Still in the game: Despite a challenging 2012, overall prospects continue to look strong

Just 22 years after embracing the market economy Mongolia has been going through another cycle of economic and political headwinds, although the country’s fundamental macroeconomic indicators appear to be more solid this time round.

In 2013 all eyes will be on the Oyu Tolgoi copper and gold mine, set to begin commercial production. This much anticipated “make-or-break” event could transform the country’s economy once and for all, opening up immense opportunities for private sector investment as well as creating new sources of growth within and outside the mining sector.

THE STORY OF MINERALS: With an estimated mineral wealth of $1trn underneath the surface, according to Eurasianet, alongside a small population of 2.8m, Mongolia’s GDP per capita could, in theory, rise quickly from its current low-middle-income bracket of $5000 to a high-income bracket of more than $30,000 over the next two decades, say forecasts.

If realised, this trajectory would make Mongolia one of the richest countries in Asia and might prompt it to follow the development path of resource-rich Gulf countries like Qatar and the UAE.

The delivery of key mining projects and changing global prices of copper and coal will largely determine if this long-term vision can be achieved.

So far the record has been mixed, due in part to political complications. The country’s landmark copper and gold mining project, Oyu Tolgoi, appears to be getting closer and closer to the production stage, despite political debates in the media.

D. Batmunkh, an advisor to the prime minister, argues that the political situation will stabilise quite quickly once production starts in 2013. “Once politicians and people in Mongolia see the results of production, the situation will calm down,” he told OBG in a December 2012 interview.

Its contribution to growth could be instantly visible. According to the IMF, if Oyu Tolgoi begins its production in 2013, Mongolia’s overall GDP growth will climb to 16.8%, compared to an earlier estimate of 11.2% that had been noted for 2012.

Over the upcoming five years the IMF expects that mining output will expand at an average rate of 20% per annum. When fully operational and running at its optimal capacity, the Oyu Tolgoi mine alone is expected to account for more than 30% of the country’s GDP, heavily shifting the overall weight of economy towards the mining sector.

GROWTH CHARACTERISTICS: Looking at the nominal GDP base in local currency in 2013, growth is expected to increase by around 27%, from MNT13.57trn ($9.5bn) in 2012 to some MNT17.26trn ($12.1bn) by the end of 2013.

Such high rates of expansion could bring a potential windfall in government revenues and create new private sector opportunities. However, it also presents the formidable challenge of avoiding overheating and the much-feared “resource curse”.

Despite the imminent mining boom, Mongolia, like other countries before it, faces the challenge of ensuring inclusive growth. At present, around 30% of the population is considered to be living in poverty, according to figures from the World Bank.

An expanding economy, expressed in average GDP growth of 8-10% over the past 10 years, can still fail to address some fundamental issues in Mongolia. The country remains vulnerable to harsh weather conditions, which can be especially detrimental to agriculture, a vital sector that continues to account for almost 40% of all informal employment.

The capital Ulaanbaatar, the country’s main urban centre, continues to draw rural migrants, but is unable to generate enough jobs and incomes for them.

Although official rate of unemployment was just 4.4% as of March 2012, according to the World Bank the unofficial number is likely much higher.

Development experts argue Mongolia is still at risk of experiencing the “Dutch disease”. Some symptoms of the disease may already be apparent, such as a lack of new employment opportunities currently being created outside the mining sector.

In the short term the pressure stemming from rural migration has eased, thanks in part to relatively benign winters in 2011 and 2012. This can be seen in rising agricultural output. Volumes increased by 17% in 2012, compared to a 0.5% decline seen in 2011 and a 16.6% decline following the especially harsh winter of 2010.

Another source of positive news for employment comes from the construction sector, which has seen growth fuelled by housing and infrastructure projects as well as easier access to credit. Following 35.6% growth in 2011, the sector expanded by a further 10% over the course of 2012.

Meanwhile, services, which include the financial sector industry, are expected to have grown by 10% in 2012 – somewhat slower than the 16.8% in 2011, but still impressive. Tighter monetary policy has helped to rein in the rapid accumulation of credit. Loan portfolios were up by 32.1%, according to Golomt Bank, compared to the enormous 72.8% credit increase that took place in 2011.

