Mongolia Economic Update - November 2013

Mongolia's economy is currently in a critical phase of its development and the next few months will dictate Mongolia's future growth and its position in the international investment community.

With much information and misconceptions of all kind circulating wildly on the internet, we wished to bring to our clients and stakeholders our own vision, as we experience it, from the ground up, interacting on a daily basis with Mongolia's decision makers. We are by no means economists nor do we posses perfect information but this document represents our current understanding of the situation and our views of what could be done to facilitate the path forward.

I - Background on Mongolia’s Economic Situation

On October 6th, 2009, after years of arduous negotiation, the Canadian public company Ivanhoe Mines and the Government of Mongolia (GoM) signed a long awaited investment agreement laying the groundwork for a US$ 4B investment into a copper and gold mine in the Gobi Desert. This was the Oyu Tolgoi mine, and it signified the beginning of Mongolia’s precipitous thrust into the arena of foreign investment and economic development.

Subsequently, in 2011, Mongolia saw extraordinary economic growth. GDP grew 17.5% on the back of a 179% increase in foreign direct investment (FDI), and headlines such as “Booming Mongolia: Mine, all Mine” (The Economist, 21/01/12) and “Mining Fuels Mongolia’s Wolf Economy” (CNN, 20/05/11) began appearing in world press.,

However, in the second half of 2012 Mongolia’s course was altered. GDP growth dropped to 12.3% against estimates of around 15%, the fiscal deficit came in at 8.4% of GDP, inflation was in the double digits, and foreign direct investment dropped 17% from 2011. This downturn has continued well into 2013. FDI levels have dropped 43% in the first half of the year, GDP expectations continue to be revised down (the World Bank recently announced it was cutting its GDP growth projections to 12% compared to it’s original forecast of 16.2% and the IMF recently cut their prediction to 11.8% from its previous growth forecast of 14% in April 2013), and the MNT has seen a tumultuous slide reaching 1,722 MNT/USD in September – a depreciation of 25% from its beginning of year rate and it’s lowest level in at least 10 years. This is particularly worrying for a currency that has been relatively stable in the not so distant past and for a country that is so reliant on the USD for investment projects.

While a downturn is clearly evident in the numbers, there is a richer story to be found in the qualitative indicators. Talk to any Mongolian business owner and you’ll hear that there are considerably fewer customers coming into their stores or requesting their services. High-end shopping malls built on the 2011 consumer hype are deserted and empty on the weekends. There is a discernible drop in the number of expatriates inhabiting the city centre cafes and pubs. And importantly, a bleak and pessimistic sentiment permeates the Ulaanbaatar community, no small fact for a country with such enormous untapped potential.

II - Reasons Behind The Economic Slowdown

Throughout Mongolia’s transition into a democratic free market economy, there have been a multitude of internal and external factors that have frightened foreign investors and contributed to the country’s various economic slowdowns. For example, in 2006 a 68% windfall profit tax was passed in Mongolia in order to incentivise copper and gold mining companies to smelt their copper within the country rather than ship the concentrate abroad. The tax would not have applied if the copper was smelted in country. Yet, no smelter existed in Mongolia and the current mines were too small to justify making the capital investment to build one. Therefore, it essentially halted all small-mid cap copper and gold mining FDI as the tax made exporting minerals unprofitable. The windfall tax was eventually repealed in 2009, but the effect it had on the economy was real and the memory by foreign investors indelible.

Then, in 2009 the Law on the Prohibition of Minerals Exploration in Water Basins and Forested Areas (also known as the Law with the Long Name) was passed allowing the government to cancel over 200 preexisting mining and exploration licenses with no grandfather exceptions. While the attempt at environmental preservation was praiseworthy, many investors lost millions of dollars worth of investment spent obtaining and operating under those licenses. Potential investors became frightened to commit capital as the fear of government intervention into legally obtained business rights became a reality.

Lastly, in late 2012 the Draft Minerals Law was proposed which would have given the state pre-emptive rights to any mining or exploration licenses transferred from one entity to another. Again, this led to what the Financial Times called an “apoplectic response” from foreign investors, even prompting the Business Council of Mongolia to claim that the draft law “threatens to shut down the entire minerals industry of Mongolia”.

While these actions were certainly significant, there were two important factors that were the proverbially straw that broke the camel’s back. These were the 2012 Strategic Entities Foreign Investment Law (SEFIL) and the ongoing dispute between Rio Tinto and the GoM.

SEFIL was passed by parliament in May 2012 as a knee-jerk reaction to the proposed sale of Ivanhoe Mines’ 58% stake in coal miner SouthGobi Resources to the Aluminium Corporate of China (Chalco), China’s largest state-owned aluminium producer. It stipulated that all investments over $75M, or those involving state-owned companies, into strategic sectors such as mining, finance, media and telecommunications, were subject to scrutiny by a government panel if the stake put the investor at over 49% ownership. The fact that the bid was announced right before parliamentary elections resulted in a hastily and poorly written law as lawmakers wanted to prove to the public that they were strong leaders worthy of re-election. As such, important clarifications were overlooked, and investors became confused by what certain aspects of the law actually meant. While SEFIL was successful in stopping Chalco’s takeover, the collateral damage it caused was calamitous. It created collective paranoia among investors and acted to substantiate the perception that the Mongolian Government was hostile towards, or at the very least extremely unstable to foreign investors.

The other major factor behind the drop in FDI and slowdown in economic growth has been the dispute between the GoM and Rio Tinto (who in 2012 acquired Ivanhoe Mines and changed the name to Turquoise Hill Resources) over the Oyu Tolgoi Investment Agreement. Since 2012 there have been calls by Government officials to renegotiate the ownership structure (as it stands Rio Tinto controls 66% equity and the GoM 34% equity), to adjust the profit sharing arrangement, and to hold Rio Tinto accountable for cost overruns stated to be above the original agreement. These substantial disagreements have led to significant delays for the Oyu Tolgoi project, causing Rio Tinto to put on hold all work on the mine’s second phase underground expansion. The delay of the more than $5 billion expansion came with the layoff of 1,700 Oyu Tolgoi mine workers as well as layoffs at mining suppliers such as Redpath and Wagner Asia.

The unfortunate result of this suspension has been the collapse of the micro economy created by Rio Tinto’s investment. Not only has Mongolia lost 1,700 potential consumers, as well as their families, who could have generated disposable income and injected much needed cash into Mongolia’s fledgling consumer and service markets, but it has also pushed back the tremendous spillover demand that phase two would have created for mining services and suppliers not to mention the additional $5Billion investment. The multiplier effect has been apparent as the delay has impacted every sector touched by OT. For an economy with a GDP of just over $10 billion, this impact is substantial.While the announcement on October 1, 2013 that the Mongolian government and Rio Tinto had resolved half of the OT issues during recent talks in London was a positive step, the ongoing dispute has been, and until resolved will continue to remain, a severe setback for Mongolia’s economy.

III - Digging Deeper Behind Mongolia’s GDP Growth

While Mongolia’s recent political instability and the accompanying economic figures might seem bleak on the surface, a little digging helps to reveal a different story. Below the bad press remains a story of strong underlying fundamentals driven by a unique and fascinating story of economic, political and social transition. In order to understand this, let’s take a look at that all important and deeply telling figure by which economists and investors alike love to measure a country’s economic success: Gross Domestic Product (GDP).

It’s easy enough to look on any of the international development agencies’ websites and see that Mongolia’s GDP is far below expectations. But is the concept of GDP really all that telling when analysing Mongolia’s economy? In 2012 Mongolia’s GDP was around $10.3 billion. To put this in perspective, we can compare this figure to similar metrics used to determine the value of a company’s annual production. Stacked up against the world’s largest public companies, this $10.3 billion would place Mongolia out of the top 40 companies in terms of profits, out of the top 900 in terms of sales, and out of the top 950 in terms of market capitalisation. This means that every micro level political decision has a significant effect on Mongolia’s macroeconomic numbers. GDP in itself is a relevant indicator of economic health for larger economies where fluctuations signify numerous factors moving in tandem, but for a country the size of Mongolia it is not sufficient to aggregate these factors into a supposedly comprehensive figure.

This is why to truly understand the growth dynamics behind Mongolia’s economy it is necessary to break GDP down into its components and analyse them individually. As a reminder, according to the expenditure method: GDP = Investment + Government Spending + Consumption + Net Exports (Exports – Imports).

1 - Investment

The hype surrounding investment in Mongolia is not for naught. Investment is vital to Mongolia’s economic development because it drives the infrastructure development that Mongolia’s business community so desperately needs. It takes but a thirty-minute drive outside of Ulaanbaatar to see that Mongolia’s transportation infrastructure is practically non-existent, and blackouts are all too common as the power system is stretched beyond its capabilities. It is also essential that Mongolia use investment to increase its value-added capabilities. This can help create long-term economic stability and ensure that Mongolia is able to weather external shocks such as the cyclical deterioration of commodity prices.

To put these concepts together, we can use the example of the Erdenes Tavan Tolgoi dispute with Chalco. At the end of January this year, Erdenes Tavan Tolgoi, Mongolia’s largest coking and thermal coal miner, announced that it wanted to renegotiate a 2011 deal with Chalco to supply $250 million worth of coal at a price of $53 a metric ton, the market price at the time the deal was signed. According to the agreement, Chalco supplied the state-owned Erdenes Tavan Tolgoi with a $250 million advanced payment (or loan) for the equivalent amount of future supply of coal. The loan was to be used to develop a washing facility and a railway line to the Chinese border, which was supposed to add value to the coal supply and make the mine profitable for Mongolia. However, instead of investing the funds in the intended infrastructure development, the government used the capital to supply cash handouts to the population in an attempt to win votes for the upcoming parliamentary elections. The mine quickly became unprofitable as it cost Erdenes Tavan Tolgoi $61 a ton produce and move the coal to the Tsagaan Khaad border, a cost higher than the original, prepaid price the two parties had agreed upon. Furthermore, Mongolia incurred a significant opportunity cost through this deal because, according to analysts in early 2013, “[The] price could be as much as $20 per tonne cheaper than the average prices of Mongolian coal delivered into China, which are already much lower than international rates.” Thus, Erdenes Tavan Tolgoi was losing out on potential sale volume as it was locked into a price that is much lower than current market prices. This resulted in the halting of exports by Erdenes Tavan Tolgoi in early 2013. After two months of an intense standoff, Chalco granted Erdenes Tavan Tolgoi a $3 increase in the sales price as well as the ability to repay the remaining balance in cash in exchange for an increase in interest on the outstanding loan.

