Key political risks to watch in Mongolia

By David Stanway

BEIJING, April 1 (Reuters) - Remote and landlocked Mongolia sits on vast quantities of untapped mineral wealth, and foreign investment in a number of gigantic mining properties is expected to transform its tiny economy in the next decade.

Analysts say it could become one of the world's fastest growing economies and it is already a key investment target for resources giants like Rio Tinto and Peabody Energy .

Mongolia aims to become a major force in the regional coal market by developing the billion-dollar Tavan Tolgoi or "Five Hills" mine, the world's biggest untapped deposit of its kind.

Erdenes MGL, the mine's operator, has chosen banks to list the eastern part of property in the first half of next year, and a shortlist of investors for the western section has also been drawn up, including consortia from Japan and South Korea as well as Peabody, Xstrata and ArcelorMittal . [ID:nL3E7E70CI]

The $6 billion Oyu Tolgoi project, jointly owned by Toronto-listed Ivanhoe Mines , Rio Tinto and the Mongolian government, will be the world's biggest copper mine outside top producer Chile once full operation starts in 2013.

To read a multimedia special report on the Oyu Tolgoi copper and gold deposit, click here: r.reuters.com/nas97p

But after decades on the remote fringes of the Soviet bloc, Mongolia is developing its economy almost from scratch, and foreign investors are watching to see whether the country's democratic government can maintain stability, build infrastructure, improve the rule of law and negotiate its way through the geopolitical pressures exerted by its two large neighbours, Russia to the north and China to the south.

Following is a summary of key Mongolia risks to watch:

POLITICAL INSTABILITY

The capricious nature of Mongolia's democratic government can complicate foreign investment projects. The five-year negotiations on the Oyu Tolgoi property were conducted against a backdrop of damaging political and legal uncertainties, including local ownership requirements and a windfall tax on mining profits that was only rescinded in 2008.

The frequent replacement of key personnel at the top levels of Mongolia's government has also caused concern, with the changes often accompanied by nationalist rhetoric and populist promises to secure more control over the country's assets.

Analysts also complain about the weakness of Mongolia's political parties and its poor regulatory capacity.

Corruption may also prove to be a long-term problem. Transparency International rated Mongolia 116th in its 2010 corruption perception index, up from 120th in 2009 but down from 102nd in 2008.

Political troubles have also arisen from the arrest in London of Mongolia's counter-espionage chief, Bat Khurts. [ID:nLDE71H1YE]

Several hundred protesters gathered outside the British Embassy in Ulan Bator at the end of February, calling on the government to expel firms like Rio Tinto from the country in retaliation.

Mining is set to transform the Mongolian economy, with investment in the Oyu Tolgoi project set to reach $2.3 billion in 2011, but there has been frustration about how the dividends are spent, as well as the impact of mining on the environment.

Public anger about the way the Oyu Tolgoi project was sold has had an impact on its handling of Tavan Tolgoi. While stakes in the western block of the project will eventually transferred directly to foreign investors, Mongolia aims to keep 50 percent of the eastern block in the hands of the state, with 30 percent listed on an overseas stock exchange, and 20 percent handed out to local enterprises and residents.

What to watch:

-- How Mongolia uses the proceeds from its mining projects. It has set up education and fiscal stabilisation funds, but it has also promised direct dividends for Mongolian citizens.

-- How it deals with rapid economic change as foreign investment transforms the country's mainly rural economy. Overall investment in Oyu Tolgoi alone will stand at roughly the equivalent of the country's entire GDP of 2009.

-- Whether Tavan Tolgoi provides the ownership model for other "strategic resource" projects, or Mongolia sells other properties outright.

REGULATORY RISK

Last April, Mongolia's president ordered a halt to the issuance and transfer of mineral exploitation licences until the government enacts stricter environmental laws.

President Tsakhia Elbegdorj's proposed amendments were discussed by Mongolia's parliament last June, but a final decision has not yet been announced. The move is unlikely to affect major projects already agreed, but raises the risk levels of doing business in Mongolia.

In November, the Ministry for Energy and Mineral Resources said it would suspend a further 254 gold mining licenses and review another 1,700 believed to contravene the country's Water and Forest Law.

What to watch:

-- Hints on the shape of the new law.

-- How the government handles populist pressures to maintain greater control over the country's strategic assets.

DEPENDENCE ON CHINA, ROLE OF RUSSIA

China already dominates Mongolia's economy, buying 84 percent of the country's exports last year. Sparsely populated Mongolia recently announced new policies to manage the flow of migrant labour into the country as it embarks upon a massive construction programme, but many Mongolians fear an influx of Chinese workers. [ID:nTOE65G05P]

Mongolia has for years sought to carefully balance the interests of its neighbours China and Russia.

This has already had an impact on the development of the Tavan Tolgoi mine. China offers a guaranteed market for Mongolian coal, but instead of building a direct rail route south to Chinese markets, the government will deliver coal east to a processing centre still under construction in Sainshand, where it can then be delivered to Russia's far eastern Pacific coast. Analysts have questioned the economic feasibility of the plans.

What to watch:

-- The growing dominance of China in Mongolia's economy has prompted many of Mongolia's elite to lean further towards Russia, but China is unlikely to step aside. China dominates Mongolia's foreign trade and economics, and will have much to say on where and how Mongolia builds its roads and railways. (Editing by Daniel Magnowski)

Source:Reuters news service