It is a very different story from when GREED & fear was last in Mongolia in May 2011. Then it was boom time. Now the story is very different based on the briefest of visits at the start of this week. The Mongolian currency, the Tugrik, has declined by 24% against the US dollar since the beginning of 2013 and by 31% since the start of 2011, though it has bounced 3.3% off its low of late (see Figure 9). While foreign exchange reserves have collapsed, declining by 67% since peaking at the end of 2012 to only US$1.35bn at the end of July (see Figure 10).
The crux of the problem has been a collapse in foreign direct investment. Mongolia’s net foreign direct investment plunged from a peak of US$4.6bn in 2011 to US$2.1bn in 2013 and was down 61%YoY to only US$551m in the first seven months of this year (see Figure 11). This has been primarily driven by the negative signal sent to foreign investors by the ongoing dispute between the Mongolian Government and Rio Tinto over Phase II of the Oyu Tolgoi (OT) giant copper and gold mine project. Yet another deadline is looming at the end of this month with the dispute focused on management fees, cost overruns and a tax dispute.
GREED & fear suspects this will be “sorted” sooner rather than later, though there is no doubt that a very negative signal has already been sent to foreign investors. The fundamental problem is the structure of the deal which politicises the whole process in Mongolia’s noisy and chaotic democracy. Thus, the Mongolian government owns 34% of the “OT” project which means almost every commercial decision, such as how to pay for the natural cost overruns in a project where mining of copper is happening 1500 metres below the surface, is politicised. Far better would be a structure where the Mongolian government is not a shareholder in the mining project but simply extracts a royalty and the proceeds from the project go to the equivalent of a Mongolian sovereign wealth fund which would make long-term investments outside the government’s annual budget.
But if that would be the preferred structure, it is not what is happening. Meanwhile, with the currency collapsing and foreign exchange reserves running out, it would be easy to predict imminent full-scale collapse and related systemic crisis for Mongolia. If that is certainly quite possible, it is not GREED & fear’s base case. First, precisely because the Mongolian economy is so small, a sudden surge of FDI can work wonders. Thus, the second stage of “OT” would represent about US$2bn of investment in an economy of US$11bn.
Second, the increasingly dire macro situation has forced the Mongolians in desperation to turn to their neighbours. Thus, Chinese leader Xi Jinping visited on 21-22 August, the first visit by a Chinese leader in 11 years, promising US$1.7bn in financing. The irony here is that, in a surge of nationalism, Mongolia rejected a bid by China for SouthGobi Resources back in 2012.
From a macro perspective, the most promising development from the Chinese leader’s visit was the expansion of an existing currency swap line between the Chinese and Mongolian central banks from Rmb10bn to Rmb15bn. But there is also talk of interesting developments in the resources area. Thus, Sinopec has a memorandum of understanding (MOU) with the Mongolian government for the Shivee-Ovoo coal-to-gas project worth more than US$30bn. Xi also signed an agreement with Mongolia during his visit on strengthening coal-processing cooperation.
But it is not only China to which Mongolia has extended the helping hand. Russian President Vladimir Putin was not too distracted by the continuing Ukraine crisis to also make his first visit to Mongolia this week in five years. The significant point here, of course, is that, as a result of Russia’s deteriorating relationship with the West as well as the historic US$400bn gas deal signed between Russia and China in May, these two countries are becoming closer. Mongolia has to recognise that reality and hopefully take advantage of it; for example by Russia building gas pipelines across Mongolia.
If this is the backdrop, Mongolia’s current macroeconomic crisis is not just about counter- productive policies towards foreign investors, though this is undoubtedly very important. What has also not helped is abjectly bad fiscal and monetary policies under a Democratic Party government, elected in 2012, nominally in favour of free enterprises.
When GREED & fear first correctly and then wrongly maintained upbeat views towards Mongolia in two previous visits (see GREED & fear – The command economy and the red hero, 8 October 2009 and GREED & fear – Slow motion, 2 June 2011), the obvious risk to the then exciting story was a collapse in Chinese demand for commodities since Mongolia, given its richness in resources, was undoubtedly late to cash in on the mainland resources boom. Note that the OT project was only signed in October 2009 and the Chinese commodity boom really kicked off in 2002.
