Broadening abroad: The economy is being diversified in many senses

Mongolia is striving to establish a coherent investment regime, following two years that have damaged investor sentiment. Authorities recognise the need for foreign direct investment (FDI) to develop and leverage its estimated $1.3trn in mineral endowment to develop a diversified economy. Adjacent to two of the world’s largest economies, trade plays a key role in the Mongolian economy, a significant appeal to FDI. Just as it strives to diversify the sources of its FDI, its policy of cultivating “third neighbours” to broaden trade patterns geographically should gradually improve terms of trade. With Mongolia’s basic balance of payments – its current account balance is offset by inward FDI – swinging into deficit from early 2013 despite a narrowing trade balance, consistent trade and investment policies are key to attaining the country’s potential. Fresh from a 16-month electoral cycle, investors are looking forward to more business-friendly policies.

The Big Two

Although trade with its immediate neighbours still dominates, with China accounting for 55% of total trade and Russia 17.3% in 2012, according to EU Commission figures, Mongolia has diversified trading patterns in the past decade. While both exports and imports grew in line with GDP from 2008 to 2012, from $2.54bn to $4.34bn and from $3.25bn to $6.74bn, respectively, the structure of trade has involved a growing number of partners. As its coal exports have grown, from 5.12m tonnes in 2008 to 20.5m in 2012, according to the Ministry of Mining, its reliance on the Chinese market has compounded. With minerals accounting for 94% of exports in 2012, China’s share of Mongolian exports has grown from 64.5% to 87.9% between 2008 and the first half of 2013, according to the National Statistics Office (NSO) figures. Although Russia accounts for a mere 1.4% of exports, it remains a key supplier of imports with 23.5% of the total in the first half of 2013, similar to China’s 25.1% share, albeit down from 38.4% in 2008. Although Mongolia trades with 130 countries, mostly through sea access insured through China and, to a lesser extent, Russia, trade with a number of key third neighbours has grown significantly in the past decade (see analysis). Mongolia still imports most of its refined fuel from Russia and exports many of its minerals – the range of which is gradually being diversified – to China. Economic growth is also expected to drive higher imports, particularly in key segments such as consumer goods and machinery.

Third Neighbours

Trade with its third-largest partner, the US that accounted for 6.6% of trade in 2012 and has grown quickly since 2010, with exports rising from $12m to $42m, while imports grew from $116m to $665m. The EU27 in aggregate is Mongolia’s fourth-largest supplier, with 7.4% of imports in 2012, and third-largest export destination, with 1.8% of the total, although trade is concentrated with the UK (3.6% of total exports in the first half of 2013), Italy (0.8%) and Germany (0.5%). South Korea and Japan are the fifth- and sixth-largest partners, accounting for 7.6% and 7.8% of imports, respectively, in the first half of 2013, but are also significant sources of FDI.

Canada too has benefitted from the mining boom by expanding its share of Mongolia’s imports to 1% in 2012, or $71.9m, up from $10.2m in 2007, and commands a 2.1% share of Mongolia’s total trade, according Canada’s Foreign Affairs, Trade and Development Department. Belarus and Singapore also expanded their share of imports to 1.6% and 1%, respectively, in 2012. Bolstered by recovering coal output and surging copper and gold exports linked to the ramp-up of Oyu Tolgoi’s phase-one from 2013, Dutch bank ING forecasts, in its 2013 International Trade Study, sustained export growth of 28% annually to $21bn by 2017, making it the world’s 59th-largest exporter.

Some 98% of this will consist of ores, metals, fuels and textiles, flowing to three main markets of China, Russia and Italy, which it expects will take 99% of exports by value. Meanwhile ING forecasts 13.1% annual growth in imports to $14bn by 2017, with 57% consisting of textiles, vehicles, equipment and industrial machinery, with 82% of goods from China, Russia and South Korea.

Terms Of Trade

With relatively inelastic demand for imports like refined petroleum and vehicles and more volatile demand and pricing of mineral exports, Mongolia’s terms of trade have deteriorated since 2012 however. “It faces the problem of differing income elasticities of demand for primary products (Mongolia’s exports) and sophisticated manufactured goods ( Mongolia’s imports),”

MAD Investments noted in a November 2013 report. The mining sector faces two challenges linked to its lack of infrastructure: high (trucking and rail trans-shipment) transport costs and low quality of unwashed semi-soft coking-coal particularly. With 93% of mineral exports flowing to China, the terms of trade remain unbalanced. “Mongolia has limited leverage on its selling price for coal, so it must focus on improving the efficiency of its production and transport infrastructure,” Howard Lambert, ING’s head of corporate and investment banking in Mongolia, told OBG.

