Moody's Investors Service has downgraded Mongolia's government issuer rating to ‘B3’ from ‘B2’ and initiated a review for further downgrade, the ratings agency said on August 26.

The downgrade reflects a sharp deterioration in the country's fiscal metrics, which Moody's does not expect will reverse materially in the next few years. "Compounded by weak growth and already very low foreign exchange buffers, this will significantly exacerbate fiscal challenges and liquidity risks facing the government," the ratings agency said.

The review, expeced to be completed within three months, will allow Moody's to assess the speed and effectiveness of the policy response to these heightened challenges, and their implications for growth and the management of external liquidity, which would depend partly on the availability and cost of external financing.

Mongolia's fiscal deficit has widened significantly in recent months due to a sharp increase in spending in the first half of 2016 and revenue underperformance, Moody's notes. That is expected to increase the government's near-term financing needs and contribute to external vulnerability pressures. "While some of the spending is likely one-off rather than recurrent, we estimate that the government's fiscal consolidation efforts will now start from a much weaker base, with a budget gap of around 15% of GDP, versus our earlier expectations of about 5% of GDP for 2016," Moody's says. The growth in expenditure will slow markedly in 2017, while revenues may recover somewhat. "Still, we expect the deficit to be only marginally smaller, at around 14% of GDP."

The wider deficits will translate into a jump in the debt burden, while the value of the existing debt will be inflated by the recent depreciation of the Mongolian tugrik. Thus, Moody’s forecasts the debt to rise to 71% of GDP in 2017 from 63% in 2015.

Mongolia’s debt affordability, as measured by interest payments to revenues, which “has already worsened significantly over recent years, to 12.2% in 2015 from 2.5% in 2012” is also expected to deteriorate further, the agency says.

Currently, the country faces a gap between its revenues of MNT5.34tn (€2.14bn) and expenditures of MNT9.7tn, after it had announced cuts in civil service salaries, higher taxes and a later retirement age. The country also faces debt repayments starting from a $580mn bond issued by the Development Bank of Mongolia due in March followed by repayments of $1.7bn-$1.8bn over the next two years, including a swap agreement with China’s central bank.

“Moody's could maintain the current B3 rating with a stable outlook, if it were to conclude that the government's response to the worsening fiscal position was likely to stabilize the fiscal position, support the resumption in growth and inward investment and allow Mongolia to retain access to international debt markets at affordable rates”, the agency said.

The current rating could be maintained with a negative outlook if, “notwithstanding the emergence of policies intended to stabilise the fiscal position and support growth”, a persistent negative pressure remains on Mongolia's credit metrics over the next 12-18 months.