Driving Unsustainable and Dualistic Growth: Impacts of Foreign Investment Inflows into Mongolia Between 1991-2016

By: Enkhuun Byambadorj

Abstract

Through an analysis of foreign direct investment (FDI) inflow trends into Mongolia from 1991-2016, this piece challenges predominant theories about FDI-led growth in lower-income countries. In the early democratization period of Mongolia, FDI inflows were driven by the strength of investment liberalization policies, which initially stumbled in implementation in the post-Soviet era. However, following the election of the Democratic Coalition in 1996, a newly realized investment-friendly market led to rapid FDI inflows such that by 2010, FDI inflows accounted for 23.6% of GDP, compared to 1.2% in 1996. The upshot in FDI inflows is disproportionately concentrated in the mineral and service sectors and in urban regions of the country, failing to generate proportionate employment growth and leading to rapid rural-urban migration rates. Both the expansion of the mining sector and urbanization have negatively influenced environmental conditions. Ultimately, I posit that FDI growth has failed to generate sustainable economic development in Mongolia. Instead, the economy has become tied to the boom-and-bust cycles of the mineral commodity market and the country has increasingly neglected development in rural regions, resulting in dualistic growth.

Grâce à une analyse des tendances des flux d’investissements directs étrangers (IDE) en Mongolie de 1991 à 2016, cet article remet en question les théories prédominantes sur la croissance tirée par les IDE dans les pays à faible revenu. Au début de la période de démocratisation de la Mongolie, les entrées d’IDE étaient stimulées par la forces des politiques de libéralisation des investissements, dont la mise en œuvre a d’abord échoué dans l’ère post-soviétique. Cependant, à la suite de l’élection de la Coalition démocratique en 1996, un nouveau marché favorable aux investissements a conduit à des entrées d’IDE rapides, de sorte qu’en 2010, les entrées d’IDE représentaient 23,6 % du PIB, contre 1,2 % en 1996. L’impact de l’afflux d’IDE s’est concentré de manière disproportionnée dans les secteurs minier et des services et dans les régions urbaines du pays, ne parvenant pas à générer une croissance proportionnelle de l’emploi et entraînant des taux rapides de migration rurale-urbaine. L’expansion du secteur minier et l’urbanisation ont tous deux eu une influence négative sur les conditions environnementales. Tout compte fait, je soutiens que la croissance des IDE n’a pas réussi à générer un développement économique durable en Mongolie. Au lieu de cela, l’économie est devenue liée aux cycles d’expansion et de récession du marché des matières premières minérales et le pays a de plus en plus négligé le développement dans les régions rurales, ce qui a entraîné une croissance dualiste.

Introduction

Foreign Direct Investments (FDI) areoverseas investments made by private Multinational Corporations (MNCs), or enterprises that conduct productive activities in multiple countries. 1 FDI represents a long-term relationship between a foreign direct investor or parent enterprise and a recipient country. 2 It is commonly theorized that FDI flowing from high-income countries (HICs)/developed countries into low- and middle-income (LMICs)/developing countries help to fill capital and technological gaps in LMICs, thereby fostering economic development. 3 This paper will examine and challenge the legitimacy of this theory by analyzing the trends and implications of FDI inflows into Mongolia between 1991-2016. The analysis will focus on the effects of FDI on the mineral and service sectors, as these are the first and second largest recipients of FDI in Mongolia, respectively.

This paper argues that the current framework of foreign direct investment inflows fails to promote sustainable economic development in Mongolia. Through an examination of the mineral and service sectors, this piece will demonstrate that FDI has, in part, created and protracted Mongolia’s dependence on primary commodities, while stimulating dualistic growth domestically. To demonstrate this point, this paper will analyze the implications of FDI on employment creation, rural and urban environments, and GDP per capita growth patterns between 1991-2016. The remainder of the paper will be organized in the following way: the second section will track FDI inflows into Mongolia during the specified period and their possible determinants. The third section will look at how FDI has influenced growth and employment in the mineral sector, while the fourth section will look at FDI influences on service sector growth and employment. These sections will also highlight how growth and employment patterns in the two sectors have led to poor environmental outcomes. Finally, the fifth section will analyze the potential long-term implications of FDI on Mongolia’s economic development.

