OBG talks to G. Ganbold, Former CEO, Golomt Bank; Norihiko Kato, CEO, Khan Bank; D. Batsaikhan, CEO, State Bank; Randolph Koppa, President: Interview

Interview: G. Ganbold, Norihiko Kato ,D. Batsaikhan, Randolph Koppa

What challenges does Mongolia’s economic slowdown pose for the banking sector? Where are there opportunities for growth?

M. BOLD: Downturns are not a new occurrence for Mongolia or its banks. For the past few decades we have been a small, open economy prone to external shocks and market fluctuations. Growth is cyclical, especially given our reliance on commodities. As such, the recent slowdown is best viewed as another iteration of a familiar pattern that will eventually give way to economic expansion. Some commentators worry that the downturns – such as the one we are currently experiencing and that in 2008 – have become more severe, but I would argue that they are just more visible, given how much larger Mongolia’s economy has become and how much more money is present. While difficult, fluctuations are normal and should not frighten newcomers seeking to invest, as the potential for growth remains unchanged.

Of course banks have been hurt by the downturn, given that their balance sheets mirror the structure of the economy. However, because Mongolia is used to periods of slowdown, the country, and especially its banks, know how to work through them. For the most part, the top banks have done an effective job of implementing measures to slow the pace of loan creation, boost liquidity, strengthen loan conditions and build up reserves. Mongolian banks are much faster and proactive than they have been in the past, which is a good indicator of the growing sophistication of the sector.

D. BATSAIKHAN: While it has been a difficult half-year for the sector given the current state of the economy, some banks have been able to sustain moderate growth compared to 2013. That said, all banks must watch the quality of their credit portfolios to make sure these do not deteriorate with the economy’s downward trend.

There are many ways to do this. One is to reduce exposure to problematic sectors to reduce the risk of incurring future non-performing loans (NPLs). Another is by educating clients, both corporate and retail, on the importance of paying their loans on time. By doing this, banks have been able to decrease the number of loans that are past due. Business strategies also need to be adjusted according to season, because some quarters tend to see more growth on the consumer side while others tend to see more on the corporate side – retail lending, for instance, was slightly quieter in the first half of 2014 but very active in the second half of 2013.

Banks need to manage risks in a sustainable way. Mongolia has had a number of bank failures in recent years, and while the majority of bad assets associated with these failures have been successfully absorbed by the system, we need to minimise the risk of similar situations. Luckily, when Savings Bank collapsed, all 1.7m deposits and all 3200 jobs were saved. If a bank fails in the future, one hopes that the same will be true.

G. GANBOLD: The current macroeconomic situation is putting significant strains on the country’s banking system. High inflation and the depreciation of the tugrik have meant higher funding costs and lower profit margins for banks; the slowing economy makes it harder for companies to repay loans; and the recent policy rate rise will have a cooling effect on loan growth. It is no secret that Mongolia is already facing issues with some companies and consumers looking to postpone payments. A year ago, the big banks were cutting rates to compete for loans; now, this has stopped, and we are working to minimise the risk of NPLs by restructuring loans and tightening credit policies.

There are still, however, strong lending opportunities in certain sectors. Mining, for example, remains a natural business for banks. Even with the slowdown, some firms are still growing and investing. Infrastructure-related lending is another area with potential. The most interesting, though, is domestic manufacturing, which the government is now prioritising through a number of special programmes. Cashmere, wool, milk, leather, textiles, and fruit and vegetable greenhouses are all areas where Mongolia can be competitive.

RANDOLPH KOPPA: While loan growth will decelerate due to the downturn, one must remember that Mongolia is still growing, albeit at a slower rate. The World Bank predicted 9.5% growth for 2014, meaning economic activity is still taking place and needs to be financed. Though imports have fallen, banks are still needed to finance trade, and business is growing as more companies realise the benefits of such products. The country still lives on imports, and as long as that is the case there will be a need for instruments like letters of credit and letters of guarantee for trade payments.

In addition, exports are up, largely as a result of the full production status of Oyu Tolgoi. We should also see an increase in gold activity starting in the third quarter of 2014. If exports continue to rise, it bodes well for the economy as a whole and, more specifically, for the mining supply chain. There are also large-scale projects being discussed that will require financing if they go forward: coal-to-gas and coal-to-liquid projects, a gas transport pipeline through the country and a new cross-country highway, to name a few.

