Key political risks for mining investment in Mongolia

For those looking to invest in Mongolia, the article takes a look at some of the key political risks to watch out for as political uncertainty ahead of parliamentary elections in June 2012 has investors worried.

Mongolia sits on vast quantities of untapped mineral wealth, the exploitation of which is likely to turn it into one of the world's fastest growing economies over the next decade.

But political uncertainty ahead of parliamentary elections in June 2012 has worried investors, with Mongolia's shaky coalition government under pressure to renegotiate a landmark 2009 investment agreement for the Oyu Tolgoi copper deposit.

The priority for Mongolia is the development of its tiny economy, and foreign investors want to know if the government can create a stable legal environment while handling the pressures exerted by impatient citizens as well as its two giant neighbours, Russia and China.

Following is a summary of key political risks to watch:

INVESTMENT POLITICS

The government has now formally given up on its idea of renegotiating the contract for the Oyu Tolgoi copper-gold mine, after earlier saying it wanted to look again at a 2009 deal with Ivanhoe Mines, now 49 percent owned by Rio Tinto.

Foreign investors were worried that renegotiating a deal two years after it was first signed would undermine confidence, but Mongolia is under pressure to boost revenues and meet ambitious social pledges made at the last elections in 2008. Some politicians have called for the prime minister to resign over his handling of the Oyu Tolgoi contract.

The controversy over Oyu Tolgoi's ownership has spilled over into another giant mine, the Tavan Tolgoi or "Five Hills" coal deposit.

Mongolia hopes to complete an investment agreement for the project before the end of 2011 as it races to launch a much-anticipated initial public offering next year, and meet the promises it made to voters.

But an initial proposal to hand development rights in the project to China's Shenhua, Peabody of the United States and a Russian-Mongolian consortium was rejected, and the government is trying to devise another deal that will include Japanese and South Korean partners.

The confusion drew attention not just to the geopolitical pressures facing Mongolia, but also to its opaque approval procedures.

The government is under pressure to pass several new laws before the end of the year, including the budget, an election law, judicial reforms, and the investment agreement for Tavan Tolgoi. Many are worried that there will not be enough time to do everything.

What to watch:

-- Progress of new laws through parliament.

-- Whether the government can produce an investment agreement for Tavan Tolgoi that will satisfy foreign partners and keep the public happy, and whether it can do it in time . In October, a senior official said Mongolia could add "one or two" banks to its list of advisers for the initial public offering. BNP Paribas , Deutsche Bank (DBKGn.DE: Quote), Goldman Sachs and Macquarie have already been shortlisted, according to some bankers.

-- Whether foreign investors will be deterred by Mongolia's less than transparent approval procedures.

THE RESOURCE "CURSE"

Mongolia's dependence on mining has alarmed environmentalists and opposition politicians, and the country is already showing classic symptoms of "Dutch disease", including soaring inflation and high interest rates.

The government is trying to put in place structures that will protect it against fluctuating commodity prices, and is keen to use the proceeds from mining to pay for infrastructure, health and education programmes and develop other sectors.

It is under pressure to spread the wealth, and has already extracted "pre-payments" from foreign firms involved in both the Tavan Tolgoi and Oyu Tolgoi projects in order to give money to the public.

What to watch:

-- How Mongolia uses the proceeds from its mining projects. It has set up education and fiscal stabilisation funds, but it has also promised direct dividends for Mongolian citizens.

-- How it deals with rapid economic change as well as inflation as foreign investment transforms the country's mainly rural economy. Overall investment in Oyu Tolgoi alone will double the country's entire GDP in 2009.

GETTING ON WITH THE NEIGHBOURS

Many of Mongolia's 2.7 million citizens are concerned about growing Chinese and Russian influence, and their fears were not allayed by the plan to hand the majority of Tavan Tolgoi's western block to Chinese and Russian interests.

China already dominates Mongolia's economy, buying 90 percent of the country's exports in the first half of 2011, mostly at discount. But if Mongolia is going to stand a chance of easing its long-term dependence, it needs cash -- and that will only come from trade with its southern neighbour.

Mongolia's growing dependence on Russia and China for fuel, power and transportation also poses a major risk to its mining sector. Russia has been known to turn off supply taps, and China is not averse to closing crucial railway links.

Mongolia also depends on Russia's railway network to fulfil plans to deliver coal to Japan and South Korea.

What to watch:

-- Will efforts to ease dependence on China merely increase Russia's hold, and vice versa? Is the Chinese market for coal and other minerals its only option in the short term?

-- How will the government handle growing nationalist sentiment, and fears about the role of foreign firms and workers.

For a feature on the wrangling over the Tavan Tolgoi project, click here:

To read a multimedia special report on the Oyu Tolgoi copper and gold deposit, click here: r.reuters.com/nas97p (Editing by Daniel Magnowski)