Now imagine the scenario if the planned railroad and washing facility had actually been built as planned. According to Eredenes Tavan Tolgoi CEO Yaichil Batsuuri, the proposed rail line to China could cut transportation costs by half, while the washing facility could help double their coal prices. Simple math shows that if transport costs were cut by half, making the total price to produce and ship the coal $49 a ton (transportation costs currently account for roughly 40% of Erdene Tavan Tolgoi’s total costs), and the price of coal doubled to $106 a ton, today’s Tavan Tolgoi problem wouldn’t have existed. Moreover, in this scenario prices could drop an additional $57 a ton and Erdenes Tavan Tolgoi would still be profitable, giving them a significant cushion if coal prices suddenly plunged.

Due to the capital deficit in the domestic markets as well as the need for technology and best practice transfers into Mongolia, most of the investment story must be explained and measured in FDI. Returning to the FDI numbers from the beginning of this report, one could fairly easily conclude that Mongolia is in trouble. But, while it is true that FDI numbers are down and the investment environment is seemingly bleak, viewing the story in context will offer a more realistic and more positive outlook. Rio Tinto’s $6.6 billion investment into phase one of Oyu Tolgoi is complete, meaning the loss of about 65% of the 2010 – 2012 FDI inflows of $10.2 billion into Mongolia, . Since the $5.5 billion phase 2 of Oyu Tolgoi was put on hold, there was no comparable investment to sustain the high levels of FDI. There is no doubt that other foreign investors have backed out of Mongolia, but the story would have been much different if it weren’t for this one investment. If the government provides the right support for another major investor to take a chance in Mongolia, the FDI environment could yet change drastically.

And there is no shortage of potential projects. Australian-owned Wolf Petroleum has been seeking investment to help exploit Mongolia’s 2.4 billion barrels of proven oil reserves, which puts Mongolia on par with Argentina and Britain.13 As a simple exercise in logic, if we pair Wolf Petroleum CEO Bataa Tumur-Ochir’s claim, “Mongolia is one of the last onshore frontiers where multibillion barrels of oil can still be discovered and produced,” with the Vice President of Collabrium Capital, Svetoslav Varadzhakov’s, statement, “As it stands, Mongolia simply does not have the infrastructure to support any kind of significant oil discovery,” out comes the opportunity for a massive investment project into Mongolia’s infrastructure development for the oil industry. Spectators of Mongolia’s economy shouldn’t take the drop in FDI out of context and must realise that the numbers can easily change at the drop of a dime.

Importantly, the government has already taken a key first step in trying to reverse the negative FDI trend and provide the support for another major investment. As previously discussed, the 2012 SEFIL has had disastrous effects on the FDI environment in Mongolia. But the announcement on October 3 that Parliament passed a new FDI law was a “long overdue significant message from Mongolian authorities that the country wants back investment, both foreign and domestic,” according to Dale Choi, an analyst at Mongolian Metals & Mining Research. In its pre-released draft state (the new law is set to take effect beginning on November 1, 2013 but is still subject to President Elbegdorj’s approval, and so the final version has not been made publicly available), the investment law is a major improvement over the previous law, and should be seen in a positive light by foreign investors.

The most important change in the draft law is the absence of wording about strategic sectors and the complete removal of the differentiation between local and foreign investors. The only investments that would be subject to scrutiny and/or limitations would be those of a foreign state-owned entity, a normal provision under most countries’ FDI laws.

Another significant feature of the new draft FDI law is the formation of a new “Investment Agency for Investments and Business Development”. This agency is mandated with implementing activities to attract foreign investments, supporting foreign investors with investment plans, and providing consulting services to help navigate other state services. This agency could be a useful tool for investors, as it will provide a single point of contact for all questions and concerns regarding the legal status of their investment. This should help provide clarity and more effective communication between the GoM and foreign investors, issues that have been key grievances among investors in the past.

The last important stipulation under the draft version of the new FDI law is the creation of stabilisation certificates. These would be granted to investments of over $10 million and would guarantee a stable tax environment for 5-10 years, subject to the implementation period of the project. Taxes included in this provision are income taxes, customs taxes, VAT, and royalty payments on the use of mineral resources. In order to apply for a stabilisation certificate, investors would have to submit a proposal to a newly-created Investment Council. In addition to the $10 million threshold, investors would be required to prove that the investment project has no environmentally adverse impact, creates new workplaces, and introduces new techniques and technology. Importantly, if Mongolia’s tax law were amended to decrease or invalidate the taxes covered under the stabilisation guarantee, the investor would be entitled to the rates mandated under the new law.

While the stabilisation certificates are a positive move to ensure consistency and stability for large investment projects (seemingly a direct response to the disagreement surrounding the Oyu Tolgoi contract), there are a few significant flaws that must be pointed out. First and foremost, these certificates would provide an unfair disadvantage for smaller investments, or those under the $10 million threshold if taxes were to increase. For example, if the government decides to increase customs tax revenue in order to support public works projects, should it only be the smaller investors who didn’t qualify for the stabilisation certificates that should bear the burden? Or should the tax responsibility be shared among all parties who would benefit? By isolating smaller investors, Mongolia could stifle its investment diversification that will help promote the consumer markets and mitigate Mongolia’s counter-party risk. It could also promote the shadow economy that does not generate tax revenue for the government because the capital will not be available and the incentive not created for smaller, consumer based companies to establish a formal business.

The stabilisation certificates also threaten smaller businesses by including VAT, a tax that is supposed to be paid by the consumer, not the company. As defined by the European Commission Taxation and Customs Union, VAT is “a consumption tax because it is borne ultimately by the final consumer. It is not a charge on businesses.”

This means that businesses simply collect the VAT on behalf on the consumer, and then pay the collected taxes to the tax collection agency. Therefore, if the government were to raise VAT, consumers could be required to pay higher taxes if they purchase items from a company that did not qualify for a stabilisation certificate. This creates an unnecessary distortion in the marketplace that will act to weaken competition.

Furthermore, some of the wording regarding the requirements is vague and difficult to interpret. For example, what does it mean to “introduce new technique and technology”? Does this include management techniques? Or is it restricted to business techniques such as new mining methods? And how does one define new technology? Will this mean proprietary technology? Or can it simply mean that companies procure and employ technology that Mongolia hasn’t seen before? The fact that the wording is ambiguous opens the door for a dangerous precedent to be set as the legal interpretations can fluctuate depending on who is in power at the time.

Lastly, in its draft state the law had no stipulation against retroactivity, a legal principle that allows for the imposition of newly created laws that would take away or impair vested rights acquired under previous law. While the stabilisation certificates propose to keep the tax environment stable for the specified period of the investment, what would happen if the new law was overturned or amended to take away the overarching concept of stabilisation certificates? Under the proposed law, there is nothing to stop the government from voiding stabilisation certificates by amending the law in the future if it finds that it was a mistake to grant those certificates.

Overall this draft FDI law is a significant upgrade from the existing law. Its passage is a key first step towards attracting back the foreign investors that Mongolia has lost over the past year and a half. While there are some key issues with the draft law pointed out above, foreign investors should be optimistic that the new FDI law will both provide improved clarity and support for future investments.

2 - Government Expenditure

Any saltwater economist can easily explain the importance of government expenditure for economic growth. According to Keynesian theory, economic output is highly dependent upon aggregate demand, a factor greatly influenced by a host of economic decisions and often one that behaves erratically. These shocks to demand can range from a slowdown in Chinese coal demand to GoM policy that scares off foreign mining investors, diminishing the demand for mining suppliers and service providers. As Keynes argued, it is then necessary for the government to intervene in order to meet the productive capacity of the economy.

One cannot doubt that gross overspending and a widening government deficit is dangerous for any economy. However, one must also accept that government spending can be used to resuscitate a slowing economy and can act as a lifeline against short-term shocks to demand. In Mongolia’s case, this spending spree was made possible by the Chinggis Bond.

On the 28th of November 2012 Mongolia emerged onto the global debt markets when it sold $1.5 billion in debt in its first Government bond offering. The sale consisted of a $500 million, five-year bond sold at its launch price of 4.125% yield, and a $1 billion, 10-year bond sold at 5.125%. Furthermore, insiders close to the bond sale have revealed that this first sale was only $1.5 billion out of a planned $5 billion total sale. This helps explain why the IMF predicts that from 2011 through 2013 general government expenditure will increase by nearly 30%. Furthermore, the fact that government expenditure accounted for 42.5% of GDP in 2012 reveals why Mongolia was able to maintain double-digit GDP growth in 2012 amid a steep decline in FDI inflows. Therefore, it is necessary to realise the importance of government spending for Mongolia’s GDP numbers. Until Mongolia exits the investment stage of its development and enters the export stage, it will continue to rely upon government expenditure to maintain its growth trajectory, something the Mongolian government has proven willing to supply.

The problem thus far has been that the GoM has not allocated its economic resources effectively. To start with, Mongolia has a legacy of providing cash handouts before parliamentary and presidential elections. While on the surface it seems as if this policy can increase the money supply and allow for increased consumer spending, all it has done is lead to unsustainably high inflation and hurt Government reserves. It has not increased the real purchasing power of the recipients the way that advocates of the handouts claim, nor has it led to greater economic output. It also comes with a significant opportunity cost as $1 wasted on cash handouts means the government has $1 less for vital infrastructure or social development projects. Furthermore, the GoM spends cyclically based upon the weather and time of year. There is a short summer season for infrastructure building and construction in Mongolia. During the winter, the weather is simply too cold and harsh for workers to operate outside, meaning that the government will spend feverishly in the summer to finance public works projects, but will reduce spending substantially during the winter months. This leads to high unemployment during the winter, as the workers who depend upon this Government spending find themselves with no one to fund their paycheques. This is a dangerous situation for Mongolia because the unemployed then come to rely upon Government support systems during the winter, meaning greater Government expenditure with no economic benefit. It also acts to crowd out private investments in the summer because of the significant decrease in the already small labor force.

It is also important to understand that while the Chinggis Bond issuance provided a much needed capital infusion into the Government coffers, a significant portion of the capital remains sitting in the bank, while the money that was spent was spread so thin across such a variety of projects that very little has actually been accomplished in terms of infrastructure development. As the World Bank explained in its April 2013 Mongolia Economic Update, “Significant upfront investment using the [Chinggis] bond proceeds seems unlikely, given that large-scale projects currently being considered would require sufficient time for proper planning and feasibility assessment.” On the surface this seems fair, given that the Mongolian government does not want to wastefully spend this vital and scarce source of capital. But the lack of planning on how to spend the bond proceeds is costing Mongolia in the form of interest payments, which have risen sharply due to the currency mismatch of the bond and the depreciating MNT. In fact, as of September 2013, there were estimates that debt servicing costs of the Chinggis Bond have risen 20% in local currency and are now costing the GoM an additional $250,000 per day. All the while, Mongolia is seeing very little yield from the capital it has committed and practically no yield from the capital still sitting in the bank.