NORIHIKO KATO: The economic slowdown has certainly had an impact on the sector’s growth outlook, and we have indeed seen an increase in NPLs in certain sectors, such as mining and construction. That said, there are still opportunities available for banks that carefully assess credit risk and are mindful of becoming too exposed to any one sector. Even in construction, there are good projects with sound fundamentals that need financing. Demand for reasonably priced, decently sized apartments will continue. Of course, some of the more questionable developments may have to slow construction or stop altogether, but these are specific, isolated cases, and the sector as a whole is in better shape than it was in 2009, the last time it faced difficulties.

Improvements can also be made on the retail side to attract more business. For instance, banks are currently working on improving electronic banking services. In Mongolia, mobile and smartphone penetration is very high. E-banking services, especially through such devices, are effective at improving customer service and making banking easier for the average Mongolian. On the whole, there are still opportunities to be had, and while the banking sector may not grow as quickly as it has in the past few years, its expansion will continue to outpace that of the overall economy going forward.

How have the government’s pro-cyclical fiscal and monetary policies impacted loan growth? What risks have these policies created?

KOPPA: The government’s stimulus programmes have certainly been aggressive; in 2013 alone it injected MNT3trn ($1.8bn) of liquidity into an economy with less than MNT10trn ($6bn) in outstanding loans. When critics cite the significant rise in mortgages as evidence that the 8% mortgage scheme is unsustainable and poses considerable risk to the banking system, they fail to mention two facts: that so far most of the mortgage holders have proven to be reliable borrowers, and that most of the risk associated with these loans rests with the central bank, not the issuers. The latter were used as a conduit, borrowing money from the former at 4% and lending mortgages at 8%. These mortgages, as long as they meet the strict lending requirements of the programme, are then securitised and 90% are bought by the central bank, leaving only 10% of the risk on the individual bank’s balance sheet.

Overall NPLs, though rising, remain relatively low. Troubled assets in the banking sector were at 5.2% at the end of March 2014, according to Mongol Bank, and in June the number remained similar. What you have to remember, however, is that this figure includes the bad loans of the recently failed banks that have been set aside and are being unwound. In fact, NPL ratios at the four largest banks, comprising 80% of loans, were around 1-3% at the end of March, with an average of 2-2.5%. These figures, a slight increase on previous periods, look manageable compared to the 17% NPL ratio the banking system had in 2009, especially given continued growth. I do expect overall NPLs to increase, as we have seen a recent uptick in past-due ratios, but I think that any such increase will be manageable.

BATSAIKHAN: Much ado has been made, and many inaccuracies disseminated, about the financial feasibility of the 8% mortgage programme. The total amount of mortgages issued under it, however, comprises a relatively small portion of banks’ balance sheets. In addition, once the mortgages are securitised and sold back to the central bank, only 10% of the risk will stay with the issuers. People tend to forget that there is significant demand for the apartments covered under the programme, those less than 80 sq metres, and a current lack of supply. The programme also serves a higher social purpose, as more than 60% of Ulaanbaatar’s population live in ger (traditional felt tent) districts. If these people can be moved into apartments that have running water and are connected to the electric grid, the whole Mongolian economy will be better off.

GANBOLD: The government’s exceedingly soft monetary policy has created risks in some sectors. As a result, banks need to adjust their risk exposures in certain areas. One potential problem area is in construction and real estate. We faced a big boom in 2011 and 2012, and now there are many unfinished projects or finished developments that cannot find buyers. It is hard to imagine who is going to fill all of the glass office towers that are going up, as we already have an oversupply of office space in the market.

KATO: Starting in 2013, credit provided by the government’s fiscal and, to some extent, monetary policies began eclipsing actual production and foreign investment as the primary drivers of economic growth. Over the course of the year, roughly MNT3tn ($1.8bn) were pumped into the market through commercial banks, which is more than the total size of Khan Bank’s loan portfolio. While this injection has increased liquidity and provided subsidised business opportunities to commercial banks – and the government was wise to channel these funds through banks’ established risk and credit selection procedures – we need to begin shifting towards a growth model based on production. While I understand the ratings agencies’ concerns about the sustainability of the stimulus policies, the 8% mortgage programme has been successful at increasing apartment ownership among low-income families, young couples and even pensioners, and it poses limited risk if banks continue to employ stringent lending standards and the economy does not slow drastically. So far there have been few instances of borrowers not servicing mortgages. That said, if we see a more pronounced slowdown and significant rise in unemployment, the programme will become more difficult to maintain.

