Frontier Securities in Ulaan Bataar -

Over the last few years, Mongolia has seen the discovery of many huge mineral deposits, the development of which, particularly related to the giant copper/gold Oyu Tolgoi deposit, will play a big part in Mongolia's road to recovery and future growth. We believe that in terms of the economy, the worst is behind us. The Oyu Tolgoi project is expected to be officially signed in the near future, which will in turn bring attention to and greater investment in Mongolia.

President Elbegdorj was elected in May on the promise of tackling corruption and bringing justice to the people. On foreign policy, he acknowledged that he will give priority to boosting friendly relation with neighbours Russia and China, while maintaining policies that encourage foreign direct investment (FDI) by making Mongolia an investor-friendly country to operate in. On August 25, the Parliament overwhelmingly approved all four draft amendments necessary for the conclusion of the Oyu Tolgoi investment agreement with Ivanhoe Mines/Rio Tinto. These amendments include a repeal of the Windfall Profit Tax, Loss Carried Forward provision, additions to Law on Water and Law on Automobile Roads. The Windfall Profit Tax on copper and gold was the main obstacle for the project moving ahead.

An investment agreement is a landmark for the future development of Mongolia's resources industry. The mining industry is the main source of income for Mongolia, meaning it's very dependant on market prices for specific commodities such as copper, coal and gold. Oyu Tolgoi is the largest undeveloped gold/copper deposit in the world. Production is expected to begin as early as 2013, with an approximate five-year ramp-up to full production. However, investment in the supply chain is expected to begin as soon as the deal is signed.

Average production capacity of the mine over its lifetime is expected to be 450,000 tonnes of copper per year and 330,000 ounces of gold. Oyu Tolgoi will, therefore, have a huge impact on the Mongolian economy. According to the Centre for Spatial Economics' report, "The Economic and Fiscal Impacts of the Oyu Tolgoi Project on Mongolia," over the project period the average percentage increase in real GDP is almost 35%. At the peak production level for the project, real GDP is 95% higher than its value without Oyu Tolgoi. This statement shows the importance of Oyu Tolgoi project to the Mongolian economy

Copper prices have been rising steadily throughout the year. Growing optimism about economic recovery and demand in China has been pushing the prices up. The price has more than doubled from the beginning of January to the end of August this year. The price rise of the international copper could indeed be a sign that the world economy is recovering. This is positive news for Mongolia, which heavily relies on copper exports for income and is neighbour to copper-hungry China.

The economy

The rapid real GDP growth Mongolia experienced in previous years came to a halt with the global economic slowdown. According to Bank of Mongolia, real GDP declined by 1.6-1.8% in the first half of 2009. Due to the economic recovery we are seeing in the second half of this year, the economy in 2009 is expected to grow 3.5%. We believe that with the signing of the Oyu Tolgoi agreement, it is likely we will see double-digit growth in the latter half of 2010.

Inflation was extremely high in the latter half of 2008 mainly due to rising prices for food and fuel. Since then, inflation has fallen steadily to a 4.9% on year in July, which shows that the country's economic woes are easing. This trend is likely to continue over the next few months to reach around 4% by the end of the year. With new investment expected to come in after the Oyu Tolgoi project is approved, inflationary pressures may rear their ugly head again, but with the Bank of Mongolia keeping a closer eye on inflation, it is unlikely that inflation will hit double digits in 2010. The current policy rate is 11.5%. As investment begins to flow in more rapidly next year, the Bank of Mongolia will closely watch its impact on inflation. As long as inflation is under control, and international reserves are rising, the Bank of Mongolia will want to drop the rate, however it is unlikely that we will see a dramatic change in the near future due to their agreement with the IMF not to change their policy rate.

For the first half of 2009, the external trade balance had a deficit of $129.9m. This year's tight credit, economic slowdown and depreciated national currency have caused imports to decline faster than exports and caused the overall trade volume to decrease. Over the next year, volume of exports may not change dramatically, but rising prices of commodities will cause the value of exports to grow. In 2010, the rising value of exports is expected to be offset by increasing investment and procurement for mining operations. Overall, the trade deficit is expected to grow in 2010. We expect the trade deficit to begin to narrow sometime in 2011.

In the first half of 2009, Mongolia's government budget deficit widened MNT261.3bn. Government expenditures grew during this period while tax revenue declined by MNT261bn, or 28.8%. Tax revenue continued to decline in July and August. Recently, the World Bank approved $40m in budget support for Mongolia. With such financial assistance and higher commodity prices, we don't see the budget deficit to be much of a concern. The government should be able to keep the deficit in a sustainable range

Over the years, FDI has increased significantly especially in relation to the mining sector. Remaining conservative in our figures for 2009, FDI inflows are forecast to be $347m. FDI figures are lower than 2008 figures mainly due to the global economic crisis and delay in the Oyu Tolgoi agreement. Once this agreement is signed it will boost FDI inflows to Mongolia. While actual mining operations will not begin for some time, investment in the supply chain and development in the mines will begin right away. FDI inflows should increase substantially in 2010.

Conclusion

Copper prices have recovered and gold prices have been stable. With global economic woes easing, Mongolia's future looks bright given the likely signing of major projects, specifically Oyu Tolgoi and in the future Tavan Tolgoi. It will boost the Mongolia's economy by creating new businesses surrounding these projects. Our projections only include the investment we expect from Oyu Tolgoi and therefore we feel we are taking a conservative outlook. In 2010 we will see rapid growth of the Mongolian economy and signing of the Oyu Tolgoi project will pave the way for even more FDI inflows into the country for other major mineral reserves. We feel that Mongolia is an untapped new star and has the potential to be the fastest growing economy in the world. We expect such rapid growth to start in 2010 and extend out for the foreseeable future.

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