Jacopo Dettoni in Ulaanbaatar -

After experiencing the buzz of double-digit growth rates and lavish interest from  international investors, Mongolia's economic miracle has turned a bit sour.

Economic growth has slowed and investors are more cautious, which has caused foreign investment to dry up. With no agreement in sight between the government and the global miner Rio Tinto over the multi-billion-dollar expansion of the giant Oyu Tolgoi copper and gold mine, largely considered a barometer of Mongolia's economy, the authorities in Ulaanbaatar are left to deal with the challenges inherited from years of unprecedented growth. “Three years of growth-oriented economic policies have led to large economic imbalances,” the World Bank warned in its latest country report published in June.

Caught between a weak commodity cycle and flagging investor sentiment, the government decided to breath new life into the economic boom through generous fiscal and easy monetary policies. As a result, the fiscal deficit ballooned and remained over 10% of GDP in 2012 and 2013; the World Bank forecasts more of the same in 2014.

In the meantime, the central bank injected fresh liquidity into the system equivalent to 20% of GDP, creating a credit boom. As a result, the economy is still barrelling along, with GDP growing at 11.7% in 2013 and 12.4% in 2012, following the stunning 17.5% rate achieved in 2011, when Mongolia hit the headlines as the hottest frontier market out there. “Today, the central bank is managing economic growth forecasts in the order of 8% to 9% for 2014,” a central bank source told bne, preferring to remain anonymous (Mongolbank's economic forecasts are not released publicly).

Flip side of growth

If the gambit is paying off in terms of economic growth, increasing imbalances represent the flip side. The credit boom achieved through central bank-sponsored programmes like the 8% mortgage rate has boosted imports in a time when exports, mostly raw minerals, were falling because of China's economic slowdown. That, combined with falling foreign investment due to the government's legal capriciousness, have led to trade imbalances that ended up eroding foreign currency reserves. Mongolbank's foreign reserves fell to $1.6bn in May, down from over $4bn at the beginning of 2013, according to official figures. Without taking into account existing currency swap agreements with other central banks, net reserves could be as low as $540mn, credit rating agency Fitch Ratings has estimated.

Plummeting foreign reserves hit the local currency, the tugrik, hard, which has lost 10% against the US dollar so far this year, following a 17.6% decline in 2013. In a country with little domestic production and a heavily reliance on imports, a weakening currency immediately translates into inflation, with prices currently growing at an annual 14.6% clip, according to June figures from Mongolbank. “Monetary policy needs to be tightened, since — as in other countries — excessive credit growth has contributed to strong imports,” the International Monetary Fund's (IMF) deputy managing director, Naoyuki Shinohara, said in a June statement. 

Besides, “the consolidated deficit should be brought down steadily toward the target laid out in the Fiscal Stability Law [2% of GDP],” Shinohara added.

Silver bullet

Authorities in Ulaanbaatar often treat the giant Oyu Tolgoi mining project as a silver bullet able to cure any imbalance and lure back investors. With $4bn on the line, representing one-third of the country's annual GDP, they could have a point. Yet the negotiations over the project's expansion are not moving forward as expected and the road ahead appears bumpier than ever, with the Mongolian side showing growing signs of irritation with Rio Tinto.

In the latest in a long series of sudden about-turns, the local tax authority has filed claims for unpaid taxes, penalties and disallowed entitlements associated with the initial development of the Oyu Tolgoi mine, which could be worth as much as $130m. Rio Tinto-controlled Turquoise Hill Resources, which owns 66% of the mine – the remainder being owned by the government itself – refutes the claims and has opened an official dispute with the government. The whole issue risks further delaying an agreement over the mine's underground expansion. The company was supposed to complete an updated feasibility study and send it to parliament for final approval in a matter of weeks.

However, “distribution of the underground feasibility study will be delayed” as “outstanding shareholder issues, including tax claims, must be resolved before further investment in the underground can proceed,” Turquoise Hill said in a statement in July. That will likely put off any final agreement to 2015 as the earliest.

Given the project's magnitude, things for the Mongolian economy may indeed turn on a dime whenever an agreement is struck. Until then, the government is left alone to fight a double battle: keep the economy on track and keep the current imbalances in check. Prime Minister Norovyn Altankhuyag unveiled a 100-day economic stimulus plan back in back in April - he will probably need more than that to succeed on both those fronts.