Therefore, it is necessary to make the distinction between effective government spending and ineffective government spending. So far, the GoM’s spending patterns have proven to be largely ineffective. However, if Mongolia is able to alter this trend and employ efficient Government expenditure, the Government has the opportunity to effectively develop necessary infrastructure, improve the population’s standard of living through social projects, and help Mongolia reach long-term economic stability. With the September 13, 2013 announcement that Mongolia plans to sell up to $1 billion in yen-denominated Samurai Bonds, comes a chance for the Government to do just that. Clearly, the government’s track record is not positive, but if it can learn from the mistakes it made with the Chinggis Bond and use the Samurai Bonds successfully, Mongolia’s economy could benefit significantly.

3 - Consumption

In order to understand the importance of consumption, let’s return to our discussion of the Keynesian theory that economic output is dependent upon aggregate demand. As previously mentioned, a wide range of variables can affect this demand. So how can a country mitigate the risks of fluctuating demand dynamics? To an extent, the answer lies in promoting internal consumption. It is important to realise that a country like Mongolia has a limited market capacity, thus certain industries such as mining cannot be sustained without exporting abroad. However, there are a number of retail-based industries that can be promoted internally which can provide Mongolia with a higher degree of economic independence by reducing the impact of external demand shocks. By having demand that is mostly external, the Government is limited in its ability to apply effective monetary or fiscal policy to affect demand and boost domestic business. Yet by having industries that are reliant upon internal consumption, Mongolia can better control the fate of its economic development through strategic Government intervention.

Fortunately for Mongolia, the consumption signs are all positive. To borrow a phrase from a friend, “Mongolia is pregnant with capitalism, and it is too late to abort.” According to the World Bank’s household final consumption expenditure figures (at constant 2005 US$), consumption in 2012 has increased 47% since 2008, and a whopping 135% from 2005. Yes, the base is small, but the trend has begun and exhibits no sign of slowing down. The new generation of Mongolians, many of whom have studied abroad and repatriated because of the growing economic opportunity, are eager to become global consumers. They want to be part of the world’s fashion, technology, and entertainment trends, and are willing to consume in order to get there. This not only opens the door for entrepreneurs looking to import goods, but also for uniquely Mongolian industry. If the demand exists for imports, so does the incentive for a Mongolian company to produce. Moreover, there exists a massive shadow economy in Mongolia that if formalised, could provide a significant boost to local, taxable businesses. According to a study published by the Michigan State University Board College of Business, as of 2012 the Mongolian shadow (or “grey”) economy was estimated to be at least one-third the size of the official economy. This provides a significant opportunity for local businesses since there is very clearly demand stretching beyond official statistics.

Sustaining this rise in consumerism is the parallel growth of credit for consumption. Domestic credit provided by the banking sector has grown from 13.3% to 30.8% over the past ten years, while domestic credit to the private sector has grown from 14.4% to 52.3% in the same period. This has been facilitated by the fact that during the same period average interest rate spread has declined from 18% to 7%, indicating a greater confidence by lenders and a willingness to lend at more favourable rates for the borrower. While too much personal and corporate credit can have disastrous effects on the economy (as evidenced by the 2008 economic recession in the U.S.), a sustainable level of credit growth is not only healthy, but is also necessary for the Mongolian economy. It will allow for a rise in consumer spending, creating a demand for products deemed inappropriate for the market just a few years ago.

4 - Trade Balance

While we have just argued the importance of domestic consumption for Mongolia’s economic stability, we are not naïve enough to overlook the fact that Mongolia’s population is small. When we say small, we mean really small. As of 2012 Mongolia’s population was estimated to be just under 2.8 million people according to the World Bank. As a perspective, we can compare this to the population of a large global city such as New York City. What we find is that the entire country makes up only about 34% of New York City’s population of 8.3 million people (as of July 2012). Importantly, this population is extremely spread out. In fact, Mongolia is the least densely populated country in the world. This means that there is vast space between the different economic centres, making in-border trade difficult and costly. To put this concept in perspective, if a truck were to transport goods between Ulaanbaatar and Bayan-Olgi, a city on Mongolia’s western border, it would have to travel roughly 1,600 km. This is about the same distance between Paris and Warsaw. The difference is that because of Mongolia’s geography and lack of infrastructure, the trip in Mongolia would be much more lengthy, difficult and costly. As a result of the small population and sheer geographic size of the country, there is a limit to how far Mongolia’s economy can grow based on internal consumption. At a point, it will become necessary for Mongolia to cede some demand control if it wants to grow its economy beyond the natural threshold that its small population creates.

Currently, Mongolia is running a large trade deficit. Couple the predominantly import driven economy with a rapidly depreciating MNT and the result is lower production as input costs rise, and a lower real purchasing power as prices for imported staple goods increase. In many mineral rich countries such as South Africa or Chile a depreciating currency is actually a positive for the economy because it makes their mineral exports cheaper for their foreign buyers, thus increasing demand. However, since the Mongolian economy is highly dollarised as most of the projects are in the USD capex-centric phase of their development and are not yet exporting, the positive effect of the depreciating currency on industries such as mining will be small at best.

The trade deficit also hurts Mongolia because it faces the problem of differing income elasticities of demand for primary products (Mongolia’s exports) and sophisticated manufactured goods (Mongolia’s imports). Mongolia has used the sale of natural resources, or products with relatively flat global demand, to pay for the import of high-tech manufactured goods, or products that experience demand surges as average incomes increase. Since income has grown substantially in Mongolia due to the sale of natural resources, internal demand for imported manufactured products has grown far faster than global demand growth for Mongolia’s mineral exports. This is making it increasingly more expensive for Mongolia to maintain this consumption trajectory.

The implications of this trade deficit are certainly serious, but it is important to understand that a trade deficit is normal at this stage in Mongolia’s development. As was previously mentioned, Mongolia is in the investment phase of its economic development, and has barely begun the production and export phase. This is a necessary step, as it is simply impossible to begin true production before the proper infrastructure is built. Spectators must be patient with the trade deficit and understand that it will take time to reverse this trend. Therefore, addressing the symptom of the deficit by stabilising the MNT should be the Bank of Mongolia’s main concern at the moment.



IV - Top 3 Misconceptions

This analysis of Mongolia’s current economic environment has helped us at M.A.D. to rebuff some of the misconceptions we have been hearing lately. It is important for us to do this as rumours and misconceptions often have the effect of creating irrational fear and unnecessary panic, which in turn has a real impact on the economy.
1 - The economy is reliant upon mineral exports and is therefore susceptible to a Chinese slowdown.

There is no doubt that the Mongolian economy is influenced by the Chinese economy. Considering that over 90% of exports in 2012 went to China, it is fair to say that the Mongolian economy depends upon Chinese demand for its exports, the bulk of which are minerals (mainly coal). So, can’t we blame a slowdown in Chinese GDP growth and a subsequent drop in commodity demand for Mongolia’s drop in export volume? Just look at the facts: In the first half of 2013 Mongolia’s coal export volume fell considerably compared to the same period in 2012. At the same time, Chinese GDP growth slowed to 7.6% in H1 2013 compared to 7.8% in H1 2012, which for an economy the size of China’s is significant,.

Yet as econometrics professors always tend to point out, correlation does not equal causation. While Chinese GDP may be slowing (keep in mind to levels still far above those of developed Western markets), China still consumes more coal than Mongolia could ever think to supply. Moreover, the fundamentals that make Mongolia a natural provider of coal to China remain the same. The Mongolian coalmines in the Gobi are but a few hundred kilometres away on land from the Chinese border. Mongolia’s border crossings in the north of China are where the majority of China’s rail infrastructure is located. And Mongolia provides cheap, relatively low quality coal to which Chinese importers can add substantial value. Given these factors, if all else is held equal, one can safely assume that if Chinese demand for coal dropped, Mongolia would see a smaller, or at least equal, share, of its coal exports to China decrease than one of China’s other major coal exporters like Canada or the United States.

Yet this hasn’t been the case. As evidenced by the graph below, in the first half of 2013 China’s coal imports actually increased from the first half of 2012, despite the GDP drop. Furthermore, while Mongolia’s total export volume dropped from approximately 9 million metric tons to approximately 5 million metric tons during this period, the other top six exporters of coal to China actually saw their export volume increase (with the exception of Indonesia which experienced a negligible drop). If a slowdown in Chinese growth were the only culprit behind the drop in Mongolia’s export volume of coal, we should have seen a slowdown in Chinese imports from its other suppliers, especially those that require significant transportation miles to reach their final destination in China.

So there must then be another cause behind the drop in Mongolia’s coal exports. Given the figures, it is safe to assume that the main causes are internal and not external factors. On top of the political and production problems Mongolia has faced, Platts, a research provider of commodity information, blames pricing. “The downward trend of Mongolian exports is a reflection of the challenging price environment, with the on-going difficulty of the country’s [coal] producers to sell profitably in the recent, low-price environment.” This can, in part, be attributed to Mongolia’s lack of transportation and value-added infrastructure, which is limiting Mongolian suppliers’ ability to lower prices in reaction to global price declines. Yes, global commodity prices are hurting Mongolia’s trade balance, but it is the country’s inability to shore up domestic political and production issues as well as react to the price drops that is significantly hurting Mongolia’s economy, not Chinese GDP growth.

It is also important to note that a slowdown in China’s economy and a subsequent drop in input prices could in fact help Mongolia’s economy, rather than hurt it. According to the CIA World Factbook, in 2012 Chinese products accounted for the largest share of Mongolia’s imports, coming in at 37.6% of total imports compared to the next highest import partner, Russia, at 25.7%. If prices of these imports dropped due to a slowdown in demand from the Chinese economy, Mongolian industry might actually see a boost as production costs could fall, making it easier for them to achieve higher margins or react to the external pricing environment. While it can be argued that the decline in input prices will be negligible compared to the drop in output prices for Mongolia, this hypothetical situation acts to further support the point that, despite recent claims by the Asian Development Bank, a slowdown in China’s GDP growth cannot be blamed for the drop in Mongolian coal export volume.
2 - The decline of capital availability in emerging markets is hurting Mongolia’s FDI prospects.

According to the U.S. headquartered Institute of International Finance, 2013 private capital flows to emerging markets will decline $36 billion relative to 2012. For 2014, they predict a further decline of $33 billion, the lowest level since 2009. On a simplistic level, this would indicate that Mongolia should struggle to find capital in the global markets.

