Risks and rewards: Growth seems assured, but diversification remains key

Although inflation and commodity price fluctuations preoccupy investors and politicians in the short run, Mongolia’s biggest challenge, as long recognised by development experts and local decision makers, will be rising dependence on mining revenues. The debate on how to manage non-renewable mineral wealth is likely to come into sharp focus once the Oyu Tolgoi mine begins operations at the end of 2013, followed by ramp up of the Tavan Tolgoi’s mine coal production. “With two very large mining projects expected to reach full production this decade, Mongolia is entering a commodity boom,” the European Bank of Reconstruction and Development (EBRD) noted in a 2012 report. “History teaches us that commodity revenues offer unique opportunities for development, but can also depress long-term economic prospects by increasing macroeconomic volatility, reducing incentives to invest in physical and human capital, and undermining economic and political institutions.”

EARLY SIGNS: Some argue that Mongolia is already experiencing the first signs of the “Dutch disease”, by relying too heavily on fortunes outside its own control and investing too little into productive sectors. This has been most pronounced through boom and bust cycles triggered by mining export revenues. The IMF has had to step in five times during the last two decades to prevent a financial meltdown. A second sign of the Dutch Disease is visible in the shrinking size of non-mining sectors (with the exception of banking, telecommunications and real estate) relative to the overall economy. Agriculture, for instance, has halved in size relative to GDP since the mining boom-bust cycles began. Perhaps the biggest victims have been the small-scale manufacturing, food processing and services that struggle to retain competitiveness in the face of rising wages and currency appreciation. Their access to capital is hampered by fragmentation and a lack of both infrastructure and proper regulations.

TAKE YOUR VITAMINS: The cure against the Dutch disease, according to most experts, lies in long-term planning and strategic thinking by policy makers, who need to create alternative growth centres outside the mining industry. Chile, Norway, Qatar and Malaysia are often held as champions of developing non-resources based sectors. Meanwhile, Venezuela, Angola and Congo are classical examples of mismanagement and wasted opportunities in reducing poverty and raising the standard of living.

Arguably Chile, which also has a large copper deposit and is a leader in agriculture, is the best role model for Mongolia. The country had one of the best-performing economies in the world during the financial crisis in 2008-09 despite its heavy exposure to commodities. Chile’s record in poverty reduction is also one to match for Mongolia. In 1988 nearly 50% of Chileans lived below the poverty line. In just 12 years this number was reduced to 20%. The country increased the minimum wage by 17% while raising targeted social spending by 210%.

FIRST STEPS: The recipe for success consists of reasonably obvious ingredients, like investing a share of mining proceeds in first-class infrastructure, having a liberal business environment with strong rule of law, and being open to investment and trade.

Chile also experienced a period of high inflation in the 1970s. Getting inflation and general macro imbalances under control was a precondition for the return of investment confidence. The second priority was selling state-owned assets through privatisation to allow private enterprise as opposed to government institutions to run the economy. Taxes were lowered while pensions were privatised, helping to develop a more efficient and more far-reaching social welfare network.

Perhaps the biggest lesson lies in Chile’s openness to foreign investment and trade. By allowing foreign direct investment (FDI) to flow in and treating foreign participants on an equal footing with local firms, Chile created what is known as the “technological transfer effect,” with the country’s local talent pool now engaged in highly productive sectors.

DECISION TIME: As a late starter in the resource development race, Mongolia has the benefit of hindsight. It can pick and choose which bits of the best examples from other situations suit its needs. Apart from Chile, it is located in a region with role models that have achieved developed nation status by focusing on technological progress, such as South Korea and Japan. Mongolia has taken early steps in this direction by rolling out new communications and broadband infrastructure, with internet speeds in Ulaanbaatar increasing in recent years.

The government has also shown eagerness to invest in transport infrastructure, such as railways and roads, to improve the productivity and value-added potential of the mining sector. Going downstream within the mineral sector can indeed be the right choice during the early stages of development, as was shown by countries like Malaysia, Indonesia and Thailand. It helps to maximise the profits derived from a non-renewable resource.

Mongolia has also shown some foresight in embracing renewable energy, namely wind and solar, by building up its other permanent asset – abundant amounts of land and sunshine. However, some critics argue the government has overlooked other key elements, such as health and quality education, which make countries competitive in the long run.

EASY STUFF: Critics maintain the most overlooked low-hanging fruit is the huge potential the country has in tourism and agribusiness. Home to one of the biggest pastures in the world (and one still entirely eco-friendly), Mongolia has an advantage over crowded and urbanised Asian neighbours.

The country’s disadvantage – a lack of human capital – requires investment in modern farming techniques and the consolidation of units into large-scale ownership or cooperatives. This, in turn, requires a fundamental change in land laws, new financial incentives and the transformation of rural lifestyles – a move policymakers are not yet ready to make.

INFRASTRUCTURE: The other development challenge facing Mongolia is a lack of infrastructure.

The country is one of the least densely populated in the world, with vast distances between small urban centres. The transport system remains highly underdeveloped. Mongolia has only one major railway line, running from Ulan Ude in Russia to Beijing, encompassing only 1500 km compared to 11,200 km of paved roads, according to the World Bank.

The “Global Competitiveness Report 2011-12” put Mongolia at 118 out of 142 countries in infrastructure quality terms – considerably behind its peers, such as Chile (41), Indonesia (76) and Peru (88) The lack of good infrastructure across the country has encouraged migration towards the capital city Ulaanbaatar. The city is struggling to meet the sudden increase in demand for employment, transport infrastructure, health services, electricity and basic sanitation. The informal ger (tent) district located on the outskirts of the city is home to as many as 400,000 people in a city of 1m total. Disconnected from a power grid and central heating, rural migrants tend to rely on burning coal stoves. These in turn have turned Ulaanbaatar into one of the most polluted cities in the world during cold winter months.

Given these pressures, infrastructure projects like power plants, water supply and affordable housing are going to be at the top of the political agenda over the next five years. Although mining proceeds will help pay in part, Mongolia needs private sector investment to launch these wider-scale initiatives.

Bitter experiences in Indonesia show it is not enough to have high GDP growth numbers, public-private partnership agreements or build-operate-transfer legislation in place to attract investors. Indonesia’s case proves the number one priority for long-term money has been political stability and legal certainty in the sanctity of contracts and property rights. Mongolia currently stands outs in international circles as the only vibrant democracy in the region, which can help attract the attention of big financial institutions. Ensuring confidence in contracts and property rights in the country will be key to maintaining this attention.

However, the recent lack of political consensus over long-term strategy may cause issues in the future. Investors have been spooked by what looks like a “rip up the script” type of politics, with each new government immediately trying to overturn what the previous one had set in stone.

Without fundamental upgrades in power, infrastructure Mongolia could lose out not just in new growth sectors but also the mining sector, according to EBRD. A coordinated investment effort and long-term strategy – one supported by all parties – remains the most important policy priority in 2013. If that does not occur, Mongolia’s slow march into a resource dependency trap appears to be inevitable.