FOCUS ON INVESTMENT RISKS: Despite retaining its status as one of the world’s most attractive “last frontier” economies, with a substantial double-digit growth likely, investors have of late been focused on Mongolia’s risks rather than its opportunities. The rise of resource nationalism during and after the June 2012 parliamentary elections, infighting in the new government coalition and an unstable regulatory environment have kept international companies invested in Mongolia on their toes throughout the course of 2012. This was compounded by uncertainties surrounding Chinese demand and the global outlook for commodities. Investors were reminded that, with 90% of exports destined for China, resource dependency can be both a blessing and a curse.

In sharp focus throughout 2012 was the ongoing dispute with Rio Tinto, which owns the Oyu Tolgoi mine, over royalties and contractual obligations with the Mongolian government and some attempts to revise the agreement to increase its share of the revenues.

The second-most-cited short-term uncertainty was the lack of clarity surrounding the implementation procedures of the new foreign investment law. That law had been hastily introduced to prevent the takeover of a Mongolian coal asset by a Chinese company (see analysis). Although it is likely the dispute with Rio will be resolved in 2013, a majority of foreign executives interviewed by OBG said the new investment would have a lasting negative impact on investor sentiment.

Meanwhile, the transformation of the Foreign Investment and Foreign Trade Agency into a department of the Foreign Investment Regulation and Registration Department (FIRRD) under the Ministry of Economic Development was yet another signal that attracting foreign capital had been downgraded as a political priority in 2012.

Taken in combination, these short-term factors led to a significant drop in foreign direct investment (FDI) in 2012. According to some sector participants, investment in the key mining sector slowed to a halt.

“It was very difficult to market Mongolia’s growth story to Asian funds in 2012,” Robert Wrixon, the managing director of Haranga Resources, told OBG. “Uncertainty over Chinese demand played a role, but more importantly investors were spooked by regulatory uncertainties.” This reversal in fortunes has been confirmed by FDI statistics. The IMF estimates that FDI in 2012 declined by 40% from $4.6bn in 2011 to just $2.78bn in 2012.

The FDI outlook for 2013 remains lacklustre in part because, according to some senior executives interviewed by OBG, it takes at least a year to build up a pipeline of new projects before an investment decision is reached. The IMF forecasts total FDI in 2013 will hit $1.9bn – almost 60% below the recent peak witnessed in 2011. However, this dip can in part be attributed to the most intensive stage of investment in Oyu Tolgoi being over. FDI numbers now increasingly reflect smaller projects in the country.

EASIER TO DO BUSINESS: Controversial headlines in the international media related to mining disputes and the foreign investment law have managed to overshadow the steady progress Mongolia has made, both in its democratic transitions and its easing of rules related to starting new businesses, obtaining credit and enforcing legal contracts in the country.

For instance, the decision to eliminate the minimum paid-in capital requirement was particularly well received by the World Bank, which moved Mongolia up in the “Ease of Doing Business” rankings from 89th in 2012 to 76th place for 2013.

“Mongolia strengthened investor protections by increasing the disclosure requirements for related-party transactions,” the World Bank stated in its report. Several mining and finance executives interviewed by OBG agreed that, in contrast to neighbouring Russia and China, judicial independence is one of Mongolia’s strengths, with governments unable to arbitrarily cancel existing legal contracts.

This fact, however, is largely overlooked by international investors, who tend to view restrictions on taking equity in strategic sectors such as minerals, banking, media and telecommunications as outweighing the benefits of an otherwise more democratic and liberal business environment.

EXTERNAL HEADWINDS: Political risks aside, the year 2012 coincided with a relatively challenging period when it came to Mongolia’s key export commodities – coal and copper.

After a bumper year in 2011, the price index of key commodities fell. Demand for copper concentrate declined by 14%, while overall demand dipped by around 12%, according to Golomt Bank.

Meanwhile, the prices of Mongolia’s most important export commodity, coal, declined by an estimated 15%, with volumes slipping by some 22%. This resulted in a 34% decline in dollar revenues from coal shipments – some $1.4bn compared to the $2.2bn seen in 2011.