In addition, the fall-out after the peak of the commodity super-cycle from the second quarter of2013 caused Mongolia’s weighted mining export prices to fall 11% in 2012 and 21% year-on-year (y-o-y) by October 2013, according to International Monetary Fund (IMF) figures. Its aggregate terms-of-trade index published by the Bank of Mongolia (BOM) fell 19.9% y-o-y by October 2013 to 1.194. Coal export volumes fell 19% y-o-y by October 2013, as coal exporters interrupted exports due to a 5% export tax calculated on higher Australian freight-on-board prices, and the 33% drop in coal-export prices was the sharpest, followed by a 17% fall in molybdenum prices, 6% in copper and 23% in gold. Despite an uptick in prices for non-mineral exports like cashmere, which grew 32.2% in value y-o-y by October, and higher copper exports from the Oyu Tolgoi (OT) mine, the value of exports slumped. After a 9% contraction in 2012 they declined 5% y-o-y to $3.48bn by October 2013, according to NSO figures. This marked a reversal from 15.2% compound annual growth in exports from 2008 to 2012, according to the Trade and Development Bank (TDB).

Structural Deficit

With limited domestic manufacturing capacity, Mongolia depends on imports for both industrial and transport equipment as well as most consumer goods. As such it remains more open to trade than the Asia-Pacific average, with trade-weighted most-favoured-nation (MFN) tariffs of only 5.2%, ranking 49th of 178 countries by the WTO. Although imports fell 7% y-o-y to $5.34bn by October 2013, a significant share of imports consist of goods for which demand is inelastic, like refined petroleum, accounting for 21.2% of imports in the first half of 2013. Mongolia has diversified fuel import sources with Belarus, South Korea and China, decreasing Russia’s share from 92.8% in 2012 to 76.5% by November 2013, according to the Petroleum Authority (PAM), but import prices remain high by global standards. Completion of construction on OT and lower mining investments curbed imports of machinery and equipment, which fell 7.3% in 2012 and 17.8% y-o-y by October 2013, according to the NSO. Imports of primary consumer products contracted 15% y-o-y, following the 25% fall in the tugrik. This was partly offset by the 11.4% y-o-y growth in construction materials imports by September, following strong government-stimulated growth in construction, and 7.3% growth in food imports. Although the trade deficit narrowed by 10% y-o-y to $1.86bn in October 2013, down from $2.07bn a year prior, the current account deficit reached $2.83bn, a 2% y-o-y increase, given higher services-trade and income-account deficits. Lower FDI inflows in 2013, returning to the pre-OT trend, have compounded the impact on the balance of payments.

Returning To Trends

In a low-savings environment, where the savings rate only grew from 32% of GDP in 2005 to 35% by 2011, according to Standard Chartered research, FDI has played a key role in driving economic growth – accounting for 88% of gross fixed capital formation in 2012, according to the UN Conference on Trade and Development (UNCTAD). Following the OT investment agreement (IA) in October 2009, FDI inflows accelerated from $0.6bn in 2009 to $1.7bn in 2010, a record $4.6bn in 2011 and a slightly lower $4.4bn in 2012, equivalent to compound annual growth of 85% between 2008 and 2012, according to TDB. The stock of inward FDI reached $13.15bn in 2012, up from $182m in 2000, according to UNCTAD. While Mongolia’s rating by major credit agencies – of “BB” by Standard & Poor’s (S&P), “B1” by Moody’s and “B+” by Fitch – does not directly influence investors’ attitudes it has lowered the cost of funding, even if S&P and Fitch downgraded the country’s outlook to negative in 2013.

