Friday, May 23, 2014

Guest post: will Mongolia default?

In November 2012, Mongolia issued US$1.5bn of five and 10-year sovereign debt – cutely called “Chinggis bonds” after the 13th century Mongol conqueror Genghis Khan. These were happily snapped up by yield-hungry investors as Mongolia continued to post one of the world’s fastest GDP growth rates. The government, in theory, should have used this money to invest in commercially viable infrastructure to provide power, transport and logistical infrastructure to support the country’s continued growth.

But with a substantial portion of this debt maturing within the next 3 years, concerns have been mounting about the government’s ability to repay. While some of the US$1.5bn bond was used to build useful social infrastructure within the capital, Ulaanbaatar – including new roads and schools – an equally significant portion was spent on pork-barrel and pump-priming programs. Moreover, the government has little to show in terms of commercially viable investments that generate returns.

Mongolia already runs a substantial fiscal deficit. If spending by the Development Bank of Mongolia is included, it amounts to at least 12 per cent of GDP. With Mongolia’s debt-to-GDP now above 50 per cent, the Ministry of Finance has been urging Parliament to raise the legal debt ceiling from 40 per cent of GDP to 70 per cnet of GDP, as a means to issue more bonds for debt servicing.

However, parliament so far has refused to budge, while the World Bank has strongly advised the government against raising the ceiling, following an internal assessment of Mongolia’s debt sustainability and its current debt tenors. It also appears unlikely that international investors would be overly willing buyers of new Mongolian debt, given the clear and present risks. On the side lines of the recent Asian Development Bank meeting in Kazakhstan, representatives from Mongolia’s Finance Ministry admitted that the current debt situation was a difficult one, although they declined to comment on specifics.

Perhaps the biggest worry, however, is that the mining sector has largely come to a standstill. The country’s two flagship projects, the Tavan Tolgoi coking coal mine, and the Oyu Tolgoi copper-and-gold project – in which global mining giant Rio Tinto has a 66% stake – are not contributing meaningfully to government coffers. Sources suggest that Tavan Tolgoi, which has a contractual obligation to sell coal to China’s Chalco, is currently exporting for as little as US$30-40 a ton, below the cost of the production. Moreover, pricing pressures continue to persist, with Chalco reportedly struggling to find buyers in China.

Oyu Tolgoi has yet to fully commence commercial production, with ongoing tripartite disputes between the Mongolian government, which wants a greater equity stake in the project, Rio Tinto, which has invested substantial sums of money in the project but has been losing confidence, and with the Chinese government/Chalco, which also holds a 9% stake in Rio Tinto, but has been reported to be seeking greater control over the project’s offtake in return for providing the electricity required for commercial production.

Meanwhile, medium-sized miners, including Hong Kong-listed Mongolian Mining Corp (MMC) and South Gobi Resources, have either stopped production or are struggling to repay debts, given the weak export environment. New foreign investments have come to a halt also in part due to the persistent uncertainty in the country’s legal environment and the high-profile detention of senior executives at South Gobi.

For now, the economy remains relatively robust, mainly due to the trickle-down effects of the economic boom over the last five years and recent fiscal stimulus spending. The local currency – the tugrik – has taken a beating, as has the stock market, but some investors continue to see value opportunities and strong long term fundamentals.

That may be justified. But in the short term, the lingering issue of how Mongolia will repay its debts remain unresolved. There are effectively three options. The first is that Oyu Tolgoi, a project which alone is expected to account for more than 30% of GDP once it reaches full production, finally gets underway. While Mongolia has over 200 major projects that contribute to government revenue – not only in mining, but in infrastructure and construction – many are either cash flow negative or simply do not have sufficient scale to shore up government coffers.

Another option would be to draw on Chinese funding. The Chinese government recently doubled the size of its currency swap with the Mongolian central bank to Rmb20bn, as a measure to help instill confidence in the currency and shore up foreign exchange reserves. Nevertheless, Mongolia is unlikely to veer towards full dependency on Beijing for sustenance.

A third option would be to draw on other sources of funding and development aid, including from the World Bank, the Asian Development Bank, Korea Exim Bank, Japan International Cooperation Agency (JICA), and the Japan Bank for International Cooperation (JBIC). However, new grants may come with certain conditions and caveats attached that could prove tricky to enforce in Mongolia’s shaky political system, while new lending facilities may be deemed unfeasible if the debt ceiling is not extended.

For its part, in December 2013 JBIC recently provided a guarantee for the Development Bank of Mongolia (DBM) to issue its first ever Samurai bond, at US$290m with an ultra-low coupon of 1.52%. However, DBM has since struggled to use this money for local project finance. It reportedly has been seeking to convert its yen borrowings into US dollars as a means to avoid exchange risks stemming from a weakening yen, but has yet to find a willing counterparty.

There is still time for Mongolia to bring its fiscal house in order, but the clock is ticking.

Gavin Bowring is a research director at Asean Confidential, a research company owned by the Financial Times

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