Falling coal volumes and revenues, according to those interviewed by OBG, was due to softer demand in China as well as a political dispute with Beijing over the derailed acquisition of the SouthGobi Resources coal mine. Under a moderately bearish scenario demand and volumes are expected to pick again in 2013, resulting in at least a 10% increase in coal export revenues.

The best-performing export commodity was iron ore, which saw a 17% increase thanks to a small rise in the price index and higher volumes. The iron ore price index was the only segment in commodities that showed an increase, rising by 8% in 2012.

Nonetheless, analysts at Golomt Bank estimate that, as a result of lower commodity prices in 2012, overall export receipts have dropped by 11.8% in 2012 from $4.8bn to $4.2bn. This figure compares unfavourably with 65.6% growth in export value achieved over the course of 2011.

As a result of this slowdown in economic activity, government revenues fell far below original forecasts. IMF projections show that government revenues declined from 40.3% of GDP in 2011 to 37.1% in 2012, leaving it with a larger deficit of 5.2% compared to 4.8% in 2011 and a 0.5% surplus in 2010.

On the positive side, some analysts told OBG that the slowdown in foreign capital inflows has helped to avert the prospect of economic overheating. This is a welcome macroeconomic development for a country which has been rescued by the IMF five times in the last two decades, largely due to problems related to its payments balance.

According to the World Bank, the feverish rate of expansion of Mongolia’s economy has cooled from 17.5% in 2011 to a more sustainable rate of 11.8% in 2012. By most international standards Mongolia still remains one of the fastest-growing countries in the world, even compared to other emerging markets located in Africa and Asia.

WELCOME TO BOND MARKETS: Investor appetite for the Mongolian growth story was confirmed by a landmark $1.5bn bond issue equal to 20% of GDP in November 2012. Although a number of investors had been concerned by shrinking foreign reserves and unfriendly business decisions in 2012, the debt offer was ultimately well subscribed.

Apart from helping to plug a hole in the government’s finances in 2012, the mega-debt issue drew the attention of international financial media and investors.

“This is a big-bang entry into global capital markets,” Jan Dehn, the co-head of research for Ashmore Investment in London, told the Wall Street Journal in a November 2012 interview. Some analysts did remain more sceptical, arguing the high demand for Mongolian debt was more of a function of timing rather than of sound macro fundamentals.

John Foley, a columnist for Reuters in Beijing, argued this bond has bought Mongolia a $1.5bn licence to “play tough”. Referring to its dispute with Rio Tinto, Foley also expressed concerns about how these proceeds will be used, given the country’s limited experience in implementing large infrastructure projects that the government said it plans to fund with the new cash.

Batmunkh told OBG that the main priority will be to invest in a new railway and road infrastructure to support higher-value-added services in mining. “Mongolia is a developing county which urgently needs investment in infrastructure now in order to unlock productivity gains,” he said. Batmunkh also mentioned a state intention to improve the supply chain of key meat products, which were largely responsible for driving up the inflation basket in 2012.

QUEST FOR MACRO STABILITY: While a great relief, the debut on international capital markets has also put the spotlight on the country’s macroeconomic risks. The 4.1% yield on Mongolia’s five year bond – lower than Italy’s at the time of issue – suggests that international bond investors were willing to look through short-term political and macroeconomic challenges towards the country’s larger potential.

Nonetheless, a subsequent crash in the bond price on the secondary market, coming after the junior coalition partner Mongolian People’s Revolutionary Party (MPRP) threatened to pull out of the government, was a reminder why ratings agencies continue to assign a high risk premium to the country.

Mongolia is rated BB- by Standard & Poor’s and B1 by Moody’s, both of which fall below the investment-grade threshold – similar to countries such as Georgia and Bangladesh. Analysts are divided on which are the main risks in the short to medium term but the majority agree that the biggest ones relate to monetary and fiscal policy decisions.

In a risk assessment matrix published in November 2012, the IMF cited overly expansionary fiscal policy, the decline in non-oil commodity prices, financial stability, and socio-economic and political issues as the main concerns facing Mongolia in 2013.