Yet there are two important distinctions to be made between Mongolia and “emerging markets” when looking at capital flows. The first is a classification issue. Mongolia is not an emerging market. Rather, it is a pre-emerging market, or a frontier market (and is arguably a pre frontier market). This is an important distinction because of the inherent differences between what capital markets consider to be emerging markets vs. frontier markets. As David Larrabee, Director of Member and Corporate Products at the CFA Institute, points out, “The stocks of emerging market firms are often leveraged to the fortunes of the developed world, [while] frontier market [investments] tend to be more pure plays on the growth of their home countries.” As such, the sell-off of assets in emerging markets hasn’t been realised in the frontier markets. In fact, the opposite has occurred. As of the beginning of September 2013, mutual funds focused on frontier markets have seen inflows of $1.5 billion, while mutual funds that invest in emerging markets have seen more than $2 billion in outflows. This trend has been supported by the fact that frontier markets have simply been outperforming emerging markets. Through August 2013 the MSCI Frontier Market Indices have returned 10.5% for the year, while the MSCI Emerging Market Indices have returned (11.9)%. When making this separation, it is easy to see that the global sell-off of emerging markets investments hasn’t, and shouldn’t, affect Mongolia simply because it fits into a category untouched by this trend.

The second distinction is that, unlike emerging markets such as the BRICS (Brazil, Russia, India, China and South Africa), Mongolia has and will continue to rely on singular investment projects to drive its economic growth through the foreseeable future. Undoubtedly, this has been the case with Oyu Tolgoi. Mongolia’s economy doesn’t have the capacity to support multiple large-scale investments, thus it is dependent upon the actions of one or two investors. The sample size is too small to judge using trends in the global capital markets. Even if frontier markets were to experience a 40% decline in assets under management or available capital, how would this actually affect Mongolia’s $10 billion economy? Unless you were to argue that the one or two major investors would see a decline in global numbers, perceive the frontier markets in their totality to be depressed, and therefore decide that Mongolia isn’t a safe investment, the decline in global capital availability is irrelevant for Mongolia. And as Larrabee stated, investments into frontier markets are a play on the growth of the home country, not on the fortunes of the global market. As evidenced by the fact that even in its slower state Mongolia is projected to be one of the fastest growing economies in the world over the next 5 years, it is unlikely investors would employ this logic.
3 - When the real estate bubble in Inner Mongolia pops it will bring down Mongolia’s real estate market.

Inner Mongolia is an autonomous region of China, established by the Chinese Communist Party in 1947. Whatever your political leanings, the fact remains that Inner Mongolia is a part of China, not Mongolia. The politics are different. The culture is different. The economies are different. And importantly, the real estate markets are completely separated and insulated from each other.

Inner Mongolia’s real estate boom and imminent crash has been built upon speculation in the luxury market. This is most evident in Ordos, a desert city located about 560 kilometres west of Beijing. Similar to Mongolia, development started about 10 years ago when one of the largest deposits of coal in China was discovered there. However, unlike Mongolia, luxury housing development started at the site of the mine on pure speculation and quickly grew with the expectation that the proximity to the mine would bring about 1 million new residents. This would be comparable to speculators developing high-rise luxury apartments in Khanbogd because of its vicinity to the Oyu Tolgoi deposit. Since Ordos’ development was not based on existing demand fundamentals, the city was left largely unoccupied (in 2010 only about 28,000 people had taken up residence), eventually being dubbed “The Biggest Ghost Town in China.”, As Patrick Chovanec, a professor at Tsinghua University's School of Economics and Management, points out, Chinese investors bought residential units in Ordos because of an anomalous demand for empty apartments. He explains, “Demand for empty residential units as a store of value (like gold) is real demand, but it’s also a historical aberration. It’s based on a highly unstable set of unique circumstances, including (1) limited investment alternatives for Chinese savers, (2) a limited track record, since China converted to private home ownership in the early 1990s, in which investors have never really seen a sustained downturn, and (3) minimal holding costs for idle property, including the absence of any annual property tax.”

This situation in Inner Mongolia, portrayed through the story of Ordos, has not been replicated in Mongolia. Real estate growth has been centred in Ulaanbaatar, not secondary cities close to the mines, and has been driven by demand fundamentals such as undersupply of housing due to in-migration and rising disposable income levels. The fast rising prices have been a factor of supply and demand dynamics, not overhyped speculation. There is no basis for comparison between the real estate market in Inner Mongolia and Mongolia, and it is unfounded to claim that one will affect the other.


V - Key Steps to Securing Long-Term and Sustainable Economic Growth

Criticism is easy, solutions are difficult. This is why it is necessary not only to challenge the ideas of others but also to offer our own opinions on how to improve Mongolia’s economy. There is a natural divide in the following ideas: those that are already being discussed within the GoM and those that are not. Therefore, the following section is split into those two categories.
1 - Ideas Currently being Discussed by Mongolian Government
A - Issue a Local Currency MNT Bond

The “Original Sin” hypothesis, first introduced by economists Barry Eichengreen and Ricardo Hausmann, states that less developed countries are more vulnerable to international financial crises and economic shocks because they are unable to use their domestic currency to borrow abroad. This exposes them to currency mismatches (projects that generate local currency but are financed in foreign currency), which become problematic for the developing Governments when the local currency depreciates against the foreign currency in which they borrowed, making it increasingly expensive to service their debt. This can create an unsustainable situation in which rising financing costs cause the currency to depreciate even further as Government debt levels increase, acting to cripple developing economies that both depend on imports and access to foreign capital. Mongolia is one example of such an economy.

Looking at the recent trends, Mongolia’s current debt situation seems to be straight out of a textbook. As previously mentioned, in November 2012 Mongolia had a $1.5 billion debt issuance, selling the 10-year bond at a yield of 5.125%. However, as of September 13, 2013 yields have risen over 300 basis points to reach a yield of 8.171%, while at the same time the MNT has experienced a precipitous decline, falling from 1,392 MNT/USD on the date of the Chinggis Bond issuance to an all time low of 1,722 MNT/USD on September 12, 2013. This leaves Mongolia in a difficult situation as the depreciating MNT means that the USD-denominated Chinggis Bond becomes progressively more expensive to maintain.

Therefore, in order to both increase its access to capital and hedge its one-sided currency exposure, the Mongolian government should attempt to issue sovereign debt in MNT. Besides currency hedging, this will also force the Mongolian government to employ credible and efficient monetary policy. On the one hand, by having USD denominated debt the incentive to inflate away domestic debt will be diminished because higher inflation will lead to significantly higher borrowing costs. On the other hand, if a mandate is issued to attract investors and then maintain low borrowing costs for MNT denominated debt, the government will be forced to implement a solid framework to ensure stable monetary policy. Otherwise, as described in “The Original Sin” theory, the Mongolian government will simply find no interest for MNT denominated debt in the international bond markets. Lastly, Mongolia has the opportunity to give a much-needed boost to the Mongolian Stock Exchange’s (MSE) volume and liquidity by listing this debt locally. This can help to legitimise the exchange as a whole and create new sources of domestic capital.

While it is easy to sit back and say that Mongolia should issue debt in MNT, it is a different story convincing investors to buy. However, the environment is right for this type of bond issuance. First, coming off the announcement on September 18, 2013 that the U.S. Federal Reserve will continue its asset purchasing through quantitative easing, global bond markets have seen yields tighten, meaning that appetite for higher yield in emerging market sovereigns should gain traction in the near term. Second, with the MNT at an all time low, investors should realise that by investing in MNT denominated bonds they would have opportunity not only for yield but for currency appreciation as well. The MNT/USD rate has averaged in the 1,200-1,400 range over the past 10 years, and in the mid-term should return to those more sustainable levels. It is important to note, however, that these factors play a role in the short-term, thus necessitating that Mongolia issue MNT- denominated debt sooner rather than later. If the government is able to have this foresight and take action within the next few months, we feel that a successful bond issuance could have extremely favourable effects on Mongolia’s long-term monetary stability.
B - Sign a Definitive Peace Treaty with Rio Tinto

Mongolia is at the point where it needs the Rio Tinto debacle to be over. Whether Rio Tinto was irresponsible, greedy, arrogant, or even outright dishonest is irrelevant. There is more for Mongolia to gain by throwing in the white towel and moving forward than there is by reworking a better deal for the Oyu Tolgoi mine. Investors are waiting on the sideline for this dispute to be resolved, and the amount of FDI lost is far more significant than the amount of additional revenue that could be gained or costs that will be incurred. It is true that Mongolia may have gotten the short end of the stick, and may consider the investment contract to be a loss, but the Mongolian government must learn from its mistake, put aside its pride, and move forward in order to regain the trust of foreign investors. The dispute is preventing Mongolia from attracting bigger, better investments, which it now has the opportunity to make more favourable for the country by applying the lessons it learned from Oyu Tolgoi.

Furthermore, by owning and managing a 34% stake in Oyu Tolgoi the GoM faces a significant opportunity cost. By employing time and effort to the daily operations of the mine, the GoM is reducing its ability to focus on the more important issue, running the country. It has a partner who has been conducting mining operations since 1873, so why not convert its 34% into higher royalty payments and instead focus on creating a comprehensive legal framework for mining FDI. Both Rio Tinto and the government of Mongolia would benefit from this agreement as profits and therefore royalties would increase, and they would be able to move forward doing what each does best. In the long-term, Rio Tinto and Oyu Tolgoi will be but a distant memory compared to the potential economy that can be created in Mongolia. A young economy like Mongolia must accept the pains of development, realise they are a necessary part of its growth story, and move forward with managing the country’s (and not the mine’s) development.
C - Establish a Sovereign Wealth Fund

According to Clay Lowrey, the former U.S. Treasury Assistant Secretary for International Affairs, a Sovereign Wealth Fund (SWF) “is a government investment vehicle which is funded by foreign exchange assets, and which manages these assets separately from official reserves.” Importantly, as of 2009 over 70% of SWF fund dollars were sourced from the sale of natural resources. The idea of a SWF has been popular among resource rich countries for a variety of reasons, but there are three that are of particular importance for Mongolia.

First, these countries have understood the value in turning the resources, or capital assets, into foreign financial assets that can then be saved for a rainy day or used to create intergenerational wealth. This concept is vital for countries that rely upon the sale of natural resources for Government spending because natural resources are both non-renewable and subject to external pricing shocks, creating uncertainty and volatility in spending abilities. This concept proved vital for Chile when in 2008 the global financial crisis hit, sending copper prices and production levels tumbling (copper accounts for around 15% of Chile’s GDP). However, the fact that the central government’s financial assets equaled roughly 20% of GDP in 2008, “allowed the government to significantly ease fiscal policy during the bust. Not only did Chile weather the storm better than others, but its fiscal support package (which relied upon a $9 billion withdrawal from its SWF) was entirely domestically financed.” ,

This is an important lesson for Mongolia considering that in 2012 mining accounted for roughly 25% of GDP growth. As previously discussed, this left Mongolia susceptible to global commodity pricing shocks (predominantly to coal), which have slowed GDP growth, sent the MNT soaring, and necessitated that the government finance a fiscal deficit of 8.4% of GDP, the highest level in the last 13 years). If Mongolia had a SWF to tap into for a fiscal support package, it would have had the ability to buffer its economy against the drop in commodity prices and employ government spending without depleting its reserves. As commodity prices are cyclical, there is no doubt that in the future Mongolia will experience another global shock to prices. It must prepare for this scenario by saving the windfall from resource revenues today in foreign financial assets to ensure economic security in the future.

