ResCap
Nov October 2012
30, 2010
November 30, 2010

Resource
Investment
Capital

Equity Research | Mongolia
A fundamental ...
ResCap
November 30, 2010

Resource
Investment
Capital

Equity Research | Mongolia
A fundamental perspective on the Mongoli...
Resource
Investment
Capital

ResCap
November 30, 2010

Equity Research | Mongolia
A fundamental perspective on the Mongoli...
ResCap

Resource
Investment
Capital

Figure 2: Origins of GDP, 2011 (% of total)
Other, 17.8%
Industry, 25.1%

Trade, 11.7...
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developed by Turquoise Hill Resources (formerly Ivanhoe Mines) will
complete construc...
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Capital

deficit will reduce significantly, despite continued import growth due to
rising dome...
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Investment
Capital

declining in 2013 and beyond, putting pressure on Mongolian exports.
Figure 7 shows p...
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Capital

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Figure 8: FDI and Current Account, 2008 - 2011 (US$bn)
1.5

(US$ billion)

1.0
0.5
0....
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Resource
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Capital

Figure 10: Government Revenue Growth, 2010 - 2011 (%)
250%
2011

2010

200%

150%

91...
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Capital

Source: Bank of Mongolia

Most recently, headline inflation rate in Ulaanbaatar was 1...
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rising again from June 2011 onward. Money supply growth decelerated to
24 percent on ...
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Capital

Mongolia’s   monetary   and   fiscal   policies.   While the BoM attempts to curb
inf...
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Capital

Figure 14: Foreign Reserves (US$bn) and Growth Rate (%), 2009 - 2012
3.5

25%
20%

3....
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Resource
Investment
Capital

Figure 15: Total Outstanding Loans (US$m) and Growth Rate (%), 2010 - 2012
7.0

80%
7...
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Figure 17: MNT/USD Exchange Rate, 2000 - 2012

Financial crisis hits Mongolia harder than in other
resource-rich c...
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Resource
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Case study: The Economic Impact of Oyu Tolgoi
Oyu Tolgoi (OT) is a large open pit and...
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Summary and currency implications
The Mongolian economy experienced a robust recovery...
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medium term, beginning in 2012. In the short-term, the togrog has and will
continue t...
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While tightening monetary policy typically could lead to a local currency
appreciatio...
Mongolian togrog (MNT) report

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A fundamental perspective on the Mongolian togrog (MNT

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A fundamental perspective on the Mongolian togrog (MNT

