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The Mongolian economy is overheating, fueled by a mining boom and soaring government spending, but promises from the newly elected coalition parties to distribute the spoils of mineral wealth means fiscal buffers are unlikely to be significantly strengthened after the election. This makes Mongolia vulnerable to a re-run of its 2007-2009 economic crisis if prices for the country’s commodity exports fall sharply for a sustained period.

Mongolia has only saved 2% of GDP in its Stabilisation Fund, which is too small to shelter it from shocks. This leaves the country with little fiscal flexibility in the event of a sustained drop in commodity prices. The accumulation of systemic risks – extremely loose credit environment, inconsistencies arising from implementation of tight monetary policy, and expansionary fiscal policy and pro-cyclical public finances – makes this increasingly hard to fix.

Government spending surged by 50.1% in May on a year-to-date (ytd) basis, driven by pre-election cash handouts, outlays on wages and salaries, and capital spending. Revenue growth has failed to keep up, slowing to 18.9% ytd from 33.6% in 2011. This widened Mongolia’s fiscal deficit to 7.6% in May, from 3.6% at end-2011, on a 12-month rolling basis. We expect the deterioration to continue until further fiscal mineral revenues flow in or spending is reined back.

There has been a lack of political will to adhere to fiscal discipline. There is a significant risk that the Fiscal Stability Law, which is binding from 2013 and would cap the structural deficit at 2%, will not be implemented effectively.

Rapid concentrated credit growth and a weak supervisory regime mean the banking sector could also suffer problems if a global slowdown were to result in falling commodity prices. Credit surged by 44.1% yoy at the end of May and 72.8% at end-2011, amid a negative interest-rate environment. Contagion risks are heightened further by cross-ownership as well as heavy exposure among some banks via interbank transactions.

Non-performing loans are still low at 6.1% in May 2012, compared with their peak of about 25% in November 2009 when Mongolia was hit by a full-blown banking crisis. However, this improvement is primarily attributable to the rapid growth in lending. The outstanding NPLs and loans-in-arrears have been slow to come down, and remain large at MNT375.7bn (USD283m) as of end-May 2012.

The volume of US dollar deposits in the banking system may expose the system to solvency risk through currency mismatches – when banks use funding from foreign-currency deposits to fund local-currency lending, especially in times of a sharp depreciation of Mongolia’s currency. Approximately 30% of deposits are denominated in foreign currency.

Moreover, the election showed rising political pressure to limit foreign ownership in resource industries. However, Fitch regards an extreme form of resource nationalisation as unlikely given the dependence of Mongolia on foreign investment and technical know-how to extract the mineral wealth.