I. Background and Context: Foreign Direct dInvestment Trends Between 1991- 2016

This section contextualizes Mongolia’s FDI inflows within economic policymaking. The time period between 1991-2016 was chosen for analysis because: one, this is a long enough timespan to observe trends; and two, the versatile FDI inflow patterns of this period allow for nuanced analysis.

I.i Steady FDI Inflows: 1991-1996

As seen from Figure 1, FDI inflows as a percentage of GDP stayed fairly constant with incremental increases throughout 1991-96 with an average of 0.70% of GDP. This timeframe will be referred to as Period 1. FDI flows during this time were largely a result of weak market, trade, and investment liberalization policies implemented following the fall of the former Soviet Union (FSU).

For almost 70 years up until 1990, Mongolia was de facto part of the 16th republic of the Federated Soviet Union (FSU). It received considerable financial and technical assistance from the USSR and was closed to foreign trade and investment everywhere except with members of the FSU. 4 As a result, the disintegration of the Soviet Union in the early 1990s led to severe macroeconomic shocks for Mongolia, with GDP per capita per annum growth falling to -10% in 1991. 5

In response to external economic shocks and domestic political pressure, Mongolia set out on a stabilization reform agenda in 1990 to create a private sector-led open economy. Part of the reform agenda was attracting greater foreign investments to boost economic recovery. While market aspirations were genuine, policy implementation in the 1990s was unorganized across different levels of government and, at times, reflected Soviet-era policy agendas. 6 The institutional capacity to implement market reform was weak and the political will to enforce them was also lacking, especially in regional and municipal contexts. As a result, the early transition years were chaotic and “inappropriately phased.” 7 For example, while price deregulation took effect in 1991, local governments would introduce price regulations to counteract liberalization at the national level. 8 Similar tactics limited the extent of reform during Period 1.

Davaakhuu et al. posit that foreign investors look for economies that are open, stable, and with good institutional infrastructure and low barriers to investment. 9 Weak implementation of reform during the 1990s failed to create this environment conducive to FDI, explaining the relatively unchanging rates of FDI inflow despite attempts to attract investment.

I.ii Growing FDI Inflows: 1997-2010

The newly elected Democratic Coalition took office in 1996 and embarked on a “radical reformist” agenda. 10 The Foreign Investment Law (FIL) was initially passed in 1993 to encourage foreign investment, and revisions in 1998, 2002, and 2008 further strengthened the liberalization agenda to create a more investment-friendly environment. Example revisions included tax and regulation exemptions for investment companies, legal stability guarantees like the prohibition of confiscation of foreign investment assets, and no restrictions on size and contents of investments. 11 These policies, along with Mongolia’s accession to the WTO in 1997, created business and economic confidence, and FDI inflows rose from accounting for 1.2% of GDP in 1996 to 23.6% in 2010. 12 This rapid upshot in FDI seen in Figure 1 from 1997-2010 will be referred to as Period 2.

I.iii Volatile FDI Inflows: 2011-2016

Compared to the fairly steady and steadily increasing FDI in Periods 1 and 2, respectively, inflows between 2011 and 2016 were relatively volatile. This timeframe will be referred to as Period 3. As observed in Figure 1, FDI inflows reached a peak of 43.9% of GDP in 2011 but plummeted to -37.2% of GDP in 2016. Such alarming volatility during Period 3 reflects the country’s growing dependence on its commodity exports. 13

Since the 2009 foreign investment agreement with MNC Rio Tinto and creation of the Oyu Tolgoi copper-gold mine, mineral extraction has soared in Mongolia. By 2016, minerals (copper, gold, and coal) accounted for 72.5% of exports, with copper holding the largest share (28.2%). 14 As FDI flows depend on the profitability of investment, it would be reasonable to argue that mineral commodity prices, in part, dictate FDI trends during Period 3. To test this, Figure 3 shows trends in FDI inflows and world copper prices on the same graph. It can be observed that the two variables coincide well during Period 3. While being careful to draw causal statements, a high correlation between commodity prices and FDI can be seen, showcasing increasing dependence on commodities.

