During socialist period, the system of Mongolia economy closely based on the Soviet model. Joining CMEA(Council for Mutual Economic Assistance) in 1962 has provided a large market for exports, a secure supply of required imports and exceptionally favorable terms of trade. The Soviet Union also provided a huge amount of technical assistance, including large numbers of senior technical advisers located in all the major ministries.
Mongolia embarked on a transition to a market-guided economy in July 1990, immediately after the first multi-party elections and the formation of a coalition government. There had been some modest reforms in the period 1986-1989, but these occurred within the context of a planned economy. Reforms intended to create a new economic system, namely a market economy. Within a year of the commencement of the transition, Mongolia was subjected to three external shocks: an aid shock, a trade shock and macroeconomic management shock. Soviet aid was reduced considerably in 1989 and then, in 1991, terminated. This deprived the economy of external resources in the form of concessionary loans that had been used to finance virtually the entire investment program. Also in 1991, CMEA collapsed, thereby imposing a trade shock on Mongolia. The country suddenly lost its export market and in addition suffered a sharp deterioration in its external terms of trade. A macroeconomic management shock created by the withdrawal of senior technical advisers from the Soviet Union. The management of state expenditure on investment and production suddenly became more difficult as the Mongolians were left without experienced people to help them run the economy.(Griffin 3)
It is hardly surprising that the transition to a market economy did not proceed smoothly. As can be seen in the table, inflation, which had been absent in 1989 and 1990, suddenly became very rapid in 1991, the first full year of the transition. The 'real' economy also performed poorly. Gross domestic product per head, based on estimates prepared by the IMF, declined in each of the first four yeas of the transition. In addition to the soaring inflation, average incomes fell sharply and poverty suddenly became a serious social problem.
Inflation and Growth, 1989-9
Why did incomes fall and poverty increase so dramatically? Some have argued that Mongolia's difficulties are due to the three shocks described above. There is no doubt that these shocks constituted a severe blow to the economy. While these were serious blows, there were a number of offsetting external stimuli which cushioned the blows: a large inflow of financial aid from other sources, suspension of debt-servicing on Soviet loans, provision of technical assistance by a number of donors, and greater diversity in trading partners and hence an improvement in the quality of imports.
Another explanation for difficulties encountered during the transition places emphasis on failures of implementation of economic policy. There were errors in implementing the privatization program. There were serious mistakes in monetary policy: an excessive volume of credit was created and the allocation of credit among enterprises was poor. Fiscal policy ran into problems: government current expenditure rose sharply in the early years in order to support loss-making enterprises and this resulted in extraordinarily large public-sector deficits.(Griffin 21)
However, the fundamental problem was not implementation but major flaws in the design of the transition strategy. The sequence of reforms was incorrect; the government choose the wrong priorities. The key error was to give first priority to the rapid transformation or property relations.
Privatization in Mongolia was implemented by distributing vouchers to the entire population. The government distributed state assets to private citizens. This transfer scheme resulted initially in a highly equitable distribution of wealth, but it did little to increase economic efficiency or improve the allocative function of the markets for goods and services. Ownership is diffuse, shareholders exercise little control over management, financial accountability is poor, and many of large privatized enterprises continue to have majority or minority state ownership. Also privatization has not led to greater competition, lower costs and allocative efficiency. Because of the very small domestic market in Mongolia, privatized enterprises are able to exercise monopoly power.(Griffin 12)
Therefore, Privatization of state enterprises should not have been placed at the center of the reform effort because it has relatively little to do with the creation of an efficient market-guided economy. Further privatization of state enterprises and of the stock of state-owned urban housing should be postponed until the transition is complete and policy-makers should turn their attention to more pressing issues.
A second flaw in the design of the transition strategy was to dismantle controls and push ahead with rapid price-liberalization before macroeconomic stability had been achieved. The results were very rapid inflation and negative real rates of interest which damaged incentives to save and distorted the allocation of capital.
Success in a market economy depends on the ability of enterprises and households to respond quickly to changes in relative prices. If inflation is rapid, however, changes in relative prices become blurred, masked by the change in the average level of prices. Moreover, changes in relative prices become arbitrary and temporary, affected by the vagaries in timing of price-changes in specific market, and this makes it difficult for enterprises and households to interpret market-signals correctly. The result is high risk of investment, great uncertainty for economic activity.
A related flaw was the premature creation of a private commercial banking system. This helped to fuel inflation and increase instability, and it made it harder for the government to organize an orderly transition to a market economy.
Macroeconomic stabilization should have been the top priority. In practice government should take steps to balance the public accounts combined with firm monetary policy. That is to ensure well forming real positive interest rates. During this stabilization period the banking system should not be privatized since excessive credit creation during the transition to a market economy would likely result in either open or suppressed inflation depending on the extent of price-liberalization. Thus tax reform, expenditure reform and interest-rate reform should take the lead, complemented by the creation of effective market institutions. Unfortunately, this did not occur in Mongolia. Tax reform came too late to prevent the emergence of huge fiscal deficits.(Griffin 14)
Again, Mongolian economic difficulties during the transition could be explained in many ways. But the key error that the government committed was improperly designed transition strategies. The property right rights were given too early and the government showed lack of efforts on balancing public account. Also inefficient management on newly-privatized enterprises could be another critical factor of the failure.
Griffin, Keith. Poverty and the Transition to a market Economy in Mongolia, New York; St. Martin's Press,1995.