The second reason that SWFs have been popular among resource rich countries is that many have needed to issue debt during the investment stage of their development in order to build the infrastructure to begin generating value. Therefore, they see SWFs as a way to earmark capital earnings from invested resources revenues in order to slowly wind down debt levels in the future. This has been evident in Quebec, where the Jean Charest government set up the Generations Funds in 2006 and began depositing water power royalties paid by hydro electricity producers with the explicit intent of helping to pay down the provincial debt.

Again, this is a lesson from which Mongolia must learn. It has an estimated total of roughly $4.5 billion in external debt and is set to issue another $1 billion through its Samurai Bonds, creating a desperate need for Mongolia to begin planning today for its future debt payments. This becomes even more important when we understand that this debt is issued in foreign currency, therefore creating volatility and uncertainty in its interest payments due to FX risk. By wisely investing the revenues made possible by these debt issuances into a SWF, Mongolia can maximise its development capacity while at the same time lowering its cost of financing by assuring the global debt markets that it will not default on its payments.

The third reason for the popularity of SWF is that underdeveloped countries with small economies that have used natural resources as a way to initiate economic growth simply have not had the capacity to absorb the windfall of resource revenues all at once. This was clearly seen with Ghana, a country that in 2010 began producing oil for the first time and saw its GDP grow from 8% in 2010 to 15% in 2011. Because of its lack of capacity and experience with the new oil revenues, it set up a savings and stabilisation fund in 2011 and parked some of the money into foreign assets until it could figure out how to put it to good use.

It is evident that Mongolia is experiencing the problem that Ghana attempted to avoid by setting up the SWF. Ever since the mining boom hit, the Mongolian government has been pressured to show the population that it will benefit from the influx of government revenue as well. Thus, mining revenues have been spent quickly and irresponsibly primarily through cash handouts and white elephant projects. This has created the situation in which the government has seen its budget deficit rise, but has not experienced any real benefits from its spending. It is clear that the government would be wise to invest the mining revenue into a SWF and let the capital appreciate as it carefully determines the best way to spend it. While short-term gains will be forfeited, long-term stability will be gained in the form of effective government spending.

Though it is oftentimes difficult to understand the need to save when there is such a short-term need to spend, it is evident that a SWF could be extremely beneficial for Mongolia. It is vital that the government uses this savings approach and not fall victim to the political pressures of spending its resource revenues today. While Mongolia has made some efforts towards the goal of managing mining revenues through the establishment of a “Development Bank of Mongolia”, it has had very little real impact due to mis-management and a confused investment remit.

Fortunately, the concept of a SWF is already being discussed by the GoM. There is currently a law being prepared by the GoM and supported by both the World Bank and the Asian Development Bank to set up a Mongolian SWF, which they hope to submit to Parliament in spring 2014. If passed, this legislation would be a major breakthrough for the GoM and would help ensure that the country experiences sustained and independent economic growth in the future.
2 - Our Suggestions for Additional Policy
A - Optimise Framework for Corporate Law, Business Regulation and Public Tenders

Local companies here in Mongolia are suffering from the lack of a proper regulatory framework that both clarifies and encourages business. At the moment, there is an abundance of unnecessary red tape and restrictions on businesses that discourage growth and push entrepreneurs away. These deterrents mainly come in the form of corporate law and business regulation, as well as the public tender system.

The process for raising capital through equity investments in Mongolia is extremely burdensome. The legal process for changing the ownership or share structure of a company for just a single investment can take up to two months and is an administrative nightmare. This is a significant deterrent for a Mongolian based entity looking to raise capital, and limits companies’ ability to expand using either foreign or domestic capital.

This is why many companies opt to structure their businesses using offshore entities. The problem, though, is that this handicaps small and medium size enterprises (SMEs) that either lack knowledge and experience with offshore structures or can’t afford the administrative and legal fees that accompany this process. Yet, Mongolia needs these SMEs in order to diversify the economy and empower local entrepreneurs. It therefore becomes necessary for Mongolia to change this system to make it easy for any company to raise capital domestically and expand. The benefits will be significant, as a growing local economy will help boost consumption and create economic independence for Mongolia.

The other major inadequacy in Mongolia’s business framework is the tender system. It is easy to speak with foreign contractors in Mongolia and discover that they are at a disadvantage to local contractors. This should come as no surprise, as this type of protectionist policy is evident in any developed country and city in the world. Isn’t it natural to assume that the London government would prefer to employ a local contractor rather than a Chinese one for a public waterworks tender?

Yet, unlike the tender systems in London, New York, or Tokyo, these protectionist polices are unofficial. While Mongolia’s tender process is formally considered to be free to all bidders, in reality it is reserved mainly for friends and family of the politicians granting the tenders. This has resulted in the GoM’s overwhelming loss of credibility. Consequently, many outside contractors are beginning to find it a waste of time and money to submit bids, making it increasingly difficult for Mongolia to attract credible and well-established contractors. This is a major problem considering that the scopes of Mongolia’s (and specifically Ulaanbaatar’s) public works projects are far beyond the capacity of local contractors who simply don’t have the human resources, technological know-how, or experience to properly undertake many of the necessary infrastructure projects.

If the GoM wants to effectively develop the necessary infrastructure to promote long-term development in Mongolia, it must limit its protectionist sentiment by creating a transparent and competitive tender framework. By gaining credibility and by granting bids to those who are truly the most qualified to undertake the public works project, the Government can more efficiently allocate its limited economic resources and ensure infrastructure building that will last.
B - Restructure the Tax Environment

Recently, the GoM proposed the following Ulaanbaatar relevant taxes:
Property Gift Tax
City Tax
Service Tax
Legacy Tax
Increases in Personal Income Tax
Vehicle Pollution Tax
Community Parking Tax
City Pollution Tax (for Gers)
Waste Tax

Given the government’s need to generate additional revenue, these tax increases are certainly justified. The problem is that the system for tax collection in Mongolia is highly volatile and inefficient. As borrowed from the M.A.D. 2013 Real Estate Report, “Tax collection systems in Mongolia are not fully automated or integrated, making collection of income taxes patchy. Because of this, tax evasion is rife. Businesses which sit on the boundary between formal and informal trade are often guilty of large-scale tax evasion.” Specifically regarding real estate taxes, “Interpretation of the laws relating to property tax depend greatly on the interpretations applied by individual tax inspectors and are apt to diverge significantly on a case by case basis.” (For more information please visit: http://mad-research.com/mongolia/overview-of-the-mongolian-tax-system/) This inefficiency and inconsistency loses Mongolia’s government a significant portion of its tax revenue, which has a detrimental effect on the government’s fiscal budget. This hurts all actors in Mongolia, even those companies who work to avoid paying their taxes since in the long-term the lack of available capital will limit public infrastructure development upon which all businesses rely.

While creating new taxes will certainly act to increase revenues, the government must first fix its inefficient tax collection regime. By increasing taxes on honest taxpayers while still allowing for others to avoid payments, a greater incentive is created for the law abiding portion of the population to cheat. They may be put at an even greater disadvantage by having to pay higher taxes relative to their peers, and can be pushed further from profitability, or even out of the market altogether. This is certainly not a system that the government wishes to create. Furthermore, it may mean that the increases generate only marginal gains in actual tax revenue. However, by increasing efficacy of tax collection and creating a fair playing field for all in addition to the tax increases, the government can significantly improve its fiscal budget while creating a transparent and consistent tax environment. This will improve the competitive business environment while at the same time providing the government with the revenue it so desperately needs to improve its administrative capabilities and fund necessary public infrastructure projects.
C - Create or Employ a Public Relations Agency for the Government

According to Edward L. Bernays, named the “Father of Public Relations” in his New York Times obituary, “Public relations is the attempt by information persuasion and adjustment to engineer public support for an activity, cause, movement or institution.” As an exercise, place Mongolia in the context of the aforementioned definition and ask yourself if effective use of public relations could not only be beneficial, but in fact necessary, for Mongolia’s economic development. After spending just minutes reading through news reports on Mongolia, it is abundantly clear that Mongolia is in desperate need of a public relations agency to present a unified voice and help convince the Mongolian public, journalists and foreign investors that it is serious about responsible and sustainable economic development.

When the world (and more specifically foreign investors) reads about Mongolia in the news, it is often presented with mixed signals from Government officials who are speaking as individual politicians, not as a cohesive administration. It is certainly expected that politicians will disagree and debate key issues related to the country’s development. This is, indeed, how a properly functioning democracy should work. However, when high-level members of the administration in power present inconsistent views on its policy it leaves the public confused and unsure about where the government actually stands. This creates uncertainty, which as any investor knows, is the most dangerous word that exists when it comes to political risk.

As an example, on August 2, 2013 a report was published by Reuters titled, “Mongolia Says Parliament Approval Not Needed for Oyu Tolgoi Financing.” The basis for this report was a quote by Prime Minister Norov Altankhuyag claiming, “Parliament has already made the decision [on Oyu Tolgoi] and signed their agreement. Cabinet doesn't have to be involved. All issues can be discussed and decided at the board of directors' level.” Yet just two and a half weeks later a quote was published regarding the Government’s decision that it would need to approve financing for the underground expansion. In that quote, Chairman of the Democratic Party in Parliament, D. Erdenebat, exclaimed, “We can survive without Oyu Tolgoi for some period. I don’t consider the Government’s actions to be wrong.” Given these conflicting ideas, what are foreign investors supposed to think? How can they form any cohesive thoughts on what the Government thinks about this issue when two of the highest-ranking officials in the same party offer such differing opinions? This creates a dangerous situation for foreign investors, one in which many are simply not willing to involve themselves.

Furthermore, even when Mongolia attempts to provide a unified, positive message to foreign investors, it is highly ineffective in doing so. For example, in 2011 the GoM spent both time and money promoting its “Eye on Mongolia Campaign” on CNN in order to attract FDI. They even published a website highlighting how attractive Mongolia is as a market for foreign capital. Yet when one clicked through the site, it immediately become useless as all of the information was in the Mongolian language. Given that essentially no foreign investors speak Mongolian, and Google Translate doesn’t even offer Mongolian as a translatable language, this made it very difficult for foreign investors to receive the information that the Government spent so much time trying to convey. Another example can be seen by visiting the website for the Ministry of Economic Development of Mongolia and trying to view the English version page. Here is the link to the site: http://www.med.gov.mn/. While it is possible that the link is too confusing to figure out how to use, it is more likely that it just doesn’t work.