  1. 1. ResCap Nov October 2012 30, 2010 November 30, 2010 Resource Investment Capital Equity Research | Mongolia A fundamental perspective on the Mongolian togrog (MNT) Mongolian Togrog (MNT): A Fundamentals-Driven View EXECUTIVE SUMMARY Country data Capital city Land area Population Language Currency Fiscal year Ulaanbaatar 1,566,500 sq. km 2.8 million (2010 census) Mongolian Togrog (MNT) FX rate 2011: MNT1,266:US$1 January – December Economic indicators (2011) GDP (per capita) (US$) Real GDP growth (%) CPI (%) Foreign reserves (US$) 8.5bn (3,045) 17.3 10.2 2.5bn Political structure Official name Mongolia Form of state Republic Legislature Single-chamber parliament with 76 members President Elbegdorj Ts. of the Democratic Party Prime Altankhuyag N. of the Minister Democratic Party Elections June 2012 (parliamentary) and May 2013 (presidential) Central bank Purevdorj L. governor Parliamentary Enkhbold Z. of the speaker Democratic Party Nagi Otgonshar +976-7010 0095 nagi.otgonshar@resource-cap.com Enkhbayar Davaatseren +976-70 100095 enkhbayar@resource-cap.com The Mongolian economy experienced a robust recovery from the 2009 financial crisis, recording economic growth of 6.4 percent in 2010 and 17.3 percent in 2011. This rapid expansion has continued through the first half of 2012 with real GDP growth of 13.2 percent outpacing many other emerging and frontier nations. The contents of this report discuss key macroeconomic trends and policy factors in Mongolia and their potential effects on the Mongolian currency (MNT). Since the implementation of a flexible exchange rate mechanism in 2009, the togrog has experienced substantial volatility. The global financial crisis and sharp declines in commodity prices contributed to a 38 percent depreciation relative to the US dollar between October 2008 and March 2009. However, with   a   rapid   economic   recovery,   the   togrog   became  the  world’s   second   bestperforming currency in 2010, finishing the year 13 percent higher against the US dollar behind the South African rand, which appreciated 14 percent. After an 11.4 percent depreciation against the US dollar in 2011 on the back of global risk aversion, the togrog has appreciated markedly in the first half of 2012, rising from Tg1,396.4:US$1 at the end of December 2011 to Tg1,329.8:US$1 at the end of June 2012. Bank of Mongolia (BoM) intervention in the currency market has helped  curb  the  togrog’s   appreciation, which we believe was tied to political motivations prior to the June 2012 election. An important characteristic of the MNT is the very small speculators market which does not impact the movement, unlike other major global currencies. The MNT is driven predominantly by capital flows which we forecast are tied very closely to the prospects of Oyu Tolgoi and Tavan Tolgoi mining projects in Mongolia. The dynamic macroeconomic environment in Mongolia will exert both upward and downward pressure on the local currency. In the short-term (6-12 months), we expect the togrog to experience continued volatility and downward pressure, driven by high domestic inflation, a widening trade deficit, rapid money supply expansion, declining commodity prices, and global macroeconomic risks. Political risk, particularly given the uncertain policy environment after the recent change of government, will be another source of volatility for the togrog. In the medium- and longer-term, however, macroeconomic trends and policy factors are expected to support modest currency appreciation. This will be driven by strengthening export prospects contributing to trade surpluses driven by Oyu Tolgoi exports, effective fiscal and monetary policy, political reform and the robust recovery of the financial sector in Mongolia, among other factors. 1
  2. 2. ResCap November 30, 2010 Resource Investment Capital Equity Research | Mongolia A fundamental perspective on the Mongolian togrog (MNT) Mongolian Togrog (MNT): A Fundamentals-Driven View Table of Contents EXCUTIVE SUMMARY............................................................................. 1 MACROECONOMIC OVERVIEW ............................................................................. 2 Economic growth ........................................................................................... 3 External sector ............................................................................................... 5 Commodity prices .......................................................................................... 6 Foreign direct investment .............................................................................. 7 Fiscal policy .................................................................................................... 8 Monetary policy ............................................................................................. 9 Banking sector .............................................................................................. 13 Exchange rate ............................................................................................... 14 CASE STUDY : THE ECONOMIC IMPACT OF OYU TOLGOI……………………………….….16 SUMMARY AND CURRENCY IMPLICATIONS ........................................................ 17 2
  3. 3. Resource Investment Capital ResCap November 30, 2010 Equity Research | Mongolia A fundamental perspective on the Mongolian togrog (MNT) Mongolian Togrog (MNT): A Fundamentals-Driven View Macroeconomic overview Economic growth Mongolia’s   transition   from   a   centrally-planned economy to a marketoriented  economy  began  in  1990  with  the  country’s  democratic  revolution.   The period between 1990 and 2000 was fraught with challenges for the transition, including periods of hyperinflation, high unemployment, food and production shortages, natural disasters, and the Asian and Russian financial crises. Gross Domestic Product (GDP) growth reached a low of 1.3 percent in 2000, and began to improve in the mid-2000s as the private sector   developed   and   the   country’s   mineral   wealth   became exposed to global markets. By 2003, the private sector comprised 70 percent of Mongolia’s   GDP. Figure 1 presents an overview of Mongolian GDP and growth trends as compared to the Organization for Economic Cooperation and   Development’s   (OECD) Asia-5 nations (Indonesia, Korea, Malaysia, the Philippines and Thailand), those most affected by the financial market turmoil since 1997. Figure 1: Mongolian GDP (US$bn) and Growth (%) Compared to Asia-5 (OECD) 35.0 20.0 17.3 17.2 30.0 25.0 14.0 10.2 11.8 12.2 15.0 10.0 20.0 15.0 (%) (US$ billion) Mongolia’s  economy  recovered   strongly from the domestic downturn of 2009, with GDP nominal growth of 6.1 percent in 2010 and 17.3 percent in 2011 5.0 10.0 0.0 5.0 0.0 -5.0 2005 2006 2007 2008 2009 2010 2011 2012F 2013F 2014F 2015F 2016F 2017F Mongolian GDP (LHS) Asia-5 GDP growth (RHS) Mongolian GDP growth (RHS) Source: Bank of Mongolia, Bloomberg Mongolia was hit hard by the global financial crisis in 2009, largely due to its reliance on trade with China, sensitivity to global commodity prices, and unusually harsh weather conditions (known  locally  as  “zud”) between 2008 and 2010. However, the Mongolian economy recovered well, with GDP growth of 6.1 percent in 2010 and 17.3 percent in 2011, outperforming many other emerging and frontier economies. Figure 2 shows the origins of GDP in 2011, with the largest contributing sectors as industry (25.1 percent) and mining (16.4 percent). 3
