Risk drivers and outlook

Mongolia’s mining activity had a positive influence on the risk profile when it boomed a few years ago. Endowed with among the world’s biggest reserves of copper, coal and gold, Mongolia has huge resources to allow a progressive improvement of medium- to long-term political risk currently classified in category 5/7. What’s more, political stability is expected until 2016 after the comfortable re-election of a pro-business president last June. However, it recently became clear that turning the huge mining potential into an enduring blessing will be a challenge. With still young institutions, Mongolia is vulnerable to shifting economic management and to external shocks. Over the past two years, risks increased as macroeconomic developments were not up to expectations. Despite robust growth performances - that are also expected for the future, though at a lower level – Mongolia’s twin deficit (current account and budget) has sharply widened. Main factors were adverse external developments (e.g. lower mining prices and commodity demand from China) given Mongolia’s ever-growing dependence on the mineral sector, and an expansionist fiscal policy around elections, thereby making its soaring public debt less sustainable. Moreover, beside much higher external debt ratios, legal uncertainties around a crucial investment law (finally adopted end 2013 and rather favourable to investors) sharply reduced FDI last year, which created balance-of-payments pressures. As reflected in Credendo group’s recent tightening of medium- to long-term cover policy, the likelihood of risk classification downgrades this year has increased due to continued political risk deterioration.

This is notably the case for the short-term political risk classification (2/7) as foreign exchange reserves have considerably dropped due to weaker export and FDI. As for Mongolia’s commercial risk - which is in C, the highest category - it will remain negatively affected by further downward pressures on the overvalued local currency togrog. Therefore, until adjustments are made, macroeconomic stability is ensured and institutional reforms are implemented, cautiousness should persist for some time.

Facts & figures

Pros

  • Immense mining reserves
  • Surrounded by two economic powers, particularly first trade partner China
  • Attractive mining potential to FDI
  • Generally stable political situation in a democratic system

Cons

  • Vulnerable to external shocks (mining prices and demand)
  • Young institutions to address mining revenue bonanza
  • Volatile economic policies
  • Rising wealth divide, high poverty

Main export products

  • Coal (33.9% of current account receipts), copper (14.9%), crude oil (6%), transport (4.4%), tourism (3.8%), gold (2.2%)

Income group

  • Lower middle income

Per capita Income (USD)

  • 2,310

Population

  • 2.8 m

Description of electoral system (four-year cycle)

  • Presidential election: next in 2017
  • Legislative election: next in 2016

Prime Minister

  • Norovyn Altankhuyag

Head of State and of government

  • Tsakhiagiin Elbegdorj

Country risk assessment

A business-friendlier government to cope with a challenging economic boom

With a president re-elected in 2013 and his Democratic Party (AN) leading a comfortable government coalition in Parliament since 2012, political stability is expected until the 2016 elections. Last June, smooth elections allowed incumbent President Elbegdorj to renew his four-year mandate after winning a narrow majority of the vote during a single round. These electoral successes in one of Central Asia’s rare democracies – as the peaceful change of government demonstrates - are valuable for AN’s quest to fulfil its promises.

President Elbegdorj has committed to improving the legal framework for FDI, business practices, and importantly– in voters’ eyes - increase transparency of all public accounts and strengthen Mongolia’s young institutions. The fight against corruption will receive high attention in the short term but the outlook could be clouded by a political landscape largely dominated by AN personalities.

This situation could indeed be detrimental to anti-corruption goals if the management of Mongolia’s massive natural resources mostly benefited political and economic elites as unfortunately is often observed with commodity-rich developing countries. Moreover, economic policy will not be necessarily an easy task as the leading AN party faces infighting among various factions. Mongolia faces sporadic (violent) unrest especially during election time, as was last witnessed in 2008/09. Since then, domestic stability has prevailed. In an ethnically homogenous country, tensions can surface on socio-economic grounds. Despite rapid economic growth, high poverty, fast widening inequalities within a small population, insufficient redistribution of massive mining revenues, lack of job opportunities and environment degradation represent the highest risks to stability.

A welcome new investment law

Besides corruption, the government will be assessed on how it tackles these political risk factors by 2016. Government measures are also carefully regarded by foreign investors. Given their high interests in Mongolia’s giant mines, they were quite relieved when the new foreign investment bill was adopted in Parliament last October. The bill is clearer and does not make any distinction between local and foreign investors. It thus confirmed President Elbergdorj’s stance towards investors, which much unlike the opposition’s, is more moderately nationalist and welcoming. Still, some minor restrictions remain in place. The investment law notably prevents foreign-majority ownership in strategic industries, probably to avoid a risk of Chinese invasion and economic control on Mongolia’s key mines. Moreover, the approval by a State investment agency is required from a certain level of participation by a foreign state enterprise in sectors such as mining, banking or telecom. Therefore, while restrictions have been reduced notably in the mining industry, there is still some caution when it comes to the regulatory environment for investments. After all, experience shows that implementing legislation can be tricky and contract renegotiation attempts are not rare, especially in mining.