II. Implications of FDI on the Mineral Industry

Historically, MNCs operating in developing countries have focused on investing in extractive and primary industries. 15 Mongolia is no exception to this, with an overwhelming 61% of FDI flowing into the mining sector from 1990-2010. 16 The sector’s strong appeal to FDI is both a result of natural resource stocks and domestic policies targeted at foreign investors.

Mongolia is rich in mineral resources such as copper, gold, uranium, iron ore, and coal. The government took strategic steps throughout the 1990s and 2000s to promote this sector, such as the Gold Program in 1991 that liberalized investment policies in the mining sector. Along with favorable environments for FDI in the 2000s, MNCs such as Rio Tinto saw a large reservoir of largely untapped mineral resources in a country lacking the institutional and infrastructural capacity to exploit them. Additionally, lax environmental regulations reduced costs of foreign investment in mining. These factors made the country’s mineral sector ripe for FDI. 17 As a result, the mining sector grew from accounting for 9.3% of GDP from 1990-95 to 29.2% in 2006-2008 as seen in Table 1. The mineral sector’s economic size more than tripled.

Despite this unprecedented growth, the mining sector accounted for only 3.5% of employment in Mongolia in 2010 and grew to merely 4% by 2018. 18,19 Figure 4 shows that despite the overwhelming increases in FDI flowing into the mineral sector throughout Periods 2 and 3, the share of employment in the industry sector has grown by a less than proportionate amount. The fact that only about 4% out of 29% share of employment in industry is from the mineral sector in 2018—even though the mineral sector accounts for most of the output from industry—also speaks to the meager influence of mining sector growth on employment creation.

The mineral sector has also had negative impacts on local herding environments. According to the Minerals Law, mining companies are required to restore mined sites. However, many companies illegally drain polluted water and carry out careless explosions,

“While the service sector has been more successful in employment creation, it has simultaneously exacerbated inequities between urban and rural areas.”

as on-the-ground implementation of environmental regulations falls short of policy goals. As most mining in Mongolia is surface mining that excavates pastureland, herders surrounding mine sites lose herding ground and livestock, forcing them into unemployment and to look for jobs in cities. This has contributed to Mongolia’s rapid rural-urban migration since 2000. 20 Thus, while FDI has promoted the growth of the mining sector, investments have not only failed to contribute to employment generation but have had detrimental effects on herding environments as well.

III. Implications of FDI on the Service Sector

The second largest recipient of FDI in Mongolia is the service sector, having received 23.5% of FDI inflows from 1990-2010. 21 This has been a favorable sector for investors because Mongolia’s relatively cheap labor reduces the cost of production for MNCs. Additionally, the same liberalization policies targeting trade, prices, and investment that promoted FDI into the mineral sector have also encouraged foreign investment in the service sector. As a result, the service sector grew from accounting for 14.2% of GDP by the end of 1980s to 21% from 2006-2008. 22

Unlike the mineral sector, Figure 2 shows that the service sector has generated considerable employment in the economy: between 1990-2010, this sector accounted for 20.4% of total employment, second only to the agricultural and herding sector. This is because, unlike the capital-heavy nature of the mineral sector, the service sector is predominantly dependent on labor. While the service sector has been more successful in employment creation, it has simultaneously exacerbated inequities between urban and rural areas. FDI is highly concentrated in urban settings, with more than 90% of total investments registered in the capital city Ulaanbaatar (UB). This disproportionate flow of FDI into cities is a partial result of the lack of physical infrastructure in rural regions and concomitant agglomeration of markets and industries in UB. Since the service sector is also predominantly located in urban areas, a majority of employment creation has been in cities. Just as the Harris-Todaro model predicts, this supply-side job creation has induced urbanization during Periods 2 and 3. 23 Meanwhile, the rural sector has been overlooked by foreign investment and has been unable to gain from the benefits of FDI.

