Last week, this is what I tweeted
— Julian Dierkes (@jdierkes) May 14, 2015
It looks like the day after is upon us, according to press reports and a series of Turquoise Hill press releases. Below are my initial comments, but note that these are based on the publicly-available information only, and are preliminary in nature.
What’s in the Agreement
- On the question of outstanding taxes that had been assessed and in dispute, Oyu Tolgoi and the government seem to have agreed on a tax bill of $30m, without prejudice, i.e. without any admission of guilt on either side.
- Oyu Tolgoi forgoes a 2% smelter royalty it had inherited from BHP Billiton.
- There is a change to how the royalty on sales is calculated.
- The management fees that Rio Tinto charges for operating Oyu Tolgoi are reduced from 6% to 3%.
What’s Not in the Agreement
Pending further announcements of details,
- Any reduction in the 34% share in Oyu Tolgoi held by the government.
- Any debt forgiveness or assumption of government debt.
- Any significant changes to the royalty structure (in part because the 34% stake remained.
On balance then, I’m a little surprised that there are no momentous changes in the Oyu Tolgoi structure. It had seemed that both, Rio Tinto and the government, had lost faith in their partnership. While it was always clear that progress would ultimately benefit both sides tremendously, simply because of the overall size of the project, it seems that the results of negotiations have not reconfigured the relationship. Perhaps it was the process of negotiations itself that will allow this agreement to have some longer-term durability?
Various financing deals for the underground construction had expired, so negotiations for $4b in project financing will have to start anew. Given the fundamental economic soundness of the Oyu Tolgoi project, this should not be a huge hurdle.
Once financing has been established, Oyu Tolgoi should be able to ramp up underground construction in the course of the summer. A construction workforce will have to be recruited and machinery and materiel procured.
As construction gets under way, a Mongolian workforce will have to be hired toward operations at the mine.
For the Mongolian government, a number of issues that have come up over the last two years remain unresolved as the Oyu Tolgoi governance structure does not seem to be changing with this agreement.
When Erdenes Mongol looks at business operations at Oyu Tolgoi, how active will this holding company be? Presumably, there will not be any involvement in day-to-day operations, but in bigger decisions, is the state holding tasked with the maximization of financial benefits to the state, i.e. maximal revenue flows to the general budget, or does it take a more comprehensive and holistic view of operations? Is the holding run (at arm’s length, one would hope) by the Ministry of Finance or do ministries like environment, labour, etc. also get a say? For the long-term operations of this mine, answers to such questions will definitely be needed!
The 2011 boom in Mongolia was built on construction activities at Oyu Tolgoi. I don’t see any particular reason why a boom should not result from the underground construction that will commence with the agreement that was reached.
While much of the construction-related employment may be foreign labourers and expats, construction will draw on local suppliers to house, feed and maintain a large workforce. Presumably, domestic air travel to Dalanzadgad will resume and a number of infrastructure projects will be accelerated further adding to a construction boom.
Also, presumably, the turgrik will either appreciate or at least hold its value (depending on the fiscal situation). Would there be any reason for inflation to decline other than a halt to the depreciation of the turgrik?
Other than the $30m tax bill, a construction boom doesn’t produce immediate revenue flows for the Mongolian government, if anything the agreement will strain government budgets more as the required investment will amount to up to $2b that the government currently doesn’t have. Open pit operations will continue and continue to generate revenues but not on a scale to finance the underground construction.
While Rio Tinto has obviously been persuaded by the negotiations that this agreement provides stability in the medium term, it seems unlikely that this would immediately reverse the decline of FDI into Mongolian. Mining projects already underway and undertaken by purely Mongolian-focused companies may be able to find financing somewhat more easily again and the associated activities might see a modest rebound of FDI.
But how has the mutual distrust between Rio Tinto and the government been overcome? While the agreement is a once-a-decade step for Mongolia, will it outlast the current decade? The 2009 Investment Agreements ran into trouble 4 years into its existence. Looking at that experience, it seems unlikely that FDI would rebound on a large scale.
For PM Saikhanbileg, the agreement is a huge victory, particularly since it comes just over a year before the election and there is some chance that voters will see positive economic results from this agreement by the time of the election.
This may not be enough to persuade voters to return the DP to power (in fact this still seems very unlikely at this moment), but it may soften the blow and allow Saikhanbileg to claim underground operations at Oyu Tolgoi as his legacy, more than the DP’s legacy, perhaps in the 2020 parliamentary election.
Since Saikhanbileg’s super-coalition was constructed with the goal of moving on large projects (Tavan Tolgoi appears to continue to be mired in a complex web of domestic business interests, contracts, and foreign relations), the signing of this agreement surely dooms the coalition sooner rather than later. It was never expected to outlast next winter, simply because parties wouldn’t want to go into the 2016 election with coalition partners lest they cannot establish the distinctiveness of political choices, but with this agreement out of the way (and everyone, including the MPP) being able to claim some credit for this, why should the MPP stay in this coalition?
The fiscal situation doesn’t improve significantly and that’s the DP’s mess to deal with. The construction and affiliated service industry boom that will be spurred by this agreement will happen relatively independently of government actions. Unless there is an unfortunate argument that the MPP and some of its prominent politicians want “in on the boom”, it would seem that this agreement would spell an end to the coalition though perhaps not before the parliamentary summer recess.
All in all, May 19 2015 will have been very significant to Mongolia’s development. While I had been feeling quite gloomy after my recent visit to Ulaanbaatar, this agreement changes everything. As I had previously argued, the Mongolian government has to “just” get Oyu Tolgoi right as the scale of this project will sustain capacity-building for other economic activities. None of this is guaranteed by this agreement, but it seems to be a positive step at least.