MACRO ADVISOR: Mongolia is finely balanced between default and the next boom

MACRO ADVISOR: Mongolia is finely balanced between default and the next boom
Mongolia's capital Ulaanbaatar.
By Chris Weafer of Macro-Advisory  March 29, 2016

Four years ago, Mongolia’s economy grew at 17.3%, the world’s fastest. This year’s growth is expected to be little more than 1.0%. The reason for the collapse is because of the big drop in foreign direct investment (FDI) from $4.7bn in 2011 to only $230mn last year. The economy is very sensitive to the volume of FDI and, in particular, to activity in the mining sector.

The core reason for the decline in FDI was self-inflicted; during the last parliamentary election in 2012, the main opposition Mongolian People’s Party (MPP) campaigned with an anti-foreign investment message and secured one-third of the votes. That allowed it to influence government decisions and to block many major mining projects.

The country’s biggest mining project is the Rio Tinto-controlled Oyu Tolgoi copper-gold mine. $6bn was spent in Phase 1 of the project, but it was stopped in August 2013 as a result of the political pressures. However, the removal of the MPP from the grand coalition has allowed the government to resolve many of the disputes with the mining companies and to approve several very big projects. Phase 2 of Oyu Tolgoi has now been approved by the state and financing put in place. Also, Centerra Gold has resolved its dispute over the ownership of a major gold mine and an Australian company has been given the go-ahead for a $1.3bn rail project. A consortium led by EnGie has also been green-lighted to go ahead with a $1.3bn power plant in the capital.

The Oyu-Tolgoi project is, in particular, a key indicator of the government’s attitude to foreign investment and an important benchmark for other investors. The final approval to go ahead with the $6bn next phase lies with the board of Rio Tinto. It is expected the approval will be given in the second quarter, but the board may wait until the June 29 parliamentary election is completed to ensure the current prime minister’s position is strengthened and there is no reversal of government policy.

The trend in FDI flows over the next few years is therefore very dependent on Rio Tinto’s decision and, in turn, on the June election result (see table below). A positive result will see FDI rise to over $2bn within 18 months and GDP expand by 3-5%. A reversal in political support for the mining sector will very likely lead to a recession by the end of this year and GDP contraction in 2017.

Because of the delays and political uncertainty as a result of the outcome of the 2012 election, Mongolia’s financial position is very weak. The country must repay $1.1bn in external debt between mid-2017 and early 2018. Currently its total foreign exchange reserves just about cover that. Sovereign external debt is over 50% and will rise to 60% within two years. Total foreign debt equals 182% of GDP currently.

The Bank of Mongolia stopped its price stabilization programme from early in 2015 and increased its key rate to 13%. That contracted M1 money by over 7% last year and helped reduce average inflation from almost 10% to less than 5%. The cost was additional pressure on households and small businesses. The central bank started this year with a cut in the key rate to 12%. The tugrik lost 30% in value against the US dollar since early 2013 and is expected to drop by another 8-10% this year. The BoM has no money with which to intervene and support the currency.

Still speculative

All of the rating agencies have the country’s sovereign risk at speculative because of the existing weak fiscal position and because of the external pressures as a result of weak commodity prices and the exposure to China’s economy. The yield on external debt instruments has risen sharply over the past six months because of the threat of a default in 2017 and because of commodity and China exposure.

But all rating agencies accept that the county’s economy, fiscal position and risk assessment could “turn on a dime” with the right election outcome and a recovery in FDI. China and global commodity demand are important for the medium to longer term, while the election result and FDI flows are critical over the short to medium term.

But even with a favourable outcome from the June election, FDI will not rise as quickly as it did previously. The commodity price backdrop is much less favourable today than was the case in 2010-2013. It is much more difficult to justify major investment projects based on current prices. That will lead to a slower build-up of investment than was seen previously. However, as all of the major projects are very long-term – eg. Oyu Tolgoi will take several years to develop and will then have an 80-year operational lifespan – it is expected that projects will go ahead once approved.

Mongolia’s economy is critically dependant on commodity prices; copper, coal and gold in particular. It is also very tied to the Chinese economy, which last year accounted for 85% of all exports. That combination certainly doesn’t offer any comfort for investors and justifies a high risk premium. But the reason for the exceptionally high risk assumption, which has the country’s 5-year dollar bonds yielding 14% and the 10-year dollar bond yielding over 12%, is because of domestic politics.

So, what’s changing and what may cause a 180 degree turn in risk assessment? The answer is again politics. Obstruction to foreign led projects from the MPP caused a collapse in FDI and the contagion from that has badly affected all other areas of the economy. Unemployment is officially at 8%, albeit unofficially the figure for under-employment is a lot higher, and the country is running out of money. The budget ran a deficit equal to 6.5% of GDP last year.

That dire economic circumstance forced the MMP out of the grand coalition last year and allowed Prime Minister Chimed Saikhanbileg’s Democratic Party a freer hand to push ahead with approvals for some big projects in the mining, railway and power sectors. But while keen to re-engage with Mongolia and clearly encouraged by the more investment-friendly approach from government since the middle of last year, directors of big international mining companies will want to make sure that the change is made more secure with a consolidation of the PM’s position on June 29.

Only then will investors also start to reflect on the possibility of the next boom in their risk assessment rather than the threat of a default.

Chris Weafer is a founding partner of Macro-Advisory, which helps investors cut though the noise & focus on underlying trends, real political risks, & opportunities in Russia/CIS, Eurasia Union, & Mongolia. Follow him on @ChrisWeafer