The rise of the service sector has created another challenge for cities. Along with the urbanization of herders, UB’s development has been unable to keep pace with rural-urban migration. Those who migrate to the city often find themselves in informal urban settlements called the ger district, which lacks access to centralized heating. During winter months, this district relies on domestic coal burning for heat, aggravating urban air pollution to toxic levels. For instance, in 2018, air pollution in UB surpassed WHO safety recommendations by 133 times. 24 Therefore, the promotion of mineral and service sectors due to foreign investments have resulted in negative environmental consequences in both rural and urban areas.

IV. Long-Term Implications of FDIs on Economic Development

Another commonly cited advantage of foreign direct investments is their contribution to national development. The economic logic of FDI suggests that it allows for technological, capital, and managerial knowledge spillovers that promote savings and growth. 25 In Mongolia’s case, Javsandorj & Dehong argue that promotion of FDI in the country will create linkages both within the economy and the world market and improve domestic standards of living. 26 However, this ideal theory needs to be critically contextualized within Mongolia’s development patterns.

IV.i Protracted Vulnerability: FDI Implications on Growth Trends

The predominance of the mineral sector in Mongolia, supported by FDI, has made the economy and growth trends vulnerable to boom-and-bust cycles of mineral commodities. Figure 5 depicts FDI inflows as percentage of GDP and GDP per capita growth rates on the same graph. The stark negative GDP per capita figures in the early 1990s are representative of the macroeconomic shocks following the fall of the USSR. The economy was able to recover in 1994 following initial economic reforms that allowed the recovery of the mining and agricultural sectors. 27 GDP growth slowed down between 1996-2001 due to domestic circumstances, such as unfavorable weather for herding and closure of state-owned enterprises. However, GDP growth rates began to improve in 2002 because of, again, the enhanced performance of the mining, agricultural, and services sectors. From these trends, it is possible to deduce that during Periods 1 and 2, the mineral sector aided the recovery of the struggling economy during economic transition and unfavorable domestic conditions.

In contrast, the GDP per capita growth rates in Period 3 closely follow trends of FDI inflows (which was shown to coincide with commodity price changes in Figure 3). For example, in 2011, copper prices boomed reaching close to $9000 per metric ton. Accordingly, FDI inflows peaked at near 45% of GDP and GDP per capita rates also accelerated to more than 15%. In contrast, in 2016 copper prices fell to below $5000 per metric ton, drawing down foreign direct investment inflows to -37% and GDP per capita growth to nearly -1%. Over the span of just five years, the country went from growing in the double digits to economic contraction. Hence, in Period 3, GDP per capita rates seem to be partially dictated by commodity price fluctuations or the well-being of the mineral sector. Taken together, figures 3 and 5 depict a strong correlation between commodity prices, FDI inflows, and growth rates.

This is a dangerous predicament for Mongolia as such correlations signal that the economy has become dependent on mining boom-and-bust cycles and the associated FDI flows. Commodity prices are volatile in nature, which creates vulnerability that leaves growth outcomes at the whims of the world copper market. While Figure 5 shows that the country has somewhat recovered from the 2016 shock due to IMF stabilization policies, Bauer at al. posit that even a 15% permanent drop in commodity prices could undo the benefits of the IMF program. 28

Such precarity to macroeconomic pressures outside Mongolia’s control points to the need to diversify the economy by domestically gaining from the mineral sector and channeling mining revenue toward other productive sectors. However, attempts to ensure domestic gains from mining may, ironically, be dangerous to FDI. For example, in 2012, the government proposed changes to the mining law that would ensure 34% of mining projects were controlled by domestic companies. 29 Although the amendment was not passed, the proposal shocked foreign investors and damaged investor sentiment toward Mongolia, contributing to the decline in FDI inflows seen on Figure 1 since 2012.