FISCAL INDISCIPLINE: The most elevated of the risks in 2012 and 2013 is Mongolia’s entrenched pro-cyclical fiscal policy, which both the IMF and foreign analysts say tends to overestimate revenues and underestimate the deficit. As the IMF argued in a recent assessment, rising public expenditure leads to higher inflation, which in turn undermines Mongolia’s external competitiveness on the world stage. In the end inflation hits the poorest part of Mongolia’s population hardest – the very same people that the government says it seeks to help protect through higher spending.

Much against the IMF’s advice government spending continued to rise unchecked in the run-up to June 2012 election. Overall, the global lender estimates that public spending rose by a staggering 57% in the first six months of the year.

Much of this was due to popular pressure to increase wages, with civil servants receiving a hefty wage hike of some 50%. Meanwhile, government revenues continued to slide behind official targets, leading to a higher fiscal deficit of 6%.

“Expenditure restraint is critical to address overheating pressures,” the IMF noted in a report issued November 2012 . “Unrealistic revenue projections in the 2012 supplementary budget and the draft 2013 budget incorrectly suggest that there is ample room to expand spending while still observing the Fiscal Stability Law’s 2%-of-GDP structural deficit ceiling.”

While conscious of the risk of boom and bust cycles – having lived through many of them already – the nature of democratic nation building and party politics makes fiscal restraint hard to achieve.

A similarly loose approach is beginning to emerge in regard to borrowing as well. An external-debt-to-GDP ratio of 29.4% in 2012 appears at first glance to be quite low compared to other countries.

However, with total public debt already at 56.7% and the government taking on another 20% of debt in one bond issue, there are many who think Mongolia is on dangerous borrowing spree.

For now the buyers of $1.5bn of Mongolian debt hope the country can grow its way out of debt problem. If indeed the proceeds are invested in infrastructure, the money would have a positive impact on productivity, as was originally intended.

BALANCE OF PAYMENTS: The second most often cited macroeconomic risk in Mongolia, which manifested itself again in 2012, is new pressures regarding the country’s current balance of payment (BOP).

In contrast to most resource-rich economies, Mongolia has been running a perennial current account deficit, essentially signaling it continues to consume more than it produces at international market prices.

Despite the roll-out of new mining projects, exports have so far failed to keep up with imports, due to a small domestic manufacturing base and the still relatively low value of mining exports.

In 2012 the current account deficit reached a dangerously high level of 16.7% excluding mining related imports, according to the IMF, compared to 11.3% in 2011 and 5.7% in 2010. Exports fell from $4.7bn in 2011 to an estimated $4.4bn in 2012. Imports, on the other hand, continued to surge, rising from $5.7bn to $6.2bn during the same period.

Although some of these imports, including vehicles, are indirectly related to the mining sector, the overall gap is still a sign of the lack of value-added industry in Mongolia’s exports, with limited import-export substitution achieved in non-mineral sectors.

Meanwhile, Mongolia’s import bill continues to rise. Some items, like diesel and petrol (which accounted for 35% of Mongolia’s imports), are outside policymakers’ control. However, the rising import value of food, petrol and cars is being driven by local currency appreciation and overly loose fiscal policy.

A number of executives interviewed by OBG said that a combination of higher wages, cash handouts for shares in Tavan Tolgoi and rising bank credit has helped to fuel unprecedented domestic demand for electronic goods, vehicles and food products.

Unfortunately, few domestic sectors outside banks, real estate and beverage producers, have benefitted from this surge in consumption, with cheaper imports from China taking the majority. Given its small size and lack of economies of scale, Mongolia is at pains to expand its domestic production base.

Its best chance of narrowing the current account deficit in the short to medium term is by diminishing domestic demand while boosting the value of mining exports by going further downstream.

In the absence of other options, the gap in 2013 will likely be funded by FDI inflows and bond issues. In the case of a liquidity shortage or difficult market access Mongolia could rely on the IMF to access a standby credit line or a full programme. Given its relatively favourable macroeconomic outlook, this is not an option the government wishes to entertain.

FOREIGN RESERVES: The BOP gap and policymakers’ reluctance to allow further currency devaluation has resulted in fluctuations in Mongolia’s foreign reserves. These, according to the IMF, at one point in 2012 declined to around $1.5bn – less than three months of imports – following a 7% depreciation seen in the country’s currency.