FDI Slows

A sharp slowdown in investment came in 2012, however, as phase-one construction on OT wound down and investor enthusiasm waned. Lower global commodity prices combined with concern over political risk, caused by enactment of a restrictive foreign investment law in May 2012 and calls for renegotiating the OTIA (see analysis). As a result these changes, and a wider global trend that saw capital flow from developing to major industrial countries, FDI inflows slumped 17% in 2012 and 47% y-o-y to $1.8bn by September 2013. Despite the slowdown, oil and mining exploration and production still accounted for 90.21% of FDI in the first half of 2013, up from 85% in 2012, according to the Ministry of Economic Development (MED). The services sector, led by trading and catering, is the second-largest FDI recipient with 12% of the total, while light industry attracted 6% of all FDI, according to UNCTAD. Despite uncertainty over OT’s second phase, authorities forecast $2.5bn in FDI in 2013, Fitch forecast $2bn in 2014. “Inward FDI to Mongolia has grown from less than $1bn in 2008 to a forecast $2.5bn in 2013,” S. Javkhlanbaatar, Invest Mongolia Agency’s acting director-general, told OBG. “A rocket increase in FDI amounted to $4.9bn in 2011 and $4.4bn in 2012, mainly generated by the OT project. Stripping out the exceptional FDI increase driven by OT, annual growth has been roughly 15% since 2008, which is a normal trend.”

Broadening Sources

Mongolia’s third neighbour strategy also consists of courting a broader range of foreign investors, a policy that has proven more successful than that of trade diversification. While Mongolia’s development strategy identifies FDI as a key catalyst for growth, technology transfer and human capital development, its 2010 national security policy statement calls for limiting a country to a ceiling of one-third of all FDI, restricting foreign state-owned entities’ control in strategic sectors, and using FDI to enhance competitiveness and increase exports. The National Security Council (NSC) is an increasingly powerful body in determining investment applications in mining and energy. “The NCS’s priority is to attract as many different countries to invest as possible,” Ts. Amraa, PAM’s vice-chairman, told OBG. Indeed the NSC holds veto power on crude oil production-sharing contracts. Although statistics reveal only the first-line of ownership, with US coalminer Peabody operating through a Dutch investment vehicle for instance, some basic trends are clear. China remains the largest single foreign investor with 32% of all FDI and 5500 registered Chinese firms operating in Mongolia in 2012, according to UNCTAD.

The Netherlands, which held a dual-taxation agreement until its annulment in November 2012, accounted for another 24% of investments and was used as a key conduit by many mining investors, as was Canada with 8% of inward FDI and 100 registered firms. The British Virgin Islands account for 5% of FDI, often for mining and banking investments, while South Korea accounts for another 5% and 2000 companies active in property, telecoms and construction. Meanwhile Singapore, with 140 firms operating in Mongolia, has sought a growing role in trade, finance and property even if aggregate investments remain low.

The country’s investment appeal broadened after the 2009 mining boom, but investors became cautious starting in early 2012, given restrictive FDI regulations that were later repealed. “Although there are many opportunities, a ‘wait-and-see’ attitude prevails among foreign investors, especially outside mining and beyond traditional source countries of investment,” UNCTAD said in a 2013 investment policy review.

Deficit Curbing

Amidst the structurally high current account deficit, forecast to reach 30% of GDP in 2013, and declining FDI inflows, Mongolia faces a substantial external financing gap of 10% of GDP in 2013, according to the World Bank. While authorities have propped up domestic consumption in the short-term through off-budget infrastructure investments and an activist, unconventional, central-bank policy that has injected liquidity equivalent to 16% of GDP in 2013, they are looking towards rebounding exports and FDI in 2014 as a basis for sustainable long-term growth. One aspect consists of diversifying engines of growth towards sectors like agriculture and industry and increasing the domestic value added to Mongolia’s traditional primary commodities. In so doing the aim is to broaden its set of trading partners (see analysis).

The second key strategy will likely yield fruit faster by restoring investor confidence, a key plank of President Ts. Elbegdorj’s successful re-election campaign in June 2013. An important first step was taken in October 2013 when the new Investment Law passed Parliament, ensuring equal treatment for both local and foreign investors, and reducing barriers for foreign-state-owned entities (see analysis).

Investors, particularly in mining, await resolution of several more issues in 2014 as reaffirmation of the government’s respect for sanctity of contract. Although the government reaffirmed its commitment to the 2009 OTIA in 2013, negotiations around “22 points of dispute” including Rio Tinto’s management fee, environmental aspects and pay differentials between foreign and local staff were still on-going in late 2013, while a deadline for concluding financing arrangements for the $5.1bn second, underground, phase was extended to the end of March 2014. Meanwhile an international arbitration case involving Canada’s Khan Resources over uranium licenses at Dornod with claims of $326m in damages should reach final judgement in April 2014. More broadly Mongolia has yet to formulate a new approach to tax agreements following its unilateral cancellation of four of its 35 dual-taxation agreements – with Kuwait, Luxembourg, the UAE and the Netherlands – in November 2013 (effective from January 2014). With some 24% of FDI passing through the Netherlands, the tax status of on-going projects like OT remains unclear. Although Mongolia holds 43 bilateral investment treaties, the issue of tax-treatment remains paramount. Authorities have taken a more conciliatory approach towards private investors following the end of the recent electoral cycle in June 2013, with the president launching efforts to include investors more closely in the policy-making process – an initiative called “smart government”.

