Anatomy of the Current Economic Crisis

Having spent last week in Ulaanbaatar, it is clear to me that the current crisis is a) more severe than I had thought, and b) more real/less perceived than I had thought.

Below, I try to list elements in this economic crisis. I will follow this up with another post that focuses on the political context to the crisis.

Elements in the Economic Crisis

These are the main elements in this crisis:

  • the massive decline of foreign investment
  • a softening of economic growth in China
  • on-going uncertainty around Oyu Tolgoi
  • a current account deficit, inflation and the depreciation of the tugrik

2012: Foreign Investment

A number of the elements in the current economic crisis date to 2012, the decline of foreign investment and the decline of coal exports to China.

In May 2012, parliament hastily approved a foreign investment law to prevent the takeover of South Gobi Sands by Chinese aluminum giant Chalco. The law initially seemed to be focused fairly narrowly on establishing a review procedure by the government and parliament for foreign investments of a certain size and involving state-owned enterprises. In this, the law was not dissimilar to similar measures in countries like Canada or Australia (see my “Mongolia’s Evolving Foreign Investment Regime“, January 9 2013, East Asia Forum; also two posts on this blog: “FDI to Mongolia: Restrictions, China, and Comparisons with Canada“, Dec 5 2012, and “Foreign Investment to Mongolia: Restrictions, China, and Comparisons with Canada II“, Feb 1 2013). While the law was promoted as much by anti-Chinese sentiment as by a desire to control mining assets in Mongolia, it was poorly drafted and contained provisions that created a great deal of uncertainty among foreign investors regarding their ability to sell assets and thus cash in on investments (see for example a legal analysis provided by Hogan Lovells in the context of proposed amendments to the law, “The Proposed Amendment to the Strategic Foreign Investment Law of Mongolia: Not the cure-all as advertised” (Apr 15, 2013, PDF).

This uncertainty has lingered and has led to the shelving of exploration activities by many foreign investors, primarily from Australia, Europe, and North America. The uncertainty was confounded by proposed amendments to the mining law (see for example Mendee’s blog post, “Major Revision of Mongolian Mining Regulations is Under Way” May 11, 2013).

The result of this uncertainty has been a decline of foreign investment that some peg around 50% though it’s unclear how much of that is due to decisions not to invest further, as opposed to decisions to actually withdraw investments.

Some portion of this drop is also attributable to the conclusion of Phase I of Oyu Tolgoi construction. Since Phase II is currently on hold, this has reduced foreign investment into the OT project.

One of the ironic aspects of this decline in foreign investment from OECD countries is that apparently (no confirmable numbers on this, merely something that is talked about in Ulaanbaatar) many of the assets that may have been abandoned in the context of investment reviews by OECD foreign investors (primarily Canadian and Australian) have been snapped up by Chinese investors. The same may also hold for Mongolian projects that have faced financing challenges as the current crisis has worsened. So while the foreign investment law may have prevented the sale of South Gobi to Chalco, it may have created opportunities for the sale of smaller and medium-sized projects to Chinese investors as an unintended consequence.

It should also be noted that 2012 was a year when a number of prominent foreign companies came under investigation by Mongolia’s authority for a number of alleged violations against mining regulations and tax evasion (apparently). The prosecution of these offences – whether it may have been justified by malfeasance or not – added to the perception of embattled foreign investment.

The Mongolian government was not too bothered by howls of protest coming from investors last year. Some of this lack of concern was rooted in a sense of optimism about Mongolia’s economic development that was rooted in the high growth rates of previous years and expectations tied to what seemed like the imminent beginning of production at Oyu Tolgoi. The sense of economic (over)self-confidence that was so palatable in Ulaanbaatar was reinforced even more by the success of the launching of the Chinggis Bond in November 2012 that was oversubscribed and netted the government US$1.5b. Oddly, this capital was raised without a clear sense of what the funds might be spent on leading to a pointed line of questioning of the government’s plans from the opposition. Regardless, the oversubscription was taken to be an endorsement of the Mongolian economic and economic policy, and concerns about foreign investment were brushed aside.

I should note in this context, that some of these developments did not seem entirely pernicious to me last year. I have been of a view that Oyu Tolgoi may be all that the government of Mongolia can and should handle for some time, so that the decline in the number of other active projects seemed like a development that would allow political and regulatory energy to focus on “getting OT right”. Other projects could then be re-activated in later years when the regulatory environment was settled in the context of development of OT, and some infrastructure and training needs would also have been addressed at that point.

I am still fundamentally of this view, i.e that OT on its own is “large enough” for significant growth and so large that regulatory and development efforts will already be stretched very thin by a focus on OT. I do recognize in the current context, however, that the slowdown and uncertainty around OT (see the discussion below about how the government is not “getting OT right” in 2013) has led to an economic crisis that I had not anticipated in part because I continue to believe that OT is too big to fail for the government as well as for Rio Tinto.