It is obvious that the GoM needs a public relations arm to both eliminate the conflicting messages being sent to foreign investors in the news and to effectively promote the messages the Government does agree upon. The Mongolian government should be encouraging foreign investors through its messages, not confusing them. Take Thailand as an example. In a simple message of support, the Thai Board of Investment (BOI) announced in 2008 that it was creating an immigration “express lane” just for foreign investors. Unlike in Mongolia, this means that foreign investors don’t have to wait on long lines at the airport, and are in fact met with a welcoming environment as soon as they land. Moreover, the BOI established a “help desk” for investors, which assists in everything from obtaining visas and arranging site visits to sourcing materials. Thailand recognises the importance of FDI, and is therefore creating an environment that is easy and hospitable for foreign investors. As another example, the Indonesian Investment Coordinating Board recently launched a worldwide advertisement campaign on international television networks such as CNN and BBC aimed at attracting foreign investment. It paints a positive picture of the country as an investment destination, citing a one trillion US dollar economy, national stability, friendly and smiling people, and a large, young work force. Yes, this is paid advertising. And yes, this may not be the most accurate depiction of the country. But by running an advertisement on BBC news every 25 minutes, Indonesia is at least putting itself in the minds of foreign investors and directing the conversation through its own words, not those of outside journalists and commentators.

Mongolia has a far way to go regarding its foreign investment public relations. Yet by following the models of countries like Thailand and Indonesia, the government will help provide legitimacy for its policy and for the country as an investment destination. It will also present a transparent political environment in which foreign investors can operate with confidence. While Prime Minister Altankhuyag has attempted to begin the transparency process though hosting “The 10 Questions and Answers” sessions, allowing observers to submit questions to be answered by the Prime Minister, the fact that the questions are presubmitted and chosen based on what the Prime Minister wants to answer means that this is only a half-hearted attempt. If the GoM were to truly dedicate itself to transparency and effective public communication, this could remove the stigma that Mongolia is fraught with substantial political risk, thereby actively promoting economic development through FDI.
D - Address the Human Resource Void

According to the World DataBank, in 2011 Mongolia’s total labor force was measured at just over 1.2 million people, an extremely low number given the country’s geographic size. This is a great hindrance to economic growth because without the available workforce, businesses are limited in their ability to increase production through additional human capital and have diminishing returns on production increases since the domestic market size and demand remains small. Mongolia is very clearly missing out on growth opportunities because of this apparent investment ceiling created by the human resources void. It must address this if it wishes to sustain high economic growth figures over the long-term.

Mongolia is next-door neighbours with an extremely large work force, China. Mongolia and China have a tenuous relationship, and it makes sense that the Mongolians are concerned about being economically dominated by the Chinese, yet Mongolia needs both skilled and unskilled workers. If Mongolia is able to look past its differences with China and attract Chinese labor, it has the opportunity to strengthen private sector development and achieve sustained economic growth unhampered by its small population size. As Ortega and Peri concluded, “capital owners respond efficiently to a larger labor pool [created by immigration] by investing more,” which in turn increases the overall size of the economy. Furthermore, they determined that “employment responds to new immigrants one for one, and capital adjusts in order to maintain the capital labor ratio,” meaning that foreign labor acts to create additional jobs, not replace those held by domestic workers. This theory suggests that Mongolia could greatly benefit from an immigration policy aimed not at protecting jobs for Mongolians, but at incentivising immigration and removing the bureaucratic red tape that makes importing labor economically unattractive. By having the foresight to take this small step today, Mongolia will set itself up for sustained and independent economic growth in the future.

The void exists not only in the quantity of human capital, but in the quality as well. Specifically, Mongolia is grappling with a public administration that lacks the capacity, training and skill sets needed to effectively manage the country. This is a significant barrier to economic growth as the government’s economic resources are poorly allocated and it is ineffective in implementing and enforcing its policy. This point was echoed in a speech by Dr. Maria Barrados, the former president of the Public Service Commission of Canada, who claimed, “The success of political and economic reforms [in Mongolia] is critically depending on the governance capacities of the public administration.”

Even though the country has done little to fix this problem, the issue of public administration and government effectiveness has at least been recognised in Mongolia. This is evidenced by the fact that the 2011 World Bank Country Survey (a survey that measures the opinions of key stakeholders in the public sector, the private sector and civil society with respect to the development priorities of the country) revealed that improved governance and government effectiveness was overwhelmingly cited as the key development priority for the country (31% of respondents acknowledged that improved governance and government effectiveness was the most important development priority compared to the next highest, economic growth, which received 12%). As is pointed out in a report by Christensen, Laegreid, Roness and Rovik entitled, Organisational Theory and the Public Sector, the success of governance and government effectiveness is dependent upon public administration. “The administrative structure has a vital importance in a state for it directs the way public policies are designed and implemented. Organisational forms and their modes of operation create constraints on and possibilities for actors’ use of discretion and, as a result, shape their behaviour in the policy process.”

It is clear that Mongolia must take action today in order improve the capacity of its public administration in the future. One key step for the Mongolian government is to increase its focus on and investment in education. As shown by the graph below, public spending on education as a percentage of total government expenditure has actually been on a downward trend since 1998. This is particularly alarming given the fact that over 45% of the population is below age 24, indicating that spending on education needs to be increasing simply to maintain the baseline level that it is at today. If Mongolia wishes to improve the capacity of its public administration, and therefore improve its government effectiveness, this trend must be reversed. This is especially true given the argument made previously that the native population size is small, but the economy is growing rapidly. As government revenues and services increase, further straining the country’s limited human capital, there will be an even greater need for additional qualified public administrators. By fostering a culture of education, Mongolia can create a larger pool of capable leaders to manage the country, encourage long-term economic growth and shepherd the country toward a bright future.
E - Refocus the “To-Do List”

The Mongolian government has a limited capacity to undertake projects effectively. Mongolia is still in the toddler stage of democratic governance and a market-based economy, and cannot afford to be overwhelmed by projects that address the symptoms but not the underlying problems restricting Mongolia’s social and economic development. The GoM and the international agencies that pressure it must take a step back and realise that continuously adding items to the agenda greatly diminishes the government’s ability to undertake and complete initiatives. (Don’t worry. We understand the irony of including a section on shortening the “to-do” list within our “to-do” list, but we think ours is more relevant!)

As an example, there has been much hype and work being done on ger district redevelopment projects. Whether replacing the coal powered stoves with new, more environmentally friendly ones, redrawing the district lines to enable sewerage connections, or figuring out how to incentivise residents to sell their plots so that low-income, stationary housing can replace the gers, a lot of resources are going towards Ulaanbaatar ger district redevelopment via differing and often times conflicting solutions that are being pushed by the various international aid agencies. These are undoubtedly well-intentioned projects that will greatly improve the lives of Ulaanbaatar residents, but should the time and effort be spent on proposing additional Band-Aids to cover the wound, or should the government refocus its priorities to address the cause of the wound? If we take a step back and examine why the ger districts are facing the challenges being addressed by these projects, we are able to see that they are a result of overcrowding due to mass in-migration from the countryside. The main reason for the in-migration into Ulaanbaatar has been the perception of economic opportunity and a better life, whether because of lost opportunity due to a dzud or simply the prospect of attainable fortune in a field outside of herding. Given these realities, the government’s focus should not be on ger district redevelopment projects (which in fact further incentivise in-migration into Ulaanbaatar), but rather it should be on creating economic opportunity and improving the standard of living in the secondary cities. This would slow down in-migration into Ulaanbaatar (and even cause out-migration if done effectively), reduce the strain on Ulaanbaatar’s already stretched infrastructure and public services, and vastly improve the lives of many who move into Ulaanbaatar’s ger districts only to find unemployment, violence and alcoholism. This is certainly not a new idea, but it seems to be one that has become clouded by numerous well-intentioned but perhaps misguided ger district redevelopment projects.

While this is but one example of the overwhelming “to-do” list the GoM, and specifically the Municipality of Ulaanbaatar, faces, it is easy to find many more. Again, by continuously adding on new agenda items, the government has found itself handcuffed and unable to comprehensively tackle any of the important issues that have already been recognised, such as the Sainshand Industrial Complex or the improvement of the rail networks. Both of these projects have been internally acknowledged as essential to add value and lower transportation costs for Mongolia’s exports, yet work on them has been put on hold and replaced by prestigious sounding, but unnecessary, projects like the new airport and the Ulaanbaatar metro system. As previously explained, the GoM does not have the human resources capacity to undertake a multitude of projects at once, so when one is picked up it is inevitably at the expense of another. The idea is not to reinvent the wheel. It’s for the GoM to prioritise, refocus, and devote its full capacity to accomplishing the most pressing goals. This will not only help push Mongolia further down the road of development, but it will also solve many of the symptoms Mongolia faces today in a more streamlined and cost effective manner. This recommendation actually requires less work on the part of the government, but by doing less it can accomplish more through effective development projects.
F - Legitimise the National Statistics Office (NSO) of Mongolia

“Private economic decisions often rely on various types of federal government economic statistics both to form a basic background of analysis on which decisions are made and to provide information on changing trends, on which specific decisions are based.” Boiled down to the core, statistics are the base of planning for government, private sector and individual. They influence decisions on expenditure and investment, meaning that without accurate statistics, decisions can be made that lead to unexpected outcomes. This is why many firms need accurate statistics in order to make business decisions, and will simply opt out of the market if those accurate statistics cannot be obtained.

Currently in Mongolia, official economic statistics are very difficult to come by, and even when they are published they often differ from the statistics listed in the databanks of prominent aggregators such as the international aid agencies. For example, Mongolia’s National Statistics Office (NSO) listed CPI inflation growth in 2012 at 14%. However, the World Bank and the IMF list it at 15%, and the Asian Development Bank lists it at 14.9%. While a 0.1% difference is understandable, a full percentage point difference cannot be trusted as accurate. Furthermore, the NSO’s website is very challenging to use, and its statistics database seemingly hasn’t been updated with information past 2011. Therefore, when you talk to business leaders operating in Mongolia today, many will claim that they simply do not use the reports coming out of the NSO. Instead, they choose to look elsewhere for their information. From a foreign investor’s perspective, this is a major barrier to entry. The fact that it is so challenging to find accurate economic statistics from which to base business decisions makes it risky and difficult to justify committing large sums of capital into Mongolia.

This is why it is vital that Mongolia invest in and change the public image of the National Statistics Office. By cultivating an agency that produces complete and accurate information, foreign investors will feel confident in the decisions they make regarding Mongolia. They will not overlook it as a destination for their capital just because they cannot trust the economic indicators. Furthermore, businesses already operating within Mongolia will make decisions based on accurate information, therefore allowing for a more efficient allocation of their resources. On the surface, this recommendation seems like it will just be a check in the box, but in truth it can have far reaching implications for the country’s economic development.
G - Create a “Nation of Shareholders”

The Mongolian Stock Exchange (MSE) was established by the GoM in 1991 as a mechanism to privatise the large state-owned enterprises. In order to ensure an equitable distribution of assets, a voucher system was created in which all citizens were granted vouchers to purchase shares. Soon after the first auction of shares on February 7, 1992, Mongolia achieved the world’s highest rate of share ownership, creating a “nation of shareholders”. However, following the launch of secondary trading in 1995, many small shareholders began to sell their shares as the under-performing market offered little financial gain. As such, the total number of shareholders shrunk to 135,000 by 1997, resulting in the drying up of liquidity and trading volume.

