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Asia Frontier Capital Country Report: Mongolia

|Includes:Rio Tinto plc (RIO), SHI
AFC Country Report: Mongolia

Once the darling story for bold investors and mining enthusiasts, Mongolia has struggled in recent years to maintain investor confidence and to capitalize on its enormous resource potential. With a small population of 3 million and lucrative mineral reserves, Mongolia was tipped as possibly becoming the next Qatar or Norway. Enthusiasm for the country has waned, however, as mining giant (Rio Tinto) has been embroiled in disputes with the Mongolian government over its mega-mine, Oyu Tolgoi. The Oyu Tolgoi project proved to be a litmus test for foreign investors, and frequent changes to legislation and government backtracking spooked many investors. GDP growth has slowed from its record-high of 17.3% in 2011, and the World Bank has lowered its previous forecast for this year from lofty double-digits to an even 10.0%.

The dramatic fall in Mongolia's economic outlook has largely been attributed to the compounding effects of dwindling foreign direct investment "FDI" and an overreliance on both the domestic mining sector and on China. Rattled by Rio Tinto's problems in dealing with the Mongolian government and the country's position on foreign ownership of its resources, investors have spurned the country, with FDI decreasing 52% last year and 70% in the first half of 2014.

To offset the dramatic decline of FDI, Mongolia has increasingly turned to China, which accounts for 90% of Mongolia's exports and 50% of its imports. Mongolia is in talks with China's Sinopec Group to sign a gas project and supply accord in August to construct two coal-to-gas plants, with 95% of output going to China through pipelines and gas production expected to start in 2019.

But China's economic slowdown and recently falling commodity prices have highlighted the danger of being too dependent on one trading partner and one sector - more than 80% of the country's FDI goes into the mining sector. Exports, particularly coal, have fallen in line with China's economy, and Mongolia's earnings from coal exports fell 17% in the first half of the year. China's growth in Q2 2014, however, was higher than expected and an upwardly revised full-year economic forecast for China's economy would bode well for Mongolia.

To try and counter an overreliance on China, President Tsakhiagiin Elbegdorj signed a free trade agreement in July with Japanese Prime Minister Shinzo Abe that will cover all of Mongolia's exports to Japan and 96% of Japanese exports. The agreement was also seen as a diplomatic move by Japan, as Mongolia enjoys an unusually close relationship with North Korea that Japan may seek to leverage as it tries to free a number of its citizens that are currently imprisoned by the government in Pyongyang. While Mongolia's political neutrality makes it of strategically importance to Japan, the Ulaanbaatar government is likely keep a close eye on the ongoing events unfolding in Ukraine, which like Mongolia is an independent and democratic former Soviet Union country that shares a land border with Russia. Vladimir Putin's territorial ambitions have likely caught the attention of Mongolia, which has vast resource potential and a small population.

On the macroeconomic front, the Mongolian government has pursued expansionary fiscal and monetary policies, which have led to external debt rising to more than 150% of GDP. The expansionary policies have contributed to inflation, and the national currency, the tugrik, has fallen 10% against the dollar this year. Currency reserves have fallen rapidly from USD 2.2 billion at the beginning of the year to USD 1.6 billion in May 2014, in spite of a narrowing current account deficit.

The effect of the macroeconomic policy is that Mongolia has received two ratings downgrades this year. In April, Standard & Poor's cut Mongolia's rating from BB- to B+, and in July, Moody's cut its rating to B2, five levels below investment grade.

Moving forward, Mongolia needs to take firm action to rebuild confidence among foreign investors to catalyze the strong economic growth it experienced only a few years ago. Small yet encouraging steps have been taken, such as in April when Prime Minister Altankhuyag Norov introduced a "100 day action plan" to promote investment by approving changes to the 2006 Minerals Law and passing a new law on energy. But the "Wolf Economy" must now think from the perspective of damage control, and create effective policies and legislation to nourish the country's economic and business environment back to health.

Despite the bearish outlook covered in international media and the slump of the Mongolian Stock Exchange "MSE" Top 20 Index, Mongolia remains an interesting investment story. For one, the MSE Top 20 has not been broadly representative of the overall performance of the country's stock exchange. Many of the largest companies on the MSE by market capitalization, which are part of the MSE Top 20, are poorly-managed state owned enterprises "SOEs". In contrast, there are many small cap stocks of privately-controlled local companies that have posted strong performance. As local brokerage firm BDSec JSC has pointed out, the YTD return of the MSE Top 20 as of July 30th 2014 is -2.3%, but if you instead look at the performance of the top 20 largest privately-controlled companies on the MSE, the YTD return is 21.2%.

Although it is a contrarian investment case, Mongolia has many attractive small-cap companies with healthy fundamentals, and the bearish global outlook on the country has led to cheap prices for many of these stocks. In the longer term, we think that the government will take a softer stance in its negotiations with Rio Tinto to try and reassure foreign investors that Mongolia is open for business. After all, Mongolia's GDP is roughly USD 12 billion, while Rio Tinto's market capitalization is USD 107 billion! As the government gradually improves legislation and mining rights and FDI begins to trickle in once again, economic growth should pick up, boosting consumer spending and contributing to solid performance from mining stocks as well as domestic plays in consumer goods, textiles, materials, and hotels.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Stocks: RIO, SHI