How to Cope with Windfall Wealth

Note: This article is an abridged version of an in-depth country study produced as part of the Prosperity Index project of the Legatum Institute. Complete versions of all 12 are available on the Institute website.

Mongolia has shaken off the effects of Soviet domination in surprisingly short order. The successor to the old communist party has just surrendered power — for a second time — in a fair election. And the economy is booming: If all goes as planned, the completion of mammoth mining projects will double GDP before 2020.

Yet the source of Mongolia’s new economic fortunes — abundant mineral wealth — gives pause. History offers few examples of countries riding a resource boom from poverty to affluence without mishap. In fact, that road is so commonly bumpy that it has a name: the resource curse.

Mongolian society did pass a big test in dealing effectively with the difficulties encountered on exit from communism. It remains to been seen, though, whether the institutions forged when there were doubts about Mongolia’s viability as an independent state are up to the challenge of managing suddenly realized riches.

When public protests against the communist government erupted in mid-1990, Mongolia’s chief benefactor/oppressor, the USSR, was crumbling and precipitately withdrawing its economic support. Its other giant neighbor, China was in no mood to embrace a new democracy. Who in their right mind would have expected that plans to create a liberal state in Mongolia would succeed?

Yet, the Mongolians have pulled off the improbable. Twenty-two years later, seven parliamentary elections have been held on schedule and 17 years of more or less steady economic growth might not seem all that remarkable an accomplishment until one remembers how dependent Mongolia was on crumbs from the Soviet table.

The authors both witnessed that transition. Narantuya, a junior lecturer of Marxist political economy in the winter of 1989, remembers the deep, pervasive fear when demonstrators challenged the rule of the Mongolian People’s Revolutionary Party (MPRP). Surprisingly, the MPRP eventually opted for a peaceful transition, and scheduled multi-party elections for July 1990. A reformist government took over, with little understanding of the economic catastrophe it was about to confront.

Trade collapsed as Eastern Europe turned to the West and the USSR disintegrated. Hyperinflation threatened and living standards plummeted, with even staples in short supply. Murrell remembers searching for food in late 1991, going from one store to another and finding only one item — massive chunks of Bulgarian feta that were apparently one of the last purchases under Communist-bloc trade agreements.

Mongolia is situated some 1,600 kilometers from the Pacific Ocean via China and its population is spread across an area the size of Western Europe. In a country with low rainfall and temperature extremes, nomadic pastoralism was the universal occupation until the 1960s.

The communists overlaid this traditional nomadic culture with an orthodox socialist system. Nomads were forced into large animal-husbandry cooperatives (negdels). Mongolia’s capital Ulaanbaatar and a few other cities became industrial centers, dominated by very large state enterprises. Some tentative market liberalization occurred in the 1980s with the advent of perestroika (moderate economic "restructuring" as envisioned by then-Soviet leader Mikhail Gorbachev), but did not go far. Worse, the reforms left big enterprises largely unregulated, lacking the disciplining force of either government planners or market competition.

The MPRP won the first multi-party election comfortably, the new democratic forces being disorganized and unable to field candidates in many rural constituencies. Yet, driven by the fear of being on the wrong side of history (or perhaps just worried about future demonstrations), the MPRP selected an eager reformer and staunch anti-Soviet, Dashiin Byambasuren, as prime minister. In forming a coalition cabinet, he placed economic reform in the hands of the more radical members of the new democratic parties.

The first real economic reform occurred in January 1991 with the freeing of many prices, the adjustment of others to better reflect costs, and a doubling of salaries to offset the resulting increase in the cost of living. But at the same time, the government was using the printing press to finance expenditures.

Inflation peaked at 270 percent in 1993 and was contained to single digits by 1998. GDP, down by a relatively modest 22 percent, began to grow again in 1994. Foreign government assistance, together with IMF and World Bank aid, helped Mongolia immensely. But success also reflected the depth of the government’s political will and rapidly growing technical competence — along with lots of forbearance on the part of ordinary citizens.

Macro stability proved the greatest challenge early in the transition, but reformers nonetheless focused on privatization. The avowed aim was to turn a proletariat with nothing to lose into owners with a real stake in the system, while depriving politicians of control of the country’s resources. Large-enterprise privatization was a significant organizational accomplishment in a country lacking the infrastructure of a market economy. Moreover, in contrast to privatization in post-Soviet Russia, corruption was minimal.

Research later showed that the privatization did, indeed, succeed in lessening the state’s economic influence, but failed to increase productivity. One unanticipated development: Managers and workers were able to amass commanding ownership positions by using the vouchers issued to members of their extended families. By the end of the privatization process, half of the enterprises were controlled by insiders — evidence of Mongolian society’s inclination and capacity for collective action.

The most controversial aspect of privatization involved the aforementioned rural cooperatives. Each carried out its own privatization scheme, resulting in large inequalities and frequent allegations of corruption. Some families accumulated huge herds, while others sank into poverty. But free markets did eventually make a big difference to productivity: The number of animals increased from 26 million in 1990 to 44 million in 2009, and herd composition began to respond to export price incentives.

The decline in output, combined with runaway inflation and opposition to privatization, brought the early reformers into disrepute. A parliamentary election in 1992 — the first under the new constitution — led to a big win for the old-guard MPRP, which ruled alone until 1996. The MPRP government was pragmatic, centrist and cautious. It did, however, complete the privatization plan, deregulate prices, and make the currency freely convertible despite its communist DNA. Market democracy, it seems, had become an uncontested goal in Mongolia.

