Mongolia's Dutch Disease: A Case Study

“      ongolia has a president who says, ‘We are in grave danger because we have discovered we have a lot of natural resources. The fact that “they are forewarned gives you hope.”

 (Hernando de Soto, 2010). Mongolia, a landlocked country bounded by two major powers (China and Russia) in East Asia, had scarcely anticipated that the very natural resources which brought prosperity to its economy would become one of the major drivers of its financial volatility.

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An economy with abundant natural resources is generally perceived as being advantageous to any country. For a country like Mongolia, endowed with rich mineral deposits including copper, coal, and gold, this perception  should have been no different. However, there is a deeper complexity underlying its empirical reality. Mongolia’s heavy reliance on its extractive sector has inadvertently led to structural imbalances in its economy. This paradoxical outcome is explained by a phenomenon known as Dutch Disease. First termed by The Economist in 1977, this counterintuitive phenomena was discovered during the publication’s analysis on the economic crisis faced by the Netherlands. The sudden increase in oil wealth gave way to significant wealth in the Netherlands, causing the value of Guilder to spike up. However, this made other Dutch goods (apart from oil) comparatively more expensive making them less competitive in the global market. Consequently,the non-oil industries suffered which  resulted in unemployment rising from 1.1% to 5.1%, and plummeting the capital investment in the country (The Investopedia, 20. 

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Until the introduction of the euro in 2002, Guilder was the basic monetary unit of the Netherlands, equal to 100 cents.

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Mongolia’s possession of massive deposits of mineral resources resulted in an unprecedented 17.3% growth in 2011, making it among the fastest-growing economies in the world (World Bank, 2012). Although the discovery of resources in Mongolia had long been recognised, the abrupt upturn in its growth was a result of large scale development and commercialisation of its mineral deposits. Its economy is seeing substantial growth in mining extraction, driving foreign investment and infrastructural development. Large-scale projects like Tavan Tolgoia, a major coal deposit, and Oyu Tolgoi, one of the biggest copper and gold mines in the world, transformed Mongolia's mining industry. Significant foreign direct investment was drawn to these projects, which fueled the economy's plunge and established mining as its leading industry.

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A thorough foundational basis has been sought  by Corden and Neary (1982), explaining why an expedited increase in a country’s wealth has an outcome that defies the anticipated benefits. The consequences of a resource boom, such as a surge in mining activity, are capable of giving rise to far reaching implications to a small, open economy. These effects manifest themselves through two channels that strive on the basis that they are interrelated yet distinct: the spending effect and the resource movement effect. Both of them overwhelmingly contribute to the likelihood of structural imbalances in the economy, primarily in the tradable non- resource sectors (Corden and Neary, 1982).  

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The spending effect is when large inflows of foreign exchange, primarily through export revenues, foreign direct investment, and government royalties, appreciate the domestic currency. The appreciation in currency makes our goods relatively more expensive and encourages the shift of resources to the booming sector away from other tradable sectors. 

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Real appreciation occurs in two ways. With a flexible exchange rate regime, foreign earnings converted to local currency will push up the value of local currency and lessen the competitiveness of all manufacturing and agriculture. In a fixed or managed exchange rate regime, the government will absorb foreign inflows by issuing additional local currency. While this would increase the money supply and prices domestically, it would still lead to real appreciation (without alteration in the nominal rate), and domestic prices would increase further under inflation.

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The end result is the same regardless of the exchange rate regime: the competitiveness of non-resource tradables declines, heightening the risk of contraction. As costs rise and market shares decline, these industries may retract production, lay off workers, or exit the market entirely referred to as “direct deindustrialisation” (Dagys et al., 2020).

The budgetary restraints were enforced by the Mongolian government relatively earlier in 2010, through the The Fiscal Stability Law. This historic piece of legislation’s  intention was to restrain the budget during times of mining-induced windfalls. The law introduced rules-based budgeting, including debt sustainability targets and expenditure caps, to halt the pro-cyclical government spending during the commodity booms, which is primarily how Dutch disease causes economic instability. 

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The IMF claims that the FSL implemented three complementary fiscal rules, which were implemented gradually between 2013 and 2014. 2% of GDP as the structural deficit ceiling (effective 2013), determined using smoothed mineral price trends rather than erratic real prices. To prevent the economy from overheating, there should be a limit on expenditure growth that is linked to non-mineral GDP growth, either the growth of the current year or a 12-year moving average A cap on public debt that would limit its net present value (NPV) to 40% of GDP by 2014. 50% in 2011, 60% in 2012, and 50% in 2013 as the interim thresholds. (The IMF library )

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Additionally, the FSL incorporated mandatory budget planning and other procedural improvements into a medium-term fiscal framework. Importantly, a two-thirds parliamentary majority is needed to amend the law, highlighting the fiscal rules' intended rigidity and legitimacy.