Mining’s bright future faced with downside external risks

Testimony to Mongolia’s economic boom is that it recorded the world’s strongest average real GDP growth (13.9%) over the past three years. Given its huge economic potential, growth prospects remain strong for the coming years yet at lower levels (7.3% on average by 2018). The extractive industry is and will remain the country’s top driver of GDP growth through mineral exports and increasingly through construction and infrastructure development to support mining trade. The bulk of mineral production comes from Mongolia’s two giant mines in the South Gobi desert: Tavan Tolgoi (coal) and Oyu Tolgoi (copper and gold) where production began last summer. Supply is not a cause for concern as the mines are among the world’s largest and reserves are not to be depleted before decades.

Mongolia_Graph1EN

Risks rather arise from the demand side. Mining resources are mainly exported to China, by far Mongolia’s first trade partner – with 90% of exports - and main investor, be it to a lower extent. Besides infrastructure projects from China and Russia, its other big neighbour, Mongolia tries to diversify its trade and investment ties to the benefit of western groups. The aim is to reduce economic dependence on China, where commodity demand is expected to evolve to lower levels as a result of its economic rebalancing. Moreover, Mongolia’s heavy dependence on mineral exports – accounting for nearly 60% of current account receipts - makes it vulnerable to the more moderate world prices that are expected in the future. This was observed in 2012-2013 when exports in terms of value decreased due to price declines (particularly coal and copper) resulting from a slower growing global economy. Hence, while the quality of political institutions needs to be improved and despite steady development of non-mining sectors such as tourism, Mongolia is per se not immune to the Dutch disease in the long term as the weight of mineral exports and revenues will further grow given strong production prospects.

Mongolia_Graph2EN

Efficient or volatile economic management, a key determinant to a successful and stable development

Mongolia’s resource bonanza is a mixed blessing as high risks loom, and these are not only external shocks. Absorbing and effectively managing Mongolia’s natural wealth is a top challenge for the national authorities. An overheating economy with huge credit growth, double-digit inflation and expansionist fiscal policy since 2011 are to be avoided if the government wants to bring Mongolia on a sustainable growth path. The government has committed to policy adjustments in the medium term which, given its comfortable political mandate, raises hopes it will be able and willing to restore macro-economic stability.

However, outside binding IMF financial programmes, past governments have not shown continuity in economic policy. The risk of bad governance - with conflicts of interest and misuse of mining revenues - is not to be underestimated. The long saga over the renegotiation of the contract with Rio Tinto over Oyu Tolgoi and the investment bill highlights that. Postponing necessary adjustments would mean continued public overspending, a high budget deficit, a significant increase in external and public debt and an eventual drag on long-term GDP growth.
In fact, previous economic forecasts were too optimistic and have recently been considerably revised downward, with lower macroeconomic performances, an enduring twin deficit and much deteriorated public finances around 2012/2013 elections.

Higher FDI needed to ward off balance of payments pressure

Mongolia’s balance of payments has not evolved as initially forecast as a surplus of the current account, at first expected by 2015, is no longer even considered in the medium-term. Fuelled by large mining projects-related imports and a negative services balance, its deficit should remain for a long period in spite of rising exports from Oyu Tolgoi and only gradually decrease from more than 30 currently to 15% of the GDP by 2018.

Mongolia_Graph3EN

Therefore, the authorities will need to secure enough financing to rein in balance of payments pressures. FDI are therefore of particular financial importance in addition to their support to growth and to developing mining-related infrastructure in a huge and landlocked country. Their abrupt decline (-50% year-on-year) in 2013, was mainly due to enduring uncertainty over the investment bill, which led to a financing shortfall and increased external borrowing. It shows how crucial it is for the government to improve the business climate and to make the economy more attractive for FDI, as it did recently by passing the new investment bill. After all, FDI is the main source for financing Mongolia’s current account deficit. Investor confidence has lastly improved but cautiousness will persist. Over the past few years, changing policies and government interference have led to several legal disputes in the mining sector (the largest one involving Oyu Tolgoi, which is co-owned with Rio Tinto group), thereby affecting Mongolia’s reputation.

An operational fiscal stability law to offset propensity to run expansionist policies and recent surge in public debt

There are mixed feelings about Mongolia’s public finances. A positive step comes from the recently operational “Fiscal Stability Law” (FSL) that was passed in June 2010 to allow for fiscal responsibility and intergenerational management of mineral revenues. A sovereign wealth fund has yet to be set up. The FSL aims to ensure fiscal sustainability by avoiding overspending, limiting structural deficits (to 2% of GDP) and saving excess revenues in a stability fund that is to be tapped into when prices are low. The government pledge to fiscal discipline is supposed to bring the deficit to much lower levels. Nevertheless, the binding FSL does not include off-budget operations that have ballooned (up to an expected 9% of GDP in 2013) via the state-owned Development Bank of Mongolia (DBM - guaranteed by the government budget) which offers options to circumvent FSL rules and could represent heavy contingent liabilities offsetting benefits from the FSL.

