Mongolia: A Case Study in Foreign Direct Investment

We had a chance to speak with Marius Toime, who is currently a project finance partner at Berwin Leighton Paisner’s office in Singapore, where he specializes in mining contracts and financing in the Asia Pacific Region and is a noted expert on investment in Mongolia, on which he has written extensively.

SD: As you noted last year in the FT, Mongolian FDI has seen a 62.4% plunge in 2014. Coupled with a declining currency and energy prices, as well as continuing issues at Oyu Tolgoi and further uncertainty with Tavan Tolgoi, it looks like a perfect storm for a recession. Is there light at the end of the tunnel and how long will it take to reach?

Toime: GDP growth has been slowing dramatically. Debt at the government level has been increasing and is currently beyond statutory limits, and there is a real risk of a country-wide default. Although all of these economic signals are quite concerning, the new prime minister has taken quite definitive steps in order to avert a significant economic crisis. I think ultimately there is a light at the end of the tunnel; Mongolia does still possess an enormous amount of opportunity as a source of wealth. But there is much more that needs to be done with the current coalition to make that happen, and the largest part of that is the Oyu Tolgoi copper mine project. If project financing goes ahead, then the impact on GDP will help the country to a great degree and help restore confidence in other projects.

The other element is that the government has recently announced the layoff of some 1600 government officials, and the slashing of certain public welfare programs, as well as a mortgage subsidy that they removed some time ago. So they are taking steps to reduce the current debt burden.

SD: What are general indicators of fertile ground for foreign direct investment, both generally, and for mining and energy? Apart from presence of exploitable natural resources, what metrics and indicators do investors value when making a decision to take a position in emerging or frontier markets? Does foreign involvement in one sector spur interest in other sectors, and how quickly is this process reversed when things go wrong? Additionally, what is the role of international organizations like the WTO or the World Bank, and how much of an influence do they possess?

Toime: Typically for both frontier and emerging markets (Mongolia would generally be classified as a frontier market), investors are typically looking for favorable demographics, growing consumption levels, relatively low debt levels, and room for productivity gains both within particular industries and as a whole. Mongolia is rather particular in that it has quite a small population, especially in comparison to some of the other “tiger” economies. There is a very significant population that is emerging into a wealthier class, which then leads to higher consumption growth. Mongolia has positioned itself as primarily a mining play, and ironically that is also something the government has tried very hard to diversify away from. But mining remains the central attraction to Mongolia for foreign investment. Now that’s not to say that there isn’t interest in infrastructure and industry as opportunities for investment – agriculture, for example is one area that there is interest in from abroad. Nevertheless, the overriding attraction comes down to natural resources. Part of the current bevy of problems, putting aside the obvious regulatory ones, is that the commodities market is in its downcycle at the moment. This is particularly true for coal, which has major implications for the Tavan Tolgoi coking coal deposit. Because it’s state owned, there was a lot of hope this deposit would help turn things around. So given Mongolia’s reputation as a natural resources play, it is vulnerable to market fluctuation and the cyclical nature of the commodities business. This is all part and parcel of Mongolia’s current issues. At the same time, despite lower prices and lower confidence, any progress made on Tavan or Oyu Tolgoi is going to have a significant impact on GDP growth.

The other thing to keep in mind is that there is a broad coalition of ten international banks, who have devoted research funds to Oyu Tolgoi. However, they’ve put all of their investments on hold while the government does battle with Rio Tinto and try to make amendments to the shareholders’ agreement of Oyu Tolgoi. So this has created something of a bottleneck. These foreign banks will effectively not really provide financing for Mongolian projects because they already have an aggregate commitment of some $5 billion to the Oyu Tolgoi project. That’s part of the significance of the project to Mongolia and why it is currently seen as something of a bottleneck. Mongolia is actually delaying other projects in the mining and energy space and more broadly in other sectors as well due to this lack of access/hostage-taking by Western capital markets. Broadly speaking, these kinds of assurances are particularly important to investors.

Due to the high debt levels of the Mongolian government, it has also actively pursued infrastructure projects using Western capital markets, which are important not only for generalized economic growth but also for the movement of dry bulk products from the mines to China.

SD: So the Mongolian government is trying to diversify away from being quite so mining-dependent – what other sectors have seen development in this regard?

Toime: Agriculture is the primary one. Textiles is another. Infrastructure, both in terms of transportation and telecommunications. However, none of those sectors have attracted anywhere near the attention that the natural resources sector has attracted. For agriculture, one of the reasons why it hasn’t seen the same level of development as mining is because every few years, Mongolia suffers a very severe winter. So that reduces the predictable cyclicality of that market that is usually a required mainstay of other agricultural markets throughout the world. Mongolia is also geographically relatively isolated, landlocked, and wedged between northern China and Siberia. That presents problems in terms of routing exports out of the country. Nevertheless, Mongolia is sitting next to two of the largest economies in the world, Russia and China. And China is the largest energy consumer in the world. So there are significant opportunities there, especially as Russia continues to pivot towards China and Asia as a result of Western sanctions and the Ukraine issue.