BOLD: Many have criticised the recent policies taken by the government, but they tend to overlook some of the benefits that have come about as a result of them. For instance, the 8% mortgage programme deals with the very important issue of trying to get more people out of ger districts and into apartments with running water and working heat and electricity, and the Price Stabilisation Programme is meant to decrease inflationary pressures. While NPLs have risen slightly over the past year, they are nowhere near as high as during previous downturns – as high as 40% at some banks – and are more a function of the general slowdown in key sectors such as mining and construction than they are a result of the government’s stimulus policies. In fact, mortgages as a percentage of overall outstanding loans are still relatively small compared to other countries, and repayments on mortgages created under the programme have so far proven stable. So, the NPL ratio is not at a critical level and is still very manageable.

Again, I would like to stress the strong ability of the banking system to deal with this deterioration in asset quality. Capital adequacy ratios at 14% are higher than international norms and significantly higher than when the Mongolian banking sector faced previous challenges. In addition, people tend to overlook the positive signs in the economy such as the ramp up in production and exports from phase one of Oyu Tolgoi. Of course the slowdown has impacted banking profitability, however, the economy is still growing and with that there are opportunities for profit on the part of banks.

Given the small size of bank deposits, how can local banks finance future economic expansion?

GANBOLD: A major shortcoming of the Mongolian banking system is its inability to adequately finance the country’s growth. Local banks do not have enough equity. Because of the caps the central bank has set on counterparty exposure, the largest institutions can only lend around $50m-60m to any one client, which is a small amount considering that large capital expenditures are often many multiples of that. Some 10-20 years ago the country’s banks were bigger than its companies, but over the past five years this relationship has been reversed, and more companies have to look outside Mongolia for funding.

To compensate for this shortage of capacity, the banking system needs to attract more foreign investors. While the macro picture is out of our control, there is much we can do to improve our own governance standards to put potential investors more at ease with our institutions. Big banks are currently working to improve transparency, apply international standards of accounting and make the management more accountable for their actions by strengthening boards, often by adding independent directors who have significant experience in banking outside of the country. By doing these sorts for things, we are sending a strong message to foreign investors that Mongolia’s banks are not only open to investment but are also good bets.

KOPPA: The loan-to-deposit numbers for 2013 are slightly misleading. Yes, loans did grow by an extraordinary amount; however, most of that was funded by money borrowed from the central bank for the aforementioned programmes. As a result, it looks like loans are growing at a faster pace than deposits, when actually these have seen strong growth over the past year. That said, many local banks have successfully received foreign funding in the past and will continue to do so.

KATO: Mongolian banks have made large strides in the past few years in terms of size and accumulation of experience. Banks can afford to lend as much as $50m-60m to a single borrower under prudential ratio rules set by the central bank. While this is more than they were able to lend before, it does not meet all the funding requirements of local companies, especially in times of rapid economic expansion such as we last experienced in 2011-12. Once the economy strengthens, banks will need to tap international sources, and when they do, they will need to make sure they abide by international standards of transparency and risk management so that they are more attractive to investors and are able to engage in effective partnerships with global banks and international financial institutions.

BOLD: As I mentioned before, there is significant potential for growth in the economy, especially with respect to the funding of local producers and service providers in the mining supply chain. Also, there is a general need for funding and development of small and medium-sized enterprises across all sectors. To fund this growth, local banks will continue to have to bolster domestic deposits with foreign sources of funding. In the past, it has been relatively easy for top-notch banks to receive support from the international market, and despite recent difficulties encountered by some, I believe the challenges had more to do with macro factors than concerns about the health of the Mongolian banking sector.

BATSAIKHAN: In general, the deposit market has been negatively impacted by the economic downturn. A few banks, however, have seen an uptick in this area, especially those that have adopted deposit insurance, which is new to Mongolia. While all the major banks are now insured, the fees for this protection are high, making it hard for smaller banks to afford. In the past, when Mongolian banks have needed funding outside of deposits, they have turned to international markets with success. While I have no doubt that they will continue to do so, the banking sector could implement reforms to reassure foreign investors and bring down the cost of funding. Mongolian banks need to assure investors that their finances are clean by using global accounting standards and internationally recognised auditors.