“The president’s recent initiative to create a national consultative meeting to make government policies more consistent with our development objectives is welcome,” D. Jargalsaikhan, Mongolian Investment Holding Group’s chairman and CEO, told OBG.

Business Climate

While continuity in investment policies is needed, Mongolia is making headway in improving its investment climate even if infrastructure constraints persist. Its ranking improved by three spots to 93rd in the World Economic Forum’s “2012-13 Global Competitiveness Index”, albeit falling back to 107th in the 2013-14 edition, and by four places to 76th in the World Bank’s “2014 Doing Business ranking”. Although these do not take account of the recently enacted Investment Law, Mongolia achieved progress in three key areas in 2013 the bank said. Authorities abolished the need for notarising company statuses and charters and for registration with the tax office, reducing the time for starting a business from 12 days to 11. The requirement for submitting construction plans for low-risk buildings for technical review was also waived, reducing permit application length from 208 days to 186. Finally, the time and cost of connecting to the electric grid were both reduced, from 140 days to 104.

Significant bottlenecks remain in both soft and hard infrastructure, however. Mongolia’s ranking in protecting investors, trading across borders and paying taxes all fell by one place, and it fell three spots in resolving insolvencies and six in registering property. Indeed the main reasons for Mongolia’s fall in the most-recent WEF ranking is due to poor infrastructure and inefficient government bureaucracy. A key plank of the fouryear Action Plan is thus to attract private investment to infrastructure development under public-private partnerships (PPPs).

PPP

While infrastructure projects have long been structured under a build-transfer (BT) model, where contractors front development costs before being repaid on project completion, the government is proposing some $50bn-60bn in PPP projects. Building on the 2009 PPP policy, the 2010 Concessions Law, which includes sovereign guarantees on concessions, and the 2011 Integrated Budget Law, many of these planned projects are structured as build-transfer-operate (BTO), build-operate-own (BOO) and design-build-finance-maintain (DBFM), which minimise government risk further. Two pioneering projects in energy are testing the legal PPP framework. The first, commercialised in June 2013, is the 52-MW Salkhit wind farm independent power plants (IPP) developed by a consortium of Newcom, EBRD, Dutch development bank FMO and GE in a 51:14:14:21 split. The $120m development holds a 25-year powerpurchase agreement (PPA) to sell power to the central grid, signed in 2009. The second project is the 450-MWCHP5 coal-fired plant structured as a 25-year BOT, originally planned as a “scrap-and-build” on the existing CHP3 but since relocated south-east of Ulaanbaatar.

Although a consortium of GDF Suez, Japan’s Sojitz, Korea’s POSCO Energy and Newcom (in a 30:30:30:10 split) was selected in July 2011, the tender was cancelled in 2012 and pre-qualifications were re-launched in 2013. Originally due for commercialisation by 2016, the $1.3bn-1.4bn project now requires new feasibility and environmental studies before financial close, causing two years’ delay. Authority for steering PPPs was shifted from the State Property Committee to the new MED in 2012. While a list of 50 PPP projects was being drafted in 2014, officials recognise the importance of the first two PPPs in establishing a track record. “Seeing more projects under PPP schemes come to fruition will depend on the overall outcome of our first pioneering projects,” Prime Minister N. Altankhuyag told OBG.

Both local and foreign investors are preparing projects in energy, transport and industrial processing. “It is now up to private investors to develop bankable PPP projects, as the government is indicating its desire to streamline rules to support this,” B. Byambasaikhan, managing partner at NovaTerra, told OBG.

Outlook

Despite the downturn in trade and investor sentiment since 2012, the private sector expects more coherent and consistent trade and investment policies until 2016. In a $10.3bn economy with limited domestic industrial capacity and significant infrastructure requirements, a single project of the size of OT can generate spikes in FDI and GDP growth.

While mineral export volumes should rebound in 2014 with recovering coal output and the ramp-up of OT’s copper and gold production, significant uncertainty remains over global commodity prices. Recognising the need for more FDI to capitalise on Mongolia’s natural endowments and diversify its economy, the authorities are reaching out to investors to include them in the planning and execution of key projects.