SD: The big news coming out of the country in the past month has been the selection of the consortium led by Shenhua, Sumitomo, and Mongolian Mining Corporation over Peabody Energy. How equitable was this process, and considering how large the coking deposit is, will the incoming Mongolian administration be able to use this development to signal a turnaround to foreign investors?

Toime: If we look back at the history of Mongolia over the last five years or so, the reason why foreign investment has shrunk so dramatically has been primarily due to those two factors mentioned earlier: the Oyu Tolgoi bottleneck and declining commodity prices worldwide. It’s in this context that we have to take a look at Tavan Tolgoi and the Mongolian government’s behavior. They’ve created prepaid coal arrangements with the Chinese by taking this deal for development by Shenhua and Sumitomo. But there have also been contract settling disputes with Freeport-McRoran that is developing a smaller part of the coal deposit. For Tavan Tolgoi, most of the attention has been on the auction but when we get to the project financing phase, that’s where most expect to see problems surfacing, particularly for mining companies that are already struggling with massive debt obligations of their own. I don’t think there’s anything to suggest that the procurement phase of the project which prompted these negotiations with the three party consortium was not in agreement with Mongolian government procurement laws – but the problem is that there have been a number of auctions and tendering efforts for Tavan Tolgoi over the years and none of them seem to bring the project closer to any development. I believe that there is a bit of Chinese pressure despite the fact that the Chinese have large coal deposits of their own. Given Tavan Tolgoi’s location adjacent to the Chinese border, it always makes sense for China to be involved, but there will always be some political sensitivity to that idea within Mongolia.

SD: As you noted, the Chinese have a captive audience for Mongolian coal. However, Chinese coal consumption in 2014 was less than the previous year for the first time this century. Do you make much of this? If so, are statements made by Beijing regarding the CPC’s alleged shift away from coal and towards natural gas ones to be taken seriously? How might this shift affect Mongolia in the medium to long term, given the monopoly China currently holds over Mongolian coal?

Toime: My view is that Beijing is committed to developing alternative energy sources. I think between January and June of 2014 they installed somewhere around 2.3 Gigawatts of solar capacity, which required some $23 billion worth of financing solar ventures. That constitutes a large expenditure than solar in all of Europe put together. From China’s perspective, it’s looking at domestic issues at home as being the top priority, so protests around inequality and reports of soil and water pollutions are real issues and have been identified by Beijing as such. Coal supply is a lesser, long-term issue for them. They realize there will always be demand for coal in China, but it will grow to be a bit less as China transitions from a manufacturing-based economy to a service-based one? There is a place for coal in its supply chain, of course, but I think of more import for them are clean-coal technologies.

What does this mean for Mongolia? In order to stay competitive and be less dependent on coal prices for project advancement and government revenue, it really needs to move forward with infrastructure development. Railways down to the Chinese border are an absolute necessity because they reduce freight costs and lower the price of Mongolian export. All of it right now is currently being trucked across, which is economically inefficient. Mongolia also needs more sources of downstream domestic processing for its coal. But to do any of this, the mines have to get up and running first. And unfortunately the past actions of the Mongolian government have really rattled the foreign investment community and so now Saikhalenbileg must take steps in order to attract investment back to the country, but I think that’s just going to take time.

SD: Could Mongolia diversify its customer base for coal to other Asia-Pacific players – certain other countries spring to mind like Japan due to its nuclear power issues or perhaps South Korea? Or is this too logistically difficult to even consider?

Toime: Well, certainly there are other significant coal deposits up in the northern region closer to the Russian border. But Siberia is already a large coal producer, but this hasn’t stopped some mining companies from sending test shipments on Russian railways to Vladivostok. The key problem here is moving the dry bulk export to the seaborne market. So there are really two options. The first is to go up through Russia to Vladivostok and the second is to go south through China to Chengdau and by both methods the product can then get to its end market. The logical question, then, is whether Russia or China would be willing to allow easy passage. What taxes or dues would be levied on it? If China really needs this coal for itself, will it allow transportation of another country’s key commodity to pass through its own port and out to other countries? And Russia is also a large exporter – will it allow competition product to pass through? So there are significant challenges, but at the same time there are ambitious infrastructure plans in place for Mongolia to connect with both Chinese and Russian railways. In order to increase value and competitiveness, the best thing Mongolia can do is develop downstream processing plants within its own borders. It’s currently exporting only raw product, which decreases the price of its exports to key customers and is ultimately a lost opportunity. Somehow they have to develop that domestic industry in order to add value to their existing resources.