Meanwhile, the reformist parties finally proved able to forge a united platform, capturing two-thirds of the seats in the 1996 parliamentary elections. And the new government set about revitalizing reform. The centerpiece was, again, privatization, but this time of the very large (and much more valuable) companies omitted from the first round. From 1996 to 2000, nearly 1,000 enterprises were privatized through a variety of schemes, all requiring the new owners to pay cash up front.

Although Mongolia was in the bottom-quarter of all nations in per capita GDP in the late 1990s, it was easily in the top half on all six Worldwide Governance Indicators compiled by the World Bank. This was the case even for the category of regulatory quality (an aspect of institutional development with which Mongolia had no experience prior to 1991) and for control of corruption (in which the transition countries have generally fared badly).

Superior governance, combined with the potential of the country’s natural resource base in an era of booming commodity prices, lured foreign investors by the planeload. While it took eight years to recover from the 22 percent decline in GDP in the aftermath of Soviet withdrawal, the eight years from 2002 to 2010, by contrast, saw cumulative growth of 73 percent.

The gains were felt broadly. Infant mortality fell by a remarkable 70 percent between 1990 and 2010. And decent schooling was quickly re-established: Secondary education is now universal and female literacy is at 98 percent.

But all this begs a key question: What made Mongolia different from a slew of post-colonial and post-communist economies that made much less progress toward free-market democracy in their early years of transition?

A number of advantages followed from what was absent in the Mongolian experience. In the departure from communism, there was no strong leader — no Nursultan Nazarbayev, for example — who could dominate the political scene. The army and security services were weak and had no political designs. Ethnic homogeneity eliminated the chance for the type of internecine conflict so common in other former Soviet-dominated states.

The list goes on. Although more Mongolians live outside the country than inside, there were no prominent irredentists. No foreign country had designs on its territory. No religious group distracted attention from earthly pursuits.

But there was also plenty to build on. Mongolians have a strong sense of national identity, particularly when emphasizing their differences from their two powerful neighbors. They thus viewed the early transition as a period in which their society was under threat. There was widespread support for the transition and an understanding that times of privation were to be endured. Where transition policies did increase inequality, a respect for customary property rights along with the maintenance of decent social safety net, muted objections.

Consider, too, that despite its bucolic image, Mongolia’s nomadic economy creates the constant possibility of conflict over prime grassland and scarce water as herds and families change in size and needs. Established arrangements are challenged, and must be renegotiated in a flexible process that aims to keep costly conflict to a minimum. Serendipitously, this type of cooperative give-and-take translates easily into skills useful for market capitalism.

The threat of disaster haunts the nomads. In 2010, a freeze that prevented access to pasture land killed 11 million animals, one — quarter of all livestock. Tradition dictates that those who are unaffected share their pasture and wells with afflicted herds. And arguably, this facilitated cooperative behavior in the transition decades.

Note, moreover, that Mongolia’s eagerness to develop ‘third-neighbors’ to counterbalance Chinese and Russian influence were instrumental in attracting aid along with quick entry into the World Trade Organization. Last but not least, keep in mind some more familiar explanations for Mongolia’s success. Levels of literacy and education — notably, female education — are very high. And both educational attainment and gender equality are good predictors of success in building market democracy.

While the last decade has seen rapid growth in living standards, the development of effective governance institutions has stalled and corruption has increased. The consequences can be seen in the deteriorating performance of its political system.

From 2004 to 2008, a coalition between the MPRP and the new parties ruled indecisively; by no coincidence, it was the slowest period of economic reform to date. The new parties had expected to win the 2008 election, but the MPRP boasted of a landslide victory. Some prominent members of opposition parties claimed fraud (not subsequently substantiated by international observers), and street demonstrations followed. The police overreacted, killing five and arresting 700 people — a shocking outcome in post-communist Mongolia. All parties chose to step back from the brink, forming yet another coalition government. But it was a sobering experience for the new democracy.  

Since 2008, a number of policy decisions have also reinforced concerns that Mongolia’s road to affluent democracy will be bumpy. For one thing, governments seem less committed to fiscal prudence. The budget deficit amounted to 5 percent of GDP in 2009, closed to zero in 2010 thanks to strong mineral-revenue growth — but then opened again in 2011 as the government fulfilled it populist election promises.

More generally, there has been an erosion of the sense of individual and collective responsibility. Rising corruption is especially corrosive because it is happening against a backdrop of ongoing poverty and inequality. To be sure, Mongolian inequality is not extreme by the standards of, say, sub-Sahara Africa. But it has grown since the 1990s, along with the numbers of very poor. Some 60 percent of Ulaanbaatar residents live without clean water, sewage and electricity. And one-quarter of the working-age population is not employed in the formal economy.

The magnitude of untapped mineral wealth in stunning. Consider, for example, Oyu Tolgoi, a copper and gold project in the Gobi desert. Even before production begins in 2013, the sum invested in that one mine will equal two-thirds of current GDP. And almost everybody expects that most of Mongolia’s minerals have yet to be found.

Windfall wealth creates temptations to corruption. Arguably worse, it undermines the discipline and institution-building needed to raise productivity and to create jobs in other sectors. Mongolia is not Venezuela or Equatorial Guinea, though — it possesses the social capital to fight back. In the end, the country’s fate will turn on whether the culture that preserved civility and unity through the long, dark days of Soviet colonialism can mute the centrifugal forces of capitalism and globalism.