As of September 30, 2013, the MSE’s market capitalisation was roughly $860 million and the average daily traded volume was around $21,500. Recently, Mongolia has made tremendous progress with the MSE. Most significantly, on May 24, 2013 parliament took a major step towards increasing the market value of the exchange by approving an amended version of the Securities Market Law. Set to come into effect beginning on January 1, 2014, this law features the following significant adjustments according to Hogan Lovells, an international law firm operating in Mongolia:
Introduces of the distinction between legal and beneficial ownership
Increases the range of tradable securities to include derivates, depositary receipts and warrants, thereby increasing liquidity and capital raising opportunities
Provides greater protection for investors during IPOs and takeover through the implementation of stringent requirements on issuers and their advisors in terms of disclosure requirements, update obligations, and sanctions for non-compliance
Increases monitoring and enhances regulation of market participants
Explicitly prevents insider trading and market abuse by defining insider information and holders of insider information as well as prohibiting fraudulent trading, artificial pricing, and misleading clients in order to promote/prevent securities trading
Increases market transparency and reporting/disclosure requirements by making all annual reports and financial statements publicly available
Increases monitoring and efficient regulation by providing the Financial Regulatory Commission (FRC) with greater monitoring and regulatory powers, introducing self-regulating bodies, introducing a dispute resolution body at the FRC, and enhancing the regulatory framework by imposing administrative sanctions on offending persons, expressed in financial penalties.

It is difficult to argue with the fact that this revised law will have a major impact on the capital markets and availability of financing in Mongolia. However, Mongolia has an opportunity to use the MSE as a way to improve governance and accountability as well. In order to do this it must, as described by former chairman of the MSE Bold Baatar at the 2011 Mongolian Investment Summit in Hong Kong, reestablish itself as a “nation of shareholders” that takes a financial stake in the success of its key development projects. By creating this “nation of shareholders” who have a financial interest in the economic decisions of both investors and government, a system will be created by which business executives and government officials can no longer make decisions for personal gain (be it monetary or political) because they will be accountable to a nation that is directly impacted. At the moment, it is very difficult for a low-middle income family to make the connection between corrupt or nationalist government policy and/or greedy business decisions that act to stifle FDI and business growth. After all, how can a household that is struggling to get by be expected to care about the success of a foreign controlled “hole in the ground” hundreds of kilometres away? Yet by taking actions such as requiring that all large investments be listed and made publicly available on the MSE, Mongolia can both provide avenues for wealth generation for its citizens and promote the success of its development projects by making major investors and government accountable to the people. Now that the new Securities Market Law allows for double listings, this is entirely possible.

Yes, it can be argued that if shareholders don’t have the education to understand the complexities of the financial markets they won’t be able to connect government policy with their declining portfolio. But at the very least, these shareholders will begin to have an interest in the decisions being made and policy being passed. They will be incentivised to start learning about the issues that directly affect their wealth instead of sitting on the sidelines forming opinions based on sweeping generalisations like the one that blames foreigners for all of Mongolia’s troubles. Education can transform this country by exposing gross mismanagement in both the private and public sectors. By giving people the motivation to educate themselves, Mongolia can help mitigate the threat of poor decision-making that has so significantly restricted Mongolia’s economic growth.

Furthermore, creating a nation of shareholders will provide a sense of ownership and pride for the Mongolian people. At the moment, the greatest source of pride is Chinggis Khan. There is certainly nothing wrong with being proud of an historical figure, but the Mongolians could use something more recent and applicable to today’s global environment to unite them. If the Mongolian people had a sense of ownership for a major infrastructure project or a Mongolian businesses, the entire country would be excited about advancing and pushing forward economically. They could find strength in the present, and not only be forced to look back 800 years in the past.

Lastly, by having large cap, reputable companies on the MSE for Mongolians to invest in, there will be incentive to keep capital in the country. At the moment, most wealthy Mongolians are finding it necessary to look abroad to park large stores of their capital. Yet by requiring large investments into Mongolia to list on the MSE, the GoM could help stabilise the MNT by creating demand for MNT denominated financial products, alleviate local currency risk to companies who operate in MNT but are forced to find financing in foreign currencies, and increase availability of local capital for Mongolian businesses. Considering Mongolia is in critical need of a stable currency, FX risk mitigation, and additional investment capital, this could be a significant boost to Mongolia’s economy.




VI - Ways to to Promote Growth in the Real Estate Environment

As a real estate investment company, this report would not be complete without commenting on our views of how to improve the real estate environment. There are five main issues that must be addressed in order to push the Mongolian real estate market into the next phase of its development: 1) increase the availability of financing for real estate developers, investors and purchasers, 2) require real estate information to be listed on the public domain 3) create a proper framework for real estate development, 4) end the practice of pre-election promises regarding mortgages and cash handouts, and 5) require real estate professionals to be licensed in order to operate in Mongolia’s market.
1 - Increase the Availability of Financing

It is very difficult to access local financing for a real estate transaction in Mongolia. This is due in large part to the fact that banks are hesitant to issue loans for a development or purchase at reasonable rates because they view the investment to be highly risky. This is not a surprise considering that there is almost no reliable valuation being done on property assets, making it nearly impossible for the banks to properly underwrite and determine collateral on their loans. At the moment, all valuation is done through the observance of comparable transactions. The problem with this, however, is that official transactions are often reported at prices lower than the true asset value, making the practice of using comparable transactions for valuations unreliable. Under Mongolia’s tax law, the seller of a real estate asset is liable for a 2% tax on total income from the sale of the real estate asset. This means that the seller has a strong incentive to lower their tax burden by reporting a sales price below the true transaction value. What often happens is that the buyer and seller will come to an agreement where the official, reportable transaction rate is lowered below the actual sales price, while the rest of the payment is made through a cash transfer or secondary transaction. With the government’s limited capacity for tax auditing, this practice is relatively easy to employ.

Therefore, in order to help banks undertake proper valuations, the GoM should pass legislation granting the municipalities similar rights to those given to French municipalities under the pre-emption law. Under French law, the municipal council has first right to purchase on any transaction and can exercise that right if it can prove that the terms of a transaction are detrimental to urban planning or general interest. If implemented properly, a similar system could be useful for ensuring reliable transaction values in Mongolia. It would eliminate the incentive to cheat on the official transaction price because if it is inappropriately low, the government can pre-empt the property at the officially listed price, thereby forcing the seller to sell it at that price and miss out on the additional proceeds from the secondary (or under the table) transaction.

The other main reason banks find it too risky to issue loans for real estate transactions is that the foreclosure process on collateral assets backing nonperforming loans is lengthy and tedious. In fact, it often takes banks up to 18 months to complete a foreclosure. This acts to tie up the banks’ capital in illiquid assets, and severely limits their ability to push the non-performing loans off their books.

Understandably, under this framework banks often find it too risky to provide financing for real estate transactions, or are forced to charge exorbitant interest rates to balance their risk. If the government wants to incentivise banks to grant real estate loans at reasonable rates, it must make the foreclosure process easier and reduce the amount of time it takes to foreclose on a property. This will prove extremely valuable for the real estate market as developers, investors and homebuyers may finally have local access to financing, promoting healthy transaction volume and liquidity in the market.

All of this being explained, it must be noted that there is a fine line between providing enough availability of financing and providing too much availability of financing through mortgages. While it is vital that the GoM increase the population’s ability to secure a mortgage for a residential property, it cannot create a system that allows for the oversupply of leverage. It must avoid the bubble dynamics that a country like China is experiencing by setting sustainable mortgage rates inline with inflation (unlike the recent 8% mortgages), creating mortgage quotas for the banks, maintaining sustainable house price to wage ratios, and regulating against predatory lending schemes. If Mongolia can encourage banks to provide mortgages while using these techniques to mitigate the risk of overheating in the housing market, it can provide the necessary financing while avoiding a hard crash of its real estate market.

2 - Provide Real Estate Information on the Public Domain

Throughout mature real estate markets, completed transaction details of any real estate property become part of the public domain and are publicly accessible either at a municipality office or on the web. This means that anybody has the right to view not only the purchase price and buyer of a property, but the the blueprints, financial information, copies of permits and geological or environment surveys of any development under construction or under renovation, as well. Importantly, this is applicable to both private and public projects. In Mongolia, however, this doesn’t exist, as only landlords have access to the transaction history and details of a property. Consequently, Mongolia’s real estate market is rife with corruption. It is not uncommon to find politicians storing questionably large amounts of wealth in real estate assets, entirely sheltered from the public eye. There have also been numerous accounts of illegal buildings being constructed (mostly in Zaisan) that don’t have the proper permits or licenses, but can be built because they have the backing of a politician.

Furthermore, as described in the section above, Mongolia’s real estate market is improperly valued since valuations are based on comparable transactions that are both unreliable and simply inaccessible to the public. This not only makes it very difficult for banks to value collateral for a mortgage loan, but it also makes it nearly impossible for an investor or homebuyer to make informed decisions about their purchases.

While these problems are certainly significant, they are easily remedied. By creating an open database of property transactions made available on the public domain, Mongolia can very easily improve transparency and accountability in the real estate market. This will both reduce the opportunity for corruption because it will be easily exposed to the public (especially by a good investigative journalist), as well as inform future transactions and disincentives cheating, as any underreported property sale will be public and obvious. Only then will Mongolia be able to legitimise its property market, creating an environment that is both healthy and competitive.
3 - Create a Proper Framework for Development

As Louis Lesser, a legendary real estate developer in the United States, once commented regarding the difference between development and construction, “Developing is the key word. We don't build ourselves. We buy the land, finance the deal, and then we have the best builders build under bond at a fixed cost.” The important underlying distinction in his comment is that the developers are also responsible for then selling units, or the entire development itself, once the construction is complete. The developers hold the financial risk, as they are the ones who commit the capital. This is different from builders, or the actors undertaking the construction, as they are paid for a job and thus hold no financial risk on whether or not the development is financially successful. They sign a contract, they are paid, and they build. Accordingly, in mature markets developers are held to certain regulations that builders are not. For example, they are required to hold capital reserves backing the development in order to ensure that the project does not go bankrupt midway through. This both ensures that empty shells are not left dotting the skyline and that pre-sale buyers are not left with ownership deeds on units that will never be completed.