Still while Chinese commodity demand has now clearly peaked, as reflected in the depressed coal price, it has not collapsed given the lack so far of the “hard landing” outcome in the mainland economy while the copper story remains robust according to a recent CLSA report by commodity strategist Ian Roper (Global copper – Asian copper bulls: Pacific Ring set to fire, 1 August 2014). Indeed Chinese demand for copper from OT’s phase I is strong.
This is why Mongolia’s current troubles are the result, to a significant degree, of misguided domestic policies which have now hopefully begun to be resolved. These policies were implemented by the finance ministry but enabled by the central bank. Perhaps the main culprit was the 1970s’ sounding Price Stabilisation Programme implemented in late 2012, which mandated stable prices for core sectors. Second, an extreme version of the Fannie/Freddie securitisation model was announced last year, which allowed mortgage holders to refinance their mortgages from the market rate of around 18% to 8%.
Moreover, the central bank lent money to the commercial banks to fund these misguided programmes. The Bank of Mongolia had provided US$2.6bn in loans to the banking system as of the end of 2013, representing about 40% of total credit for the banking system. Finally, to add fuel to the fire, the proceeds from US dollar bond issues by the Mongolia Government and the Development Bank of Mongolia of US$1.5bn and US$580m, raised in November 2012 and March 2012 respectively, were used primarily to finance infrastructure and related construction loans with the result that a notable feature of Ulaanbaatar not evident three years ago is now lots of half-finished building sites.
If such policies led to a credit boom, with credit growth running at 73%, 24% and 54% respectively in 2011, 2012 and 2013 in an economy which recorded real GDP growth of 17.3%, 12.3% and 11.6% in those years (see Figure 13), the squeeze is now on. The central bank has finally started to recognise reality making its first interest rate hike in two years to 12% at the end of July (see Figure 14) as inflation has risen to 14.9% in July, up from 8% in mid-2013 when it was artificially suppressed by the price controls (see Figure 15). The result will be a credit crisis because the problem in Mongolia is that 40% of corporate loans are in US dollars because of the lower debt servicing costs, and no corporate ever anticipated the local currency to be so weak when the OT project was signed in October 2009 and the Mongolian economy looked set for a multi-year investment boom. Soaring NPL ratios on corporate loan portfolios are the resulting consequence in a banking system which is increasingly liquidity challenged having seen its loan-to-deposit ratio surge from 80% in 2010 to over 100% today. Thus, NPL ratios for the mining and manufacturing sectors stood at 17.9% and 6.4% respectively at the end of 1Q14, up from 12.2% and 3.3% a year ago. The liquidity squeeze is best illustrated by the fact that there were no buyers for government paper in the last few weeks’ government bond auctions. The major banks are the natural buyers given the lack of insurance companies and pension funds but they are already sitting apparently on the equivalent of US$1.2bn of such government paper.
But if it is all a mess there are some compensating factors beyond China’s seeming willingness to help in return, presumably, for a for now at least unspoken quid pro quo. The currency is free floating and therefore has sent a clear signal of a macro problem which hopefully will trigger a policy response. Second, outstanding government debt is not yet at the sort of level which triggers hyperinflation. Mongolia has an official government debt to GDP ceiling of 40% but adding on quasi government entities like the Development Bank of Mongolia, only set up in May 2011, it is probably nearer a still tolerable 60% of GDP. Finally, as already noted, the small size of the economy means that a decision to go ahead with phase II of ‘OT’ and other resource projects can go a long way to addressing macro problems.
As for financial market implications, “frontier” investors are advised to start focusing on the story again given the obvious potential for distressed opportunities. The 10-year dollar sovereign bond is yielding 7% which is attractive only if phase II of ‘OT’ finally gets the green light (see Figure 16). While the stock market, down 67% in US dollar terms from its February 2011 high, is actually up 19% in Tugrik terms from its low in May 2013, presumably in part acting as an inflation hedge (see Figure 17). But there is for now a woeful lack of liquidity, with average daily turnover running at only US$48,000 so far this year. This is partly the consequence of the lack of a custodian system. But the situation was severely aggravated last year by the adoption of a London Stock Exchange designed electronic trading systemridiculously over engineered for the “frontier” reality of contemporary Mongolia.