Mongolia: Succumbing to the Resource Curse?

Mongolia, rich with coal, gold, and copper has been riding high on the global natural resource boom. The country’s proximity to China makes its resources even more attractive. Over the past decade, mining sector development has led to significant foreign investment and growth in government spending, provided a boost to household incomes, and has moved much of the country beyond its nomadic herding past. In 2012, Mongolia was one of the world’s hottest economies, clocking GDP growth of 12.3 percent. However, political risks emerging over the past year put this positive frontier market story at risk.

Short-Term Risks: The Mining Sector

Amidst the hustle and bustle of the capital, Ulan Bator, trouble is brewing. In June of 2012, the Democratic Party of Mongolia came to power as part of a coalition after years of rule by the Mongolian Peoples Party. The new government has taken a more aggressive stance regarding FDI and is ratcheting up criticism of the country’s largest investor, Rio Tinto and its management of the $13 billion Oyu Tolgoi copper and gold mine (commonly abbreviated OT), which has been in development for close to two decades.

The government is refusing to support Rio Tinto’s efforts to raise an additional $4.5 billion to finance the second stage of OT that is seen as key to the long-term economic viability of the ore body. Lawmakers in Mongolia’s parliament are seeking to secure a greater share of the wealth extracted by quadrupling royalties from the current 5% to 20%. Meanwhile, the country’s president has accused Rio Tinto of mismanagement and wants to secure a greater say in the mine’s operations. The government’s moves come as gold and copper prices have been tumbling on global markets, adding to the pressure on OT.

Thus far Rio Tinto has refused to renegotiate its agreement with the government, but support is seen as essential to raising stage two funding and for successful operation of the mine. Rio Tinto and the government made an initial effort to resolve the dispute in February, but failed. Following those conversations, Rio Tinto CEO Sam Walsh went so far as to state he had serious concerns regarding “recent political signals within Mongolia calling into question some aspects of the investment agreement” between the company and the government.

Meanwhile there are problems elsewhere at Tavan Tolgoi (TT), a massive coking coal deposit near the Chinese border and the most important mining operation in the country besides OT. Development has been delayed several times for financial reasons, as the government-owned operator, Erdenes Tavan Tolgoi, is reported to have presold coal to the Aluminum Corp of China at a price below the cost of production. It is also rumored that that deal was rushed in order to underwrite pre-election cash handouts to the population by the previous government, which according to Batsuur Yaichil, the head of Erdenes, cost the firm $669 million in 2012. Erdenes has since asked the government for a $500 million dollar bailout. An IPO expected to raise cash for the firm in 2012 has been put off until at least 2014.

Longer-Term Risks: Fiscal Sustainability

The situations at OT and TT point to larger, long-term risks associated with the populist ruling coalition’s questionable fiscal management. Since coming to power, the government has issued $1.5 billion dollars in sovereign bonds, introduced a draft mining law that would dramatically change the regulatory environment and raise royalty rates, fired TT’s previous top executive, and halted coal shipments to China.

The parliament also voted in a 2013 budget heavy on spending and backed by poor revenue assumptions. The budget increases expenditures and net lending by 18% bringing it to a projected to 42% of GDP. This comes after spending almost tripled between 2009 and 2012.

Making matters worse, current policies have lead to double-digit inflation. Thus far, inflation has not reached the record high levels of 2008, when it peaked at 33.7%, but inflation in 2012 was approximately 15%, driven by skyrocketing food prices, which according to the World Bank are undermining the real income and spending power of the population, a third of which still lives below the poverty line.

Several issues complicate Mongolia’s future further. The first is $1.5 billion in sovereign debt issued in 2012, representing almost 12% of GDP. During the lending roadshow the government suggested that the proceeds would be used to finance infrastructure projects, which are sorely needed to sustain growth and lift the population out of poverty, but the recent handouts to the population suggest short-term priorities have intervened.

A second complicating factor is the revenue assumptions made by the government. The government currently projects corporate income taxes to swell by $320 million, approximately half of which is expected to come from a renegotiated investment agreement with Rio Tinto. The source of the other half of new corporate income taxes is not explained.

Perhaps more worrisome are poor assumptions regarding the major trends in global commodity prices and volumes. The copper price assumptions made in late 2012, during the budget drafting process, were approximately 5% above the forecasted averages for 2013. Making matters worse the price of copper, along with gold and coal, has continued to fall in 2013 as demand in China has eased. To mitigate exposure to commodity price volatility, the government established a stabilization fund but it is woefully underfunded, amounting to only 2% of GDP for one year.

If ongoing negotiations with Rio Tinto are not resolved equitably the smooth start of operations at OT, slated for this summer, appears in peril. Additionally, should Rio Tinto and the Government fail to settle their dispute further fresh foreign investment will likely dry up.