This places Mongolia in a double bind: the economy is both bound to mineral commodity prices and to the domestically unfavorable FDI policies. Attempts at securing gains from FDI places these same sources of investment at risk. In sum, while FDI has promoted growth of GDP per capita and the mineral sector, it has made Mongolia precarious to turbulent commodity prices, making the current path of development unsustainable.

IV.ii Dualistic Growth: FDI Implications on Employment

Previous sections have demonstrated how FDI failed to contribute to employment in the largest investment receiving sector, mining. This section further explains how FDI has been unsuccessful in promoting equitable growth between sectors and rural and urban regions.

There are two main reasons for why FDI growth has not led to employment creation. First, there is a significant disparity in the distribution of FDI within sectors, with a heavy concentration in the capital-intensive mining sector. In contrast, the labor-intensive manufacturing sector has attracted only 5% of total FDI. Moreover, as part of the country’s attempt to attract investments, the Labor Law does not require MNCs to hire local workers if the labor skills are not available. 30 This means that domestic workers are often not employed in jobs requiring technical and managerial skills and thus the argument of knowledge spillover breaks down in Mongolia’s context.

Second, disparities in geographic distribution of FDI are worsening the imbalance between rural and urban areas. As stated above, 90% of FDI is registered in the capital city. The second largest recipient of FDI is the rural Tuv Region, which receives 3% of foreign investments but accounts for 20% of the national population. Such regional disparities are worsened by sectoral distribution of FDI with the service sector receiving the second largest share. The combined effect of geographic and sectoral inequities means that: one, rural infrastructure remains underdeveloped and FDI continues to circumvent rural regions, failing to create rural jobs; and two, because FDI does not benefit rural populations and service jobs are centered in cities, rural-urban migration and, therefore, urban air pollution are aggravated. This dualistic pattern of growth is demonstrated by regional poverty rates between 1998-2015. While poverty in urban regions have improved from 39% to 32%, they have worsened in rural areas from 33% to 47%. 31

In all, the role and impact of direct foreign investment in Mongolia is fundamentally about the character of the country’s developmental path. With the current FDI framework under which disproportionate investment has flowed into the capital-intensive mineral sector and employment creation has occurred solely in urban areas, growth has become increasingly inequitable and dependent on commodities. This ultimately makes Mongolia’s path of development unsustainable.

Conclusion

The data and analysis in this paper are a lens into how FDI can influence the long-term nature of a nation’s economic development. Mongolia is an interesting and compelling case study for these dynamics because it counters the hegemonic discourse of FDI and growth theory. This paper has argued that flows of foreign direct investment into Mongolia have been unsuccessful in promoting sustainable economic development. FDI inflow trends during 1991-2016 were driven by the strength of investment liberalization policies and mineral commodity prices. The heavy preference of FDI towards the mineral and service sectors have resulted in dualistic employment and GDP per capita growth trends and detrimental environmental effects in rural and urban regions. Future policymaking in relation to FDI will need to consider these unsustainable growth factors to shift the course of economic development toward more equitable distribution of investments between sectors and urban and rural regions.

