Is Mongolia really a new mining frontier?

Mention mining and Mongolia probably doesn't instantly spring to mind.

In a recent survey carried out by Canadian group Fraser Institute, Mongolia was dubbed the second-worst destination for mining companies, dumped unceremoniously behind the likes of Venezuela and the Democratic Republic of Congo.

But, nestled deep between Russia and China, this once-overlooked country plays host to potentially some of the world's largest mineral deposits - a fact that cannot be ignored by the global mining industry.

Despite bearing witness to little exploration, it is believed Mongolia has one of the largest undeveloped copper, gold and uranium deposits in the world, as well as the largest untapped supply of coal. Its location leaves it perfectly positioned to take advantage of the ferocious appetite for metals and coal from neighbouring China, which will be the principle driver of demand for Mongolia's mineral wealth.

In 2008, China became a net coal importer, despite accounting for 46% of production just one year earlier, while copper consumption is forecast to grow around 5.4% globally, with China set to consume up to 40% of this output.

Unfortunately for Mongolia, there is little in the way of domestic investment, so foreign investment is vital if it has any hope of overhauling its economy and transforming its poor transport infrastructure. At present, just 5% of its population is involved in mining - the very industry that is shaping up to define the country's future.

Net foreign direct investment jumped by 62% in the second quarter of this year, principally driven by investment flows for mining.

"Powered by the growth in the mining sector, specifically demand for copper and coal from China, the economic outlook for the country looks stable and positive," says analyst Edwin Lloyd at Edison Investment Research.

Mongolia continues to try and forge a relationship with countries outside of neighbouring Russia and China, developing a "third neighbour policy" and making efforts to develop business relationships with Korea, Japan, the US, Canada and the EU. These efforts would appear to be paying off, with the World Bank Report for 2010 ranking Mongolia 60th in terms of ease of doing business - ahead of China at 89 and Russia at 120.

The country passed the tipping point when it finally signed a large and significant deal with UK heavyweight miner Rio Tinto (RIO) and Canadian group Ivanhoe Mines to develop a major copper and gold deposit.

The largest undeveloped deposit in the world, Oyu Tolgoi possesses current reserves of 35 million tonnes of copper and 42 million ounces of gold and is expected to produce an average of 450,000 tonnes of copper and 330,000 ounce of gold per year.

The International Monetary Fund said of the deal: "Mongolia's economic prospects received a big boost with the signing of the Oyu Tolgoi investment agreement."

And it came one step closer to getting built this week after the partners struck a new financing plan.

"The Oyu Tolgoi project is a natural fit with our strategy of focusing on low-cost, long-life assets with significant growth potential. Together with Ivanhoe and the government of Mongolia, we are determined to develop Oyu Tolgoi in a sustainable, mutually beneficial manner for the people of Mongolia," chief executive Andrew Harding said.

Lloyd says the development of the Oyu Tolgoi mine alone will be "transformational," with Mongolia poised to "generate the highest rate of growth of GDP of any country in the world over the next 10 years".

But more importantly, the deal, struck towards the end of last year, was seen as a crucial turning point in the way the nation viewed foreign direct investment, helping to pave the way for a pipeline of other contracts to be negotiated.

Nevertheless, there remain hurdles in the road for the government which is torn between encouraging foreign investment and satisfying nationalistic sentiment. It has pledged handouts to every person in the country, the second of which, MNT50,000 is taking place now, and in October announced a 30% increased in public sector wages.

On top of this, the Windfall Profits Tax expires in January, which accounted for up to 20% of government revenues, and there are no further plans for continued support from the International Monetary Fund and World Bank.

"Combined, these mean the government has to implement a strict fiscal policy over the next 18 to 24 months. This increases the need for foreign investment to exploit the mining sector," Lloyd explains.

However, while it may require greater foreign investment, environmental issues have thrown a spanner in the works.

Earlier this year, Canadian miner Khan Resources saw its uranium mining permits cancelled - a decision it continues to fight - while just last month, Mongolia's minister for mineral resources and energy, Dashdorj Zorigt, revoked 254 gold mining licences, while a further 1,700 licences have fallen under review, as a result of the Water and Forest Law, which prohibits mining operations in water basins and forest areas.

It is believed small and unqualified miners were the target, with fears that the licences were not properly explored and well thought through.

However, it highlights the struggle the country faces as it seeks to find the right balance between surging foreign interest and avoiding the mistakes made by other poor but mineral-rich countries.

Lloyd warns: "The government needs to balance a political mindset with the need to develop the enormous opportunities available, for which foreign direct investment is required. There are practical issues to investment too with a chronic lack of infrastructure."

He also notes that Mongolia would need to be careful to avoid misusing the revenues from mining.

"The current redistribution of wealth is because of pressure to give away some of these mining revenues. As elections in 2012 draw nearer there will inevitably be pressure on politicians to buy voters," he concludes.

So while Mongolia has all the markings of a 'rags to riches' tale, it looks like the happy ending still has some way to go.