To fix this, the Bank of Mongolia was able to make use of a swap line with the Central Bank of China, along with taking deposits from the Development Bank of Mongolia as well as commercial banks. As of early January 2013 foreign reserves stood at $2.6bn, worth nearly six months of imports.

STABILISATION FUND: In the long run there is a plan to offset sharp fluctuations in commodity prices through a sovereign wealth fund know as the Stabilisation Fund, established in 2011. The idea follows best international practice that countries should set aside a share of their resource revenues during boom periods to offset declines when global commodity prices and demand are weak. When it was first set by the previous government, the target size was $200m (subsequently raised to $500m). However, the initial efforts to set aside funds went off track after the newly elected government inherited a weak economy and low revenues from mining.

In July 2012 Fitch, the global ratings agency, sounded a note of caution. “Mongolia has only saved 2% of GDP in its stabilisation fund, which is too small to shelter it from shocks,” it said in a report. “This leaves the country with little fiscal flexibility in the event of a sustained drop occuring in commodity prices. The accumulation of systemic risks – an extremely loose credit environment, inconsistencies arising from implementation of tight monetary policy and expansionary fiscal policy, and pro-cyclical public finances – makes this increasingly hard to fix.”

INFLATIONARY PRESSURES: Inflationary pressures remain elevated, with price increases expected at around 14% for the 12 months of 2013 compared to the less-than-10% target set out by the country’s central bank. The Bank of Mongolia’s inflation target for 2013 is 8% and 5-7% for 2014-15.

“Adhering to the Fiscal Stability Law and maintaining budget rules and special requirements will be crucial for reducing not only the overheating risks, but also overall macroeconomic risk exposure – including inflationary pressure in 2013 and years afterwards,” N. Zoljargal, the governor of the Bank of Mongolia, told OBG.

Most economists interviewed by OBG cite supply-side constraints and the lack of a domestic production base as the main structural explanations for the country’s persistently high inflation. The proceeds from the mining sector continue to put pressure on wages as well as the local currency, thus undermining the process of import substitution that occurs in developing economies.

Zoljargal told OBG there is now a plan in the works to both lower the cost of food prices and retail gasoline prices as well as support the construction industry and help stabilise housing prices. “Ultimately, supply-side or cost-push inflation will significantly be decreased as a result of successful implementation of these programmes,” he told OBG.

MONETARY POLICY: In the absence of fiscal discipline, the burden of guarding against a financial crisis has fallen to the central bank, which is using monetary policy to offset excesses from fiscal policy.

Although it is not shielded from political interference and enjoys less independence than many of its Western counterparts, foreign analysts nevertheless say the bank has done a fairly decent job of maintaining confidence in local currency.

In 2012 the bank used its dual mandate to tighten monetary policy to respond to inflationary pressures while ensuring only gradual depreciation. It increased the policy rate by 225 basis points to 13.25% and at the same time raised the reserve requirement on banks by 700 basis points, to 12%.

These monetary measures came at the cost of lower reserves, with inflation still stubbornly above the 10% target. However, monetary tightening has helped to cool credit growth, which decelerated from 70% in 2011 to 30% in 2012, helping to prevent higher inflation as well as reducing the risk of non-performing loans and asset bubbles.

As the economy heats up in 2013, the bank will continue to face the twin challenges of anchoring expectations regarding the value of the local currency while keeping single digit inflation target.

OUTLOOK: Given a more benign outlook for global demand for commodities the central case scenario for 2013 is that Mongolia will enjoy a recovery in exports of its key coal, copper and iron ore commodities. This should help stabilise government finances while at the same time increasing foreign reserves.

The most significant milestone in 2013 remains the launch of commercial production at Rio’s copper mine, set to become the second largest in the world. The IMF expects a surge in GDP in the second half of 2013, one reaching 17% year-on-year. An increase in exports is expected to ease pressure on the current account, with the deficit to fall to 6.7%.

Inflation will remain the single most daunting task for monetary and fiscal policymakers, as a surge of foreign inflows and pro-cyclical fiscal policy will continue to put pressure on wages and the local supply chain. Some currency appreciation in the local currency could help disinflation. However, the central bank is not likely to allow any excessive exchange rate volatility, despite the floating currency regime.