MONGOLIA: OT mess holds up Mongolia’s advance

12/10/2014 | Virginia Furness
Falling commodity prices have hurt Mongolia’s economy, which relies heavily on its abundant natural resources. Improving relations with China are helping it through the squeeze but the country has yet to show its true potential to global investors
Mongolia is a country on the edge economically and geographically. It was widely touted as one of Asia’s biggest growth stories just a couple of years ago, but its outlook is now fragile. With falling commodity prices and foreign direct investment dwindling, the country’s forex reserves have dropped to critical levels. However, the Mongolian government is expected to announce the resolution of a long running tax dispute with key investor Rio Tinto, meaning that Mongolian growth could be back on track once more.
Economically, Mongolia has enormous growth potential as it sits on a rich source of minerals as yet untapped. Geographically, it is locked between China and Russia, two global powers with which it holds uneasy relationships.
Despite a GDP growth rate of 10% as of July 2014, Mongolia’s short term growth prospects appear weak and its macroeconomic performance continues to deteriorate, with rising inflation and slowing growth. Its failure to build adequate fiscal and external buffers against commodity price volatility is leaving its economy increasingly exposed. The World Bank estimates Mongolia’s fiscal deficit will remain over 10% in 2014.
Falling commodity prices, particularly for coal, which is Mongolia’s second biggest export, are hurting growth. The nation’s earnings from coal have dropped steadily from $2.27bn in 2011 to $1.2bn last year.
However, with an abundance of other natural resources like copper, gold and rare earths, Mongolia’s long term prospects are bright and with sectors like real estate and infrastructure growing fast from a low base, many believe consistently high levels of growth will return.
“Any pick-up in demand for commodities by China, India or other emerging markets will lead to rapid growth,” says Alisher Ali, managing partner at Silk Road Management. “It’s clear that the long term trend is there, EMs are continuing to grow and the bear market for commodities will not last for many years.”
And it looks like the biggest hurdle to Mongolian growth — the long running dispute between Rio Tinto and the Mongolian government over the multi-billion dollar Oyu Tologi (OT) copper mine — could be resolved soon.
In 2009, Turquoise Hill Resources and Rio Tinto signed an agreement with Mongolia’s government for the construction and operation of the OT copper-gold mining complex. But after the first phase of development was completed, the progress of the mining project ran into difficulties.
“The problem started in 2012 when the government cancelled their double tax treaties with a number of countries — one of these being where OT was incorporated — which was contrary to the investment agreement,” says a Mongolia-based analyst. “In February 2013 the government went into open war with Rio Tinto and on July 31 Turquoise Hill made the decision to halt expansion of the underground development.”
Since then, he says the two sides have been working at reducing government shareholder issues but several deadlines for resolution have been missed.
However, on September 22, Turquoise Hill published a statement saying that it had reached an agreement with the government to pay $30m in tax, down from the proposed $127m. While Turquoise Hill said that there were certain aspects of the ruling that required further clarification, analysts expect that the resolution will be made official imminently and that phase two of OT will resume.
“Policymakers are sending strong signals that the lengthy dispute surrounding OT is over and that they are ready to move forward with Phase 2 financing,” said Cousyn. “Should this indeed occur, we think it will mark the most meaningful economic inflection point for Mongolia in the last five years.”
The next project finance deadline is September 30 and while analysts believe it is unlikely that this will be met, they do believe that construction of phase two will resume before the end of the year.
“On its own it has massive impact as it is the largest project in the country,” says Ali. “But it is also a litmus test for other investors who are not committing to the country while this hasn’t been resolved. A lot of investors are looking at this issue as a signal about whether the government is serious about dealing with foreign investment.”
The first development is expected to be a rail project which will link Mongolia’s biggest coal mine, Tavan Tolgoi, to China. And after the railway, an interstate highway will be built from the Chinese border to the Russian border. This will be followed by the redevelopment of downtown Ulan Batar with all the associated potential for real estate companies, power providers and foreign investors.
However, while analysts agree the project will act as a catalyst for a fairly quick recovery, the government still faces more imminent problems.
Foreign direct inflows have fallen 64% year on year in the first five months of 2014, contributing to the elimination of the capital account surplus of the balance of payments.
“As soon as we see the resolution of OT, that will pave the way for $6bn [investment],” says Ali. “[This could have some positive impact as reaching the OT investment agreement in October 2009] proved to be a catalyst of billions of dollars and had impact on other projects being launched. [We are hopeful that] next year things will improve.”
