Terrence Edwards in Ulaanbaatar -

Mongolia’s government has made big strides in resolving a tax dispute with mining giant Rio Tinto that’s holding back a $5.4bn expansion of the huge Oyu Tolgoi copper-gold mine. But time is running out to finalise a deal as politicians gear up for elections in 2016 that will inevitably involve some multinational bashing.

The dispute over Mongolia's largest mine project has dragged on for almost two years and cost the country much of its reputation as one of the world’s hottest economies in the frontier markets arena. So investors were cheered on April 4 by remarks from Mongolian Prime Minister Chimed Saikhanbileg, who claimed that a final deal was near for the underground expansion of Oyu Tolgoi, which is 66% owned by Rio Tinto indirectly through its majority-owned unit Turquoise Hill Resources, with the Mongolian state holding the remaining 34%.

“The two sides have reached agreement, in principle, on the main points of dispute,” Saikhanbileg said during a televised speech. “Now the parties are finalizing their respective internal processes and will soon officially announce the results to the world.”

Rio Tinto’s chief executive, Sam Walsh, had also hinted that progress was being made to bne IntelliNews during a visit to Mongolia on March 29 to commemorate the millionth tonne of copper ore shipped from the mine. “There are issues we're working through with the government, and I’m hopeful we'll bring [them] to resolution,” he said. “My visit here is to show that commitment, to show our interest, and show our good will in regard to the progress in negotiations.”

Despite the positive words, a deal over the second phase of Oyu Tolgoi won't be possible until both sides can agree on a $127mn tax dispute that has since been reduced to $30mn. The amount may now be relatively small, but Rio Tinto's Walsh said the miner in November delivered its “best and final offer” to resolve the tax dispute, which includes a request for the government to spell out how exactly tax officials determined the figure. “It's more about seeking clarity than anything particularly special,” said Walsh.

Government officials, however, say they can't comply. Cabinet Secretariat Minister Sangajav Bayartsogt has objected on the grounds that Mongolia is not able to grant special tax arrangements for just one company, no matter how important – although, arguably, the 2009 investment agreement drawn up for Oyu Tolgoi did just that. Badral Munkhdul, the head of market intelligence group Cover Mongolia, warns that: “It looks like the tax law has to be changed to solve the tax dispute.”

Second helpings

The stakes are high for both sides. Rio Tinto argues that the underground mine is necessary to unlock 80% of the wealth of the mine, which is located 80 kilometres from the Chinese border in the Gobi desert. Rio needs the expansion to make the mine a worthwhile long-term investment; for Mongolia the mine means billions more in investment after more than two years of straight decline.

According to Dale Choi of Independent Mongolian Metals & Mining Research, after $6.4bn was invested in the first phase of Oyu Tolgoi in 2010-2013, ​phase two is estimated to bring another $6bn in investment over five years. For the government coffers, the first phase brought in $1.3bn in taxes, royalties and fees, and the second is estimated to bring in another $1.7bn.

Oyu Tolgoi marked the beginning and the end of Mongolia's short-lived mining boom. The signing of the investment agreement in 2009 saw the country’s GDP swing from a contraction of 1.3% that year to the world-beating peak growth of 17.5% just two years later. But the dispute with Oyu Tolgoi has sapped investor appetite, with GDP growth steadily declining to 7.8% last year. The Asian Development Bank has projected average growth of 4% for 2015 and 2016, unless Mongolia can start attracting investment again.

Mobilising construction for the $5.4bn expansion project would require Oyu Tolgoi to hire new employees and contractors for support. But the mine's influence over the economy as a whole has companies in sectors ranging from real estate to retail watching progress closely. “If Oyu Tolgoi's not running, the whole economy is suffering,” says Marcel Venhofen, executive director for the German Mongolian Business Association. He sees the impact of Oyu Tolgoi not only as a source of capital, but also to attract more expats to the country who will then boost consumer spending.

If the tax dispute is resolved, it would be one step closer to both parties signing a memorandum of understanding to allow Oyu Tolgoi to go forward with the expansion project.

Rio Tinto's Turquoise Hill Resources would then be able to approach lenders again to discuss terms to finance the underground expansion project, said Walsh. A $4bn project financing package that Rio Tinto had planned to use to fund construction of the underground mine expired last year, but Walsh said lenders such as the European Bank for Reconstruction and Development have still expressed interest in being involved. 

But while businesses want to see the return of foreign investment growth, another group of voters sees mining as only beneficial to the country’s oligarchs and foreign enterprises. And their voices are only likely to get louder ahead of parliamentary elections scheduled for 2016.

In 2012, some politicians took a strong stance against foreign investment in the mining sector. Going head-to-head against Oyu Tolgoi helped make some politicians household names. And despite the economic benefits that expanding the mine could bring to the economy, being seen as too close to foreign mining investors could be political suicide.

Prime Minister Saikhanbileg in February gave himself some political cover by asking Mongolians to voice their opinion on whether the country should push mining projects forward with a text message referendum. However, the race was close and voter response unremarkable.

Munkhdul reckons Saikhanbileg has until Mongolia's Naadam summer festival in July, when parliament breaks for recess, to alter the tax code and resolve the tax dispute. And although he sees Saikhanbileg's cabinet as unified, convincing parliament will be a difficult feat. “That's a big step,” he says. “The biggest is changing the law.”

“If the campaigning starts, and we still haven't figured out [Oyu Tolgoi], that will mean it's open hunting season,” says Munkhdul.