2012: Softening of Exports to China

In terms of the active selling and buying of goods (not investment), the Mongolian economy is dominated entirely by its trade with China of course. China continues to be the main source of imports of all manner of consumer and many industrial goods, and it is the destination of the large majority Mongolian exports, whether that is raw or processed materials, or any products.

As China’s rapid growth has slowed to be merely fast growth, the exports of coking coal from Mongolia to China have halved over the past year or so. Frik Els has collected some of the numbers of this shift for In addition to the slowdown in China, there have also been a number of managerial challenges in that some of the contracts that Mongolian firms had entered into turned out not to be very advantageous and allowed Chinese buyers to back out when prices started sinking.

2013: Grappling with OT Ownership

Earlier this year, President Elbgdorj opened a large can of worms when he outlined a detailed list of questions he had about the construction of OT (see my “Giving Power to the People of Mongolia“, beyond BRICS, Financial Times, Mar 19 2013, for example.

While many of the points that Elbegdorj has raised are legitimate areas of questioning and should also prompt some very serious thinking in the Mongolian government, none of this thinking has led to any solutions. The start of production and delivery of copper concentrate was delayed several times earlier this year and recently, further construction of Phase 2 and the associated underground operations has been suspended. Not to be outdone in a sulking contest with the Government of Mongolia, Oyu Tolgoi (i.e. Rio Tinto) fired 1,700 workers in August.

While the middle of September has brought many statements from the government indicating contrition over economic policy for the past year or so, mention of Oyu Tolgoi was conspicuously absent from all these statements.

They only good news regarding the project recently has been the appointment of three new members of the board of directors of Oyu Tolgoi by the Mongolian government according to its 1/3 ownership stake. These directors are surely politically connected to the DP and the president, but they have worked in the mining industry or on mining regulation for some time, bringing a different level of competence to their appointments.

2013: From Cushioning a Softening of Growth to Inflation and Currency Depreciation or The Budget

There have been significant infrastructure investments by the Mongolian state this year that have cushioned the blow of the withdrawal of foreign, non-Chinese investment, and the slow-down of coal exports. These investments and injections into the economy have maintained growth rates for the first half of the year. They are also putting pressure on the state budget. While this pressure has been curbed somewhat by a slowdown in expenditures, the government is facing a deficit on the order of US$100m. This is a comfortable distance from the stability-law-imposed ceiling of 2% of GDP somewhere near US$100m. The Chinggis Bond of last November clearly provided some of the cash for these investments and one can only suspect that the ¥-denominated Sumo Bond announced for later this year will be used to similar purposes. Another aim in raising funds through the Sumo Bond may be to build up foreign currency reserves given the current account deficit. It is also important, of course, to note that these are bonds so that they will ultimately represent a draw on the state budget for interest and repayment. A budget update is due on Oct 1 that will clarify some of the expenditure and likely deficit levels.

2013: A new focus on State-Owned Companies

Over the past several months, there has been increasing scrutiny of Mongolian state-owned companies and their (lack of) profitability. This may have started with some scandals surrounding MIAT, the national airline, that brought more attention to the large state-owned sector that continues to exist. Now, estimates that only 25% of state-owned companies are profitable are even being disputed by some commentators. While the impact this lack of profitability may have on the government budget is not clear to me, it certainly does have an impact.

Clearly such state-owned companies are a mix of some holdings that are meant to be subsidized (utilities, for example), some that provide much needed employment (manufacturing) and others that are more of an investment (Erdenet/OT). The fact that utility companies are operating at a deficit even when plans are progressing for the Central Heating and Power Plant 5 in Mongolia may not be surprising and should probably be evaluated differently that the losses running up at MIAT.

2012-13: The Depreciation of the Tugrik

The Tugrik has declined around 20% since the Chinggis Bond was issued (no direct and singular causal link implied here). This obviously makes all imports more expensive and is thus quite noticeable in Mongolia. Over the course of the summer, a kg of rice has thus gone from T1,600 to T2,000 a change that is representative of the price change of ordinary goods and is obviously very noticeable for shoppers. Likewise, many restaurants had stickers on their menus with new prices during my mid-September visit.

The Bank of Mongolia appears to have been intervening to support the tugrik all year and that has led to a decline of foreign currency reserves given the current account deficit that is due to the decline in exports.

Note that while there has been some discussion of manipulation of the tugrik by currency speculation, this seems somewhat unlikely. For currency speculators outside of Mongolia, the tugrik is not an attractive target as it only clears in Mongolia itself. I.e., it is very complicated (or impossible, at least directly) to hold a tugrik account abroad which means that speculation is not only complicated, but even riskier. Surely some people are speculating on the movement of the tugrik domestically, but this is probably not of a volume to really move the currency around massively.

Comments/corrections Please!

Note that I am not an economist, so if I have misportrayed anything in the above summary of the economic crisis, please comment on the post to offer corrections or further information.

The Mongolia page of the International Monetary Fund (IMF) is always a good source of macro-eonomic indicators that are updated every month.

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