The government’s pro-cyclical expansionist policy has sharply deteriorated the budget deficit in 2012/13, bringing it into double-digit territory. This negative evolution has been fuelled by the cost of banking sector restructuring   (in 2010-11), hikes in civil servant wages, higher social transfers and electoral spending in the run up to elections. The government has committed to bring deficits to much lower levels: around 2% of GDP as from 2016. Although cuts in spending are likely when no elections are held, Mongolia has a track record of fiscal slippages, which should make fiscal consolidation very challenging. To reach that goal, Mongolia will count on strong revenues   and more favourable contract terms from future mining activities and licences.

As a result of budget overspending and particularly DBM’s successful and sizeable 2012 international bond issuance (equivalent to 15% of GDP) aimed to finance huge infrastructure plans, public debt has soared from 38.8% in 2011 to 67.3% of GDP in 2013, i.e. a nine-year high. Although the debt stock is forecast to decline to 50% by 2018, Mongolia’s sovereign debt profile has thus significantly worsened and could complicate future public debt service repayments.

Mongolia_Graph4EN

More than 75% of public debt is denominated in foreign currency, which increases vulnerability as the togrog should remain on a depreciating trend from its overvalued position and contribute as well to fuelling inflation pressure. Mongolia’s floating local currency has indeed lost much value (-30% against the USD) since 2011 together with the deepening of the current account deficit.

A recovered but not risk-free banking sector

The banking sector was hit hard by the 2008/09 financial crisis but has recovered since then thanks to a bailout package, improved regulation (a new bank law was adopted in 2010) and supervision. However, risks remain. Non-performing loans are low (3.8% of total loans) but lack provisioning and are likely to increase as a result of sharp credit growth since 2010 (43% per annum on average in 2010-2012, before stabilising around 30% in 2013) and of a weakening economic activity.

Moreover, in a highly dollarized system (1/3 of loans are denominated in foreign currency, mostly in USD), loans are exposed to exchange rate risk given the declining togrog. Also, risk management practices and bank supervision need improvement and compliance as illustrated by Savings Bank’s bankruptcy. Last July, Mongolia’s fifth largest bank (with 8% of total banking assets) had to be nationalised due to insolvency and mismanagement (i.e. non-compliance of banking regulations on lending).

Deteriorating external debt ratios related to fast economic development require prudent debt management

Mongolia’s financial risk at both public and private sector level has significantly deteriorated in just two years’ time. External public debt has more than doubled since 2011 (cfr. supra) to reach 51.8% of GDP in 2013. This debt ratio is expected to come down progressively to more sustainable levels in a high-growth context as the government plans to increase the relative share of local bonds and lower the size of future international bond issuances compared with 2012. However, much will depend on the commodity cycle and the government’s fiscal policy. Besides, Mongolia’s graduation to middle-income country has changed its debt and cost profile. The country has become eligible for commercial borrowing from World Bank and Asian Development Bank, which will reduce – as is now witnessed - the future share of concessional debt in total external debt.

The latter share was halved in 2012 but that was partly due to the dramatic increase of private debt (85% of GDP) which largely comes from intercompany loans in mining projects. The private debt share, weighing 2/3 of total debt, is expected to increase further in the medium term while public debt will decrease. In consequence of such substantial developments, Mongolia’s external debt sustainability has declined with a total reaching around 137% of GDP and over 290% of export receipts in 2013. Less favourable commodity prices and/or Chinese economic activity could hinder future debt dynamics.

Challenging heavy debt servicing ahead

In the meantime, the recent upward debt evolution will have a negative impact on Mongolia’s external liquidity. In the future, Mongolia will face much higher debt service (i.e. 30% of export receipts in 2013, 44% in 2017), while extra costs will come from mounting debt payments on commercial terms. Moreover, external (public and private) debt service will be vulnerable to a weaker togrog, variable interest rates and rollover issues. There could indeed be relatively less foreign capital available flowing from advanced countries as they gradually put an end to extraordinarily loose monetary policies. In addition, if foreign exchange reserves are forecast to remain around  the three months of import cover threshold, there is a risk that official reserves are not sufficient to finance debt servicing in 2015 and 2017. The sharp drop in foreign exchange reserves in 2013 due to a large financing shortfall – making a future downgrade likely for short-term political risk - is expected to be followed by a period of stability before slowly increasing in the long-term.

Mongolia_Graph5EN

Analyst: Raphaël Cecchi, r.cecchi@credendogroup.com