal Space still constrained• Rising fiscal deficit more vulnerability when there are global

economic uncertainties• “boom-and-bust” cycle• Brings into focus the need to manage resource curse issues

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The Transmission Mechanisms: Rising Expectations• Off-Budget Financing

• government borrowing, that should be invested in productive assets to be repaid later

• The Development Bank of Mongolia issued 5-year $580mn worth of foreign currency bond offering in March 2012

• Debt issued by the DBM is of relatively short term raising exposure to external shocks or to unexpected delays in mining projects that effect commodity revenues (there is still uncertainty in the global financial system)

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V. WHAT CAN MONGOLIA DO TO PROTECT ITSELF FROM BOOM-BUST CYCLES?• Fiscal Stability

• Fiscal Stability Law becoming effective in January 2013 (Structural deficit ceiling of 2% of GDP)

• Need to make sure that the lending of the DBM is within the framework of the FSL

• Look at other countries and how they have managed mineral rich economies

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Structural deficit

6.1% of GDP as of April, 2012—

Source: The World Bank, Mongolia Quarterly Update, June 2012

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Chile’s example—

• Chile• Chile produces about 1/3 of world’s copper• Copper exports55% if its export• Copper revenues18% of fiscal revenues• Adopted Structural Balance Rule

Objectives:1. to protect public spending from the effects of changes in

commodity prices

2. to improve government’s net asset position to meet contingent obligations

Structural balance means the difference between trend revenues and public expenditures

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Chile’s example

• Chile’s Fiscal Rule

Fiscal Responsibility Law:• Each administration must announce structural balance target

within 90 days of taking office• Sovereign wealth funds:

• Pension Reserve Fund

helps cover pension guarantees• Economic and Social Stabilization Fund

receives budget surplus after payments (fiscal buffer)

Resource of the two funds are invested abroad

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Chile’s example

• Chile’s Fiscal Rule• Transparency of the rule

• Independent expert committees set up the main parameters of the rule, therefore protected from political interference

• Well understood by both public and market participants• Detailed explanations, implementation reviews, targets, all published

• Methodological improvements over time• To incorporate changes in other sources of fiscal revenue

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V. WHAT CAN MONGOLIA DO TO PROTECT ITSELF FROM THEBOOM-BUST CRISIS?• Recognize interdependency of Mongolia on global flows,

factors

• Managing Inflation

• Managing Expectations—fiscal side; Chilean example

• Policy Certainty—credibility—foreign investment

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V. WHAT CAN MONGOLIA DO TO PROTECT ITSELF FROM THE CRISES?• Monetary side

Sterilization of the financial flows• Central bank can sterilize capital inflows• Otherwise currency appreciation and inflation• METHODS:

• Domestic component of monetary base (bank reserves and currency) is reduced

• Encourage private investment overseas• Conduct Open Market Operations of central bank –

selling more of treasury bills, reduce monetary base• Widen band of exchange rate movements

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V. WHAT CAN MONGOLIA DO TO PROTECT ITSELF FROM THE CRISES?• Funds: saving for a rainy day? Chilean example and other

countries• Human development fund• Stabilization fund

• Managing these funds are the issue, how much is still saved for difficult times?

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V. WHAT CAN MONGOLIA DO TO PROTECT ITSELF FROM THE BOOM-BUST CRISES?

• Minimize off-budget financing• Although about 40% of the funds raised by the DBM is to

finance important mining related infrastructure, the remainder is to be used for projects that will not generate much revenue (undermine the goals of the FSL)

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Recent Headlines…

“”Tax proposals in Mongolia threatens Rio Tinto project”New York Times

“Mongolia's white-hot growth slows on China woes”AFP

“…the advice to Mongolian policy makers is to ‘hold your horses’ and adopt a more cautious macroeconomic stance”

The World Bank

“Mongolia: can’t live with China, can’t live without China”Financial Times

“Mongolia’s new investment law: deterrent or clarification?”Financial Times

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MAIN MESSAGE

Mongolia is now more than ever interlinked with the global financial developments

It is even more important to be able to manage complex financial developments

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Activity…

What would you do if you were…• Central bank governor• Ministry of Finance, Minister of Finance• Member of the Parliament

• in managing the “boom-bust” crises

• Private investors of large global companies• What impacts above government actions have on private investments