SD: What steps could the new government take to restore confidence? Stemming largely from investor discontent and economic decline, Mongolia’s State Great Hural passed a new foreign investment law in 2013 designed ostensibly to liberalize policies that govern foreign investment and make consistent investments laws for both national and international companies. Nevertheless, foreign companies have on occasions been denied access to the Mongolian market for seemingly protectionist reasons. Will this persist, and what steps will be needed to display a more agreeable environment for foreign investment?

Toime: The biggest tangible thing that they can do right now is resolve the dispute around Oyu Tolgoi. Once that happens, it will release a major bottleneck and help get foreign funds flowing back into the veins of the Mongolian economy. That’s the single largest aspect of the current situation that is firmly within the government’s power to resolve that will restore a great deal of confidence. Apart from that, reversing several of the less-friendly rules and regulations concerning foreign investment will help, increasing institutional capacity, reducing external debt loads. This is occurring – the Mongolian Central Bank has done a good job managing inflation and the extreme decline of the tugrik. However, these efforts are mostly piecemeal and the main element that will bring money back into the country is solving of this Oyu Tolgoi bottleneck. These other points are all slow-burn, in other words, they will take a long time to resolve.

SD: In relation to Oyu Tolgoi, we’ve already touched on the disputes over management fees and the citation of Mongolian regulations, but could you go into what the original source of the disagreements between Mongolia and Oyu Tolgoi’s developer Rio Tinto group were and how they have evolved into this current situation?

Toime: There were a number of factors. The original stipulations of the agreement were constantly renegotiated by both parties, but primarily by the Mongolian government, there were significant disputes over the development costs of the mine itself and trading costs. Mongolian officials were questioning some of the expenditure on the project. Taxes, as well, were the other issue. As for the motivation behind these disputes, most of them have been driven by nationalistic sentiment. The core issue at stake is the sanctity of the contract – and Mongolia signs the contract, but then continually calls to renegotiate it. These actions certainly haven’t done them any favors in the eyes of the investment community. If investors go into the country and cannot be assured of an underlying concession, or contracts with the government whether it’s a power purchase agreement or the paper that’s a central piece of bankability for the project is not set in stone and will not be respected by both sides, then it’s very difficult to proceed.

SD: You mention these nationalistic impulses that drove the near-breaking of this contract. There are several opinions in the Western media, dominated by foreign investment interests, what is the Mongolian or populist objection to these contracts? Do they feel like they are getting a raw deal, or is it something more fundamental?

Toime: There is a general distrust of foreigners there – not necessarily a xenophobia, but an understandable lack of trust for companies that come in and try to make money on their land. There is a fundamental misunderstanding, however, since foreign investment is a means to an end – it’s very much necessary to drive improvements in the country. The natural tendency when things are going well – when the commodity cycle was at its apex, there was significant excitement about Mongolia – and populists were raising their hands and asking, “Well, why are these foreigners making so much money on this stuff in the ground that’s owned by the Mongolian people? Why are any foreigners in the country at all?” But foreign investments provides technical and financial contributions that would not exist otherwise, and in the end, only assist in developing the local economy.

SD: You note that when projects are successful, there is a lot of eye-raising internally that generates these disputes over contracts and profits. In the current commodity downcycle, with wealth and investment leaving the country, will the opposite occur and make Mongolia more amenable to foreign investment interests in order to rescue their own faltering economy?

Toime: Absolutely. There’s now a recognition that something needs to change. That the government laid off those 1600 officials is a positive sign. The slashing of public welfare programs and others that are publicly subsidized indicates that their focus is swinging back towards creating an open and stable environment for investors and projects to develop. There’s more of a recognition that foreign investment is needed. But is it too late? There’s a lot of opportunity in Mongolia, but they really need to take steps quickly. Concessions will need to be made.

SD: New Prime Minister Chimed Saikhanbileg came in with a mandate to fix the economy, yet analysts have questioned his ability to alter the country’s downward economic trajectory. As you’ve noted, his job will be one of balancing off interests between populist, nationalistic concerns over foreign investment, and creating this environment that will bring all of that foreign wealth back in to facilitate development. What should be on his agenda, and what role should he play in this?

Toime: Well, Saikhanbileg was part of the old government. So there’s a question whether he is truly sincere, or if he plans on managing the economic decline. Certainly since he’s taken office he’s made the correct announcements about trust needing to be rebuilt with the private sector, bringing together the super coalition and leading them towards a goal. It remains to be seen if he will be successful, however. He only has a short term to do that. If definitive steps aren’t taken in the future, then Western investors will need to wait until the next election. I do think that there is a common understanding that the disputes need to be speedily resolved. Whether that’s possible in his short term remains to be seen.

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