Endnotes

1. Michael P. Todaro and Stephen C. Smith, Economic Development, 12th ed. (Pearson, 2015), 732. 2. UNCTAD, World Investment Report 2008. Mongolia: Country fact sheet. 3. Oyunbadam Davaakhuu, Kishor Sharma, and Yapa M.W.Y Bandara, “Foreign Direct Investment in a Transition Economy: Lessons from the Experience of Mongolia,” Global Business Review 15, no. 4 (December 1, 2014): 664, https://doi. org/10.1177/0972150914543427. 4. Peter Boone, “Grassroots Macroeconomic Reform in Mongolia,” Journal of Comparative Economics 18, no. 3 (June 1, 1994): 333, https://doi.org/10.1006/jcec.1994.1051. 5. See Figure 2 6. Peter Murrell, Karen Turner Dunn, and Georges Korsun, “The Culture of Policy-Making in the Transition from Socialism: Price Policy in Mongolia,” Economic Development and Cultural Change 45, no. 1 (1996): 175–94. 7. Richard Marshall, Frederick Nixson, and Bernard Walters, “Tracking Economic Policy and Poverty Outcomes in Mongolia,” SSRN Electronic Journal, 2008, 5, https://doi.org/10.2139/

ssrn.1265540. 8. Boone, “Grassroots Macroeconomic Reform in Mongolia,” 331. 9. Oyunbadam Davaakhuu, Kishor Sharma, and Yapa M.W.Y Bandara, “Determinants of Foreign Direct Investment During Economic Transition in Mongolia,” 2015, 148. 10. Richard Pomfret, “Transition and Democracy in Mongolia,” Europe-Asia Studies 52, no. 1 (January 2000): 152, https://doi. org/10.1080/09668130098316. 11. Davaakhuu, Sharma, and Bandara, “Determinants of Foreign Direct Investment During Economic Transition in Mongolia,” 144. 12. See Figure 1 13. Ariunzul Javzandorj and Lu Dehong, “Factors Contributing to Foreign Direct Investment in Mongolia,” European Researcher, no. 30 (2012): 1560. 14. “Mongolia (MNG) Exports, Imports, and Trade Partners,” accessed December 4, 2020, https://oec.world/en/profile/country/ asmng?yearSelector1=exportGrowthYear6. 15. Todaro and Smith, Economic Development, 736. 16. Davaakhuu, Sharma, and Bandara, “Determinants of Foreign Direct Investment During Economic Transition in Mongolia,” 145. 17. Oyunbadam Davaakhuu, “Development Strategies and Structural Change in Mongolian Economy: An Analysis of Trends, Patterns and Determinants of Trade and Investment,” 2013, 86. 18. See Table 2 19. Bolor Narankhuu, “Are Natural Resources a Curse or a Blessing for Mongolia?,” Mineral Economics 31, no. 1 (May 1, 2018): 172, https://doi.org/10.1007/s13563-018-0144-0. 20. Yukio Suzuki, “Conflict Between Mining Development and Nomadism in Mongolia,” in The Mongolian Ecosystem Network: Environmental Issues Under Climate and Social Changes, ed. Norio Yamamura, Noboru Fujita, and Ai Maekawa, Ecological Research Monographs (Tokyo: Springer Japan, 2013), 270, https://doi. org/10.1007/978-4-431-54052-6_20. 21. See Table 2 22. See Table 1 23. Davaakhuu, “Development Strategies and Structural Change in Mongolian Economy: An Analysis of Trends, Patterns and Determinants of Trade and Investment,” 148. 24. UNICEF, “Mongolia’s Air Pollution Is a Child Health Crisis,” accessed December 6, 2020, https://www.unicef.org/eap/press-releases/mongolias-air-pollution-child-health-crisis. 25. Todaro and Smith, Economic Development, 737. 26. Javzandorj and Dehong, “Factors Contributing to Foreign Direct Investment in Mongolia,” 1564. 27. Davaakhuu, Sharma, and Bandara, “Foreign Direct Investment in a Transition Economy,” 671. 28. Andrew Bauer et al., “Fiscal Sustainability in Mongolia,” 2017, 27. 29. Hirofumi Arai et al., “The Northeast Asian Economic Review,” 2015, 47. 30. Davaakhuu, Sharma, and Bandara, “Determinants of Foreign Direct Investment During Economic Transition in Mongolia,” 143. 31. Davaakhuu, Sharma, and Bandara, “Foreign Direct Investment in a Transition Economy,” 671.

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