The problem in Mongolia is that there is no distinction between a developer and a builder, and anybody who has land and a license to build can act as a developer. This is a dangerous situation because the party actually constructing the development holds the financial risk and is not contractually obligated to pay a fixed fee to a third party, thus guaranteeing that they have the funds at the time construction begins. As a result, there is a significantly greater likelihood of bankruptcy and failure mid-project. This, of course, leaves pre-sale investors or buyers stuck, especially in Mongolia where legal recourse is timely, costly, and often ineffectual. In addition, there is no legal recognition of off-plan contracts as the buildings are not registered until the construction is complete and the building is checked by the State Inspection Office. This leaves investors vulnerable to scam because they have no possibility of conducting due diligence checks on pre-sale purchases since property ownership certificates do no exist in the pre-sale phase. Thus, developers have the ability to oversell the buildings and then flee the country prior to completion, leaving investors with no recourse to recoup their capital.

This is why Mongolia must establish a legal framework for real estate development. Mongolia (or specific municipalities like Ulaanbaatar) should set up a government agency that both approves development projects and monitors them. By no means an exhaustive list, the agency should assess whether the developer has the project pre-financed, has proper capital reserves in case of unexpected shocks, and has a feasible and actionable development plan. By doing this, Mongolia would both encourage investment and homeownership by protecting buyers and it would improve its urban planning capabilities.

It would also benefit Mongolia if the GoM were to implement a Business Biodiversity Offsets Program. The basic premise behind this program would be to assign a financial value to the environmental and societal impact that a new construction would have on its immediate surroundings and then require the developer to make a greater investment into a new park, additional trees, or some other environmentally positive project to offset the negative impact. At the moment, every new development in Mongolia negatively impacts the environment surrounding it, meaning that the developer benefits financially at the expense of the rest of the population. By implementing a law to require a net positive impact through a Business Biodiversity Offsets Program, Mongolia will develop in a way that all of society benefits, effectively maintaining the quality of life for its residents.
4 - End the Practice of Issuing Unreasonable Pre-Election Promises about Mortgage Rates

Mongolian politicians have a history of issuing pre-election promises that have proven to be incredibly damaging to the country’s economic stability. This has particularly been the case with promises relating to low-mid income residential real estate, due in part to the fact that over 60% of the city still lives in ger areas. While there is no doubt that the city has a desperate need to provide opportunities for its residents to purchase affordable housing, it cannot achieve this goal through overinflated promises of subsidised mortgages.

Two projects of note that have proven extremely costly for Mongolia’s economy have been the 6% mortgages associated with the 100,000 Homes initiative and the more recent 8% mortgage subsidy. The 100,000 Homes initiative was one the central components of the New Development Programme (NDP), an ambitious development plan that passed through parliament in June 2010 and was set to run through 2016. The aim of the scheme was to provide affordable housing for low-income families, with the bulk of the construction (75,000 new apartments) being in Ulaanbaatar. To supplement this plan, the Mongolian Housing Finance Corporation later announced in November 2011 that it would offer eligible first-time homebuyers a 6 percent, 25-year long mortgage for apartments less than 50 square meters in size in order to provide the low-income families with the financing to actually purchase these apartments. Importantly, because the rate of the loans were artificially low given inflation in Mongolia, the government would be required to subsidise the rest of the interest payment, amounting to an additional 400-500 basis points. While this was certainly a useful tool that the Mongolian People’s Party (MPP) was able to emphasise and exploit just four months before the 2012 parliamentary elections, the loans were entirely unsustainable in the long run. Furthermore, since these mortgages were an MPP initiative, when the DP took power following the elections they quickly shut the program down.

In order to make residents forget about the rosy opportunity they would have had through the 100,000 Homes initiative, the DP created a subsidised mortgage program of their own to sell to the public. Conveniently just nine days before the 2013 presidential elections, the DP began issuing housing loans at 8% (+/- 1%) interest rates for up to 20 years through their Housing Mortgage Program. Just like the 6% loans, these new 8% loans were completely unsustainable given the current market conditions. While this became abundantly clear following the launch of the program, Prime Minister N. Altankhuyag repeatedly insisted that the program would not stop. However, on September 19, 2013 during his weekly address to the press, he quietly acknowledged its failings. “The program may stop, as people are afraid it might be influencing currency fluctuations.” Again, the people of Mongolia are being left disappointed by a pre-election promise that was simply too good to be true.

Besides continuously letting down a population that must forego the hope of being able to buy a home, these pre-election mortgage and various cash handout promises are crippling the future potential for economic gains in Mongolia. All they have been able to accomplish is to subsidise the politician-owned construction and development companies, raise inflation, and reduce government reserves, effectively stagnating the economic growth that would truly increase standard of living for the majority of Mongolia’s population. While politics will always play an important role for politicians, the country would gain tremendously if politicians stopped exploiting short-term gains at the expense of long-term stability. If instead of promising policy that is clearly unsustainable, politicians successfully educated the voter base on why a long-term, fundamental approach will serve them better, they could win elections while allowing Mongolia to move forward at the benefit of all. It isn’t expected for pre-election promises to stop altogether (these are common practice among even the most seasoned democracies in the world), but the ones that serve to damage the economy must be put to an end. Only then can Mongolia take approaches that span longer than four years and serve to increase the standard of living for the entire population.
5 - Better Regulate the Real Estate Industry Through Requiring Licensing and Certifications

On August 16, 2010 the Singaporean Parliament passed the Estate Agents Act, requiring all real estate firms to be licensed and all real estate salespersons to be registered with the Council for Estate Agencies (CEA). Importantly, to become registered, a broker would have to pass the Real Estate Salesperson examination administered by CEA. As Thomas Lee, executive VP of Resale Division at Debenham Tie Leung, DTZ claimed, “In the past, it was common to see people who try to join the real estate industry. They take advantage of the positive property market sentiments, close a few deals, only to exit and disappear when the tide turns. This was detrimental to the industry as these people [were] not serious and more importantly, [were not] well versed with the financial and legal workings involved in a property transaction”.

Just as Thomas Lee explained about the Singapore real estate market, Mongolia is currently filled with unlicensed players who can join the real estate market at will. This has created the cowboy investment environment often proscribed to Mongolia, in which people with very little knowledge and often little moral compass join the real estate industry in pursuit of short-term opportunity. As a result, many transactions occur illegally, unethically, and using misinformation. This undermines the credibility of the industry as a whole, and acts to hurt the players who can actually contribute to the development of Mongolia’s formal property market.

It is therefore of vital importance that the GoM regulate the real estate industry by requiring brokers, asset managers, valuators, etc. be properly licensed. This should include passing an internationally accepted standardised exam, and maintaining this status through continuing professional education. For example, Mongolia could employ the valuation standards created by the Royal Institution of Chartered Surveyors (RICS), which is being increasingly utilised by emerging markets to ensure that their standards meet international expectations. By creating various licensing and certification systems for real estate professionals, investors can at least be confident that they are working with somebody who was deemed qualified by a state or international body, diminishing the risk of scam by actors who claim to be more qualified than they are. This should help attract more capital into Mongolia’s property markets, and will promote a professional and sustainable real estate environment.


VII - Conclusion

There is no doubt that it is a dark time for Mongolia’s economy. In fact, we at M.A.D. think things will get worse before they get better. We expect that GDP growth could slow to a pace of 8-9% for FY 2013. Even if Rio Tinto gets resolved and the new investment law is perceived favourably, it will take time for foreign investors to digest the new investment law, reestablish supply lines, and become acclimated once again to the fast changing business environment in Mongolia. We also see the MNT sliding to a level above 2,000 MNT/USD through Tsaagan Sar 2014 (the Lunar New Year in February), a time when the MNT has historically hit the trough of its annual cycle. Since the Bank of Mongolia is predicted to run out of foreign currency in the next six months, the GoM will have a very difficult time responding to this currency crises. Also, while the Bank of Mongolia has held inflation in check this year, the depreciating MNT will inevitably equate to a rise in inflation as a majority of consumer goods are imported from abroad.

Furthermore, representatives from the Ministry of Finance recently announced that due to a shortfall in export royalty income its fiscal deficit is already over 5%, significantly above the 2% threshold set by the Fiscal Stability Law. As explained by Visor Capital, the government had originally built into its budget that the country would sell 30 million tonnes of coking coal at a price of $160, but in reality exports will most likely only reach 12 million tonnes sold at an average price of $70. The unfortunate result of this scenario is that, according to the Fiscal Stability Law, if the year-end fiscal deficit comes in above the 2% threshold the government will be required to employ austerity measures. This could have substantially damaging effects on the already fragile economy that so greatly depends upon government spending to prop up demand and GDP growth.

In terms of real estate, we foresee a continued collapse of the luxury residential sector throughout the city, but primarily in the suburban zones surrounding Ulaanbaatar with Zaisan being impacted the worst. This downturn has been triggered by both a recent exodus of executive expatriates who supported the rental market and a lack of comprehension by developers of actual demand levels for such a product.

A vast number of mixed-use developments in the Zaisan, Nukht and Yarmag areas are now considerably under-used and see increasing rates of vacancy. The office sector, in particular the Grade A and B buildings, will continue to see considerable oversupply with a number of new large scale developments coming online over the next six months. We do not expect for the office oversupply to be absorbed before 2016 at the earliest, thus prices will continue to fall and are likely to stabilise at a $25 / sqm month average. Retail units in the city centre are likely to see reduced transaction liquidity and a marginal drop in price, but are likely to retain general value stability despite an increased turnover of tenants. Retail developments outside of the city will struggle to source tenants as businesses and services are increasingly refocusing their operations to the heart of Ulaanbaatar. It is likely that retail developments in Zaisan, but particularly in the Nukht and Yarmag areas, will see a majority of vacancy and price drops throughout 2013/2014. The mid-end residential sector, particularly in the city centre, will likely be the most resilient throughout the current crisis as strong demand continues to be seen and supply remains limited. This sector might well be the only real estate sector in Ulaanbaatar that continues to see capital growth despite the economic crisis in Mongolia.

While it is difficult to be overly positive in the short-term, investors must realise that in the medium to long-term there is a bright light at the end of the tunnel. It is clear that the GoM has now realised the gravity of the situation and is working to rectify it, meaning that the political and legal environment should begin to improve relatively soon. Also, the long-term fundamentals remain, meaning that those who are willing to risk the dark times and remain committed to this country are likely be rewarded in the future. In fact, today might actually be the best time for an investor to enter the market. At the moment there are far fewer investors competing for limited investment opportunities, meaning greater negotiating power, and more liquidity as distressed sellers are getting anxious to dispose of their assets. After all, as Warren Buffet once claimed, the best time to buy is “when [the asset is] on the operating table.”

As evidenced by the list of recommendations presented in this analysis, there are certainly steps that the GoM can and should be taking to expedite this process. But as also shown in the paper, the fundamentals behind Mongolia’s growth persist regardless. We at M.A.D. certainly understand Mongolia’s short-term struggles, but we remain bullish on the long-term growth story. It is our belief that investors should too.

SOURCE OF THIS ARTICLE : MAD Research