More problematic are the country’s foreign reserves which have fallen to worryingly low levels. Mongolian Central Bank data shows that at the end of June 2014, gross foreign reserves had fallen to $1.3bn from $2.2bn at the end of 2013.
With estimates that the country burns through $200m-$300m every month, Mongolia’s finances are in a critical state and an immediate solution is needed, according to analysts.
“Even if they approve Oyu Tologi by the end of the year, which would be a big positive from a sentiment standpoint, the dollars won’t start to flow back in immediately,” says Nick Cousyn, chief operating officer at BDSec, Mongolia’s largest broker. “There’s a gap that needs to be bridged between approving OT and when large expenditures are made at the project. We don’t expect foreign direct investment (FDI) to recover until this happens.”
With the resolution of OT a distinct, if not imminent, possibility, Mongolia may be able to return to the capital markets but issuing at the sovereign level is not an option.
In November 2012, the country boosted its forex reserves by issuing an international dollar bond in what bankers at the time called an “explosive” debut. The biggest Asian sovereign debut in more than a decade, it raised $1.5bn via a dual tranche 4.125% 2018 tranche and a 5.125% 2022 note, garnering a $16bn book. The proceeds took Mongolia’s forex reserves to $4.1bn from $2.7bn.
However, Mongolia has already reached its statutory debt limit of 40% of GDP so it will not be able to issue a bond at the sovereign level.
Analysts think that the sovereign may try to tap the market via the Mongolian Development Bank. But the international capital markets remain wary of Mongolian debt, something which became clear in July when the Trade and Development Bank of Mongolia (TDBM) attempted to raise five year dollar funding.
The deal took very few orders after bankers opened guidance at 11.25% on July 9. Despite books being left open for two days, the deal was pulled. Investors were simply not willing to take on Mongolian debt — the bank was issuing on behalf of the sovereign.
“People are concerned about the position of the sovereign with regards to FX reserves,” said a fixed income investor at the time. “If you are buying a bank in a country with potential dollar liquidity risk you are making a call as there is no way that, if the sovereign is running into problems, it will not have an impact on the bank.”
That Standard & Poor’s had downgraded the sovereign’s long term credit rating to B+ from BB- just two months earlier was also not in the bond’s favour.
The analyst thinks it is unlikely that Mongolia will be able to issue an international bond — this year at least. “The Chinese could very well top up, or the Japanese, but it definitely won’t be on the scale of the last sovereign bond,” he said.
Another funding channel that Mongolia has previously tapped is the Samurai market. In December last year the Development Bank of Mongolia (DBM) issued a ¥30bn ($290m) 2023 bond at 1.52% via a private placement. DBM has played an increasingly important role as the main financier of off-budget spending in Mongolia.
Japan Bank for International Cooperation (JBIC) guaranteed the bonds and as 90% of the coupon payments are backed by the Japanese finance agency, Japanese investors viewed the paper as a JBIC credit.
“With the Samurai bond issue and recent agreed swap line extension with China, the funding gap for the Mongolian government might not be critical,” says Ali. “Perhaps an additional $500m would be sufficient before commodity prices like coking coal may strengthen and OT is resolved.”
However, BDSec’s Cousyn does not believe another Samurai is possible, at least for this year.
“Mongolia is already at, or slightly above its statutory debt limit of 40% of GDP,” he says. “Parliament is unlikely to raise that limit.”
In June 2014, the World Bank estimated that the remaining available funds for off-budget spending from these two bonds are around $1bn. Most of the available reserves are expected to be used this year to finance public projects and economic stimulus programmes.
“Under these assumptions, the overall fiscal deficit including the DBM spending is expected to reach over 10% of GDP,” the June 2014 report says.
Without access to funding via the capital markets, Mongolia may need to rely on a bail-out from an external party. Experts believe that this will come from China and not the International Monetary Fund. Relations with China have improved recently, with the Mongolian government welcoming President Xi Jinping on a state visit on August 21-22.
Most importantly for Mongolia’s funding needs, on August 21 the Bank of Mongolia (BoM) and the People’s Bank of China (PBoC) increased their currency swap agreement to Rmb15bn ($2.4bn) from Rmb10bn, effective for the next three years.
“If OT Phase 2 doesn’t go forward, Mongolia may need a bail-out package which most likely would come from its neighbours. It’s a trend we’re seeing globally, economic crises are being resolved regionally as the world doesn’t want the IMF in their business,” says a banker. “The country can’t handle the austerity associated with an IMF bail-out.”



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