  4. 4. ResCap Resource Investment Capital Figure 2: Origins of GDP, 2011 (% of total) Other, 17.8% Industry, 25.1% Trade, 11.7% Mining, 16.4% Transport and communications, 15.4% Agriculture, 13.7% Source: Economic Intelligence Unit First quarter growth in 2012 has been driven by the services, transport, and agricultural sectors In the first quarter of 2012, the Mongolian economy continued its growth trajectory with 16.7 percent year on year (y-o-y) GDP growth (Figure 3). This has been driven largely by the services, transport, and agricultural sectors: wholesale and retail trade grew 51 percent y-o-y, transport grew 11.7 percent y-o-y, and agriculture grew 13.6 percent. Agricultural sector growth is notable, as it signals a recovery from the effects of the 2009-2010 zud, which will improve earnings prospects and livelihoods particularly for rural populations, which were most severely affected by the natural disaster. Figure 3: Real GDP Growth in 2012Q1 (%) Greece -6.5 Portugal -2.2 Italy -1.4 Hong Kong 0.4 USA 1.9 Vietnam 4 Australia 4.3 Russia 4.9 India 5.3 China 8.1 Mongolia -10 -5 16.7 0 5 10 15 20 Source: Bank of Mongolia, Bloomberg The mining sector contributed 1.6 percentage points (pp) to GDP growth, with the development of Oyu Tolgoi (OT) in particular spurring growth in sectors across the entire economy (For more information on OT, refer to case study on page 16). Mining-related foreign direct investment (FDI) and government spending are also expected to be key drivers of GDP growth going forward. FDI reached a record-high US$5.3bn or 62 percent of GDP in 2011, and is forecasted to grow at an average of 26 percent per annum in 2012 and 2013, according to the Economic Intelligence Unit (EIU). Both exports and imports are expected to rise starting in 2013 as Oyu Tolgoi (OT) 4
  5. 5. ResCap Resource Investment Capital developed by Turquoise Hill Resources (formerly Ivanhoe Mines) will complete construction and expand production. The EIU forecasts that Mongolia will again be among the fastest growing world economies in 2012, with 14.8 percent y-o-y real GDP growth. According to the National Statistics Office (NSO), in the first half of 2012 the Mongolian economy expanded by 13.2 percent y-o-y in real terms (25.1 percent in nominal terms) based on the production approach to GDP. External sector The  country’s  trade  is  highly   concentrated among China and Russia Historically, Mongolia has experienced trade deficits, but with a narrow trade gap. This was exacerbated during the global financial crisis, as exports declined dramatically and the development of the mining sector has required substantial imports of goods and services. Mongolia’s  main  trading   partners and traded goods are shown in Figures 4 and 5 and Table 1 below. Since   the   country’s   trade   is   highly   concentrated   among   China   and   Russia,   Mongolia’s  trade  balance  is  highly  sensitive  to  the  economic  patterns  of  its   neighbors. Figure 4: Main Trading Partners for Imports China, 26.7% Figure 5: Main Trading Partners for Exports Russia, 1.5% Other, 4.5% Other, 46.3% Russia, 27.0% China, 94.0% Source: Economic Intelligence Unit Table 1: Main Traded Goods, 2010 Imports Main traded goods Machinery and transport equipment, manufactured goods, food and fuel Exports Mineral products, natural or cultured stones, precious metal, jewellery, coins, textiles & textile articles live animals, animal origin products, raw & processed hides, skins, fur articles Structurally,   Mongolia’s   exports   are   concentrated   among   a   few   commodities, and almost all consumer goods are imported from abroad. As shown in Figure 6 below, the trade deficit has widened over the past year, reaching US$1.7bn in December 2011, or 20 percent of GDP. We believe the trade deficit will reduce significantly in 2013 Imports required for OT construction are the most significant contributor to the trade deficit, comprising 70 percent of total imports in 2011, according to the World Bank. With the completion of OT construction by the end of 2012 and commercial production beginning in 2013, we believe the trade 5
  6. 6. ResCap Resource Investment Capital deficit will reduce significantly, despite continued import growth due to rising domestic demand. As evident from Figure 6, trade shows a tendency towards increasing from the beginning to the end of a year, and we expect imports in 2012 to continue following this pattern. However, with the recent Chinese deceleration in growth and world price fluctuations, the export pattern will be more variable since commodity exports in Mongolia remain highly dependent on Chinese demand for coking coal and copper. 0.2 0.0 (0.2) (0.4) (0.6) (0.8) (1.0) (1.2) (1.4) (1.6) (1.8) (2.0) 7.0 (US$ billions) 6.0 5.0 4.0 3.0 2.0 1.0 Trade balance Export May-12 Mar-12 Jan-12 Nov-11 Sep-11 Jul-11 May-11 Mar-11 Jan-11 Nov-10 Sep-10 Jul-10 May-10 Mar-10 Jan-10 0.0 (US $ billions) Figure 6 : Trade Balance, 2010-2012 Import Source: Bank of Mongolia, Bloomberg Commodity prices Mongolia’s  economy  is  highly   sensitive to changes in commodity prices Minerals  comprise  over  80  percent  of  Mongolia’s  exports.  The development of substantial mineral deposits including copper, coal, molybdenum, tin, tungsten, and gold have made the Mongolian economy more susceptible to commodity prices in recent years. This manifested itself in the increased value of exports leading up to the financial crisis, until sharp drops in commodity prices caused exports to drop 26 percent from US$2.5bn to US$1.9bn and the local currency to depreciate approximately 38 percent against the US dollar. The  price  of  copper,  one  of  Mongolia’s  main  exports,   fell by up to 65 percent from US$8,700 per ton in April 2008 to US$3,000 per ton in March 2009. Starting in late 2008, commodity prices surged once again, driven by strong Chinese demand. The 3-month active copper contract and New Castlequoted coking coal prices increased by nearly 200 and 50 percent respectively between December 2008 and mid-July 2011. During this period, the Mongolian economy benefitted from boosts in prices of these two main commodities. After another run up in commodity prices until September 2011, a decline in prices owing to the sluggish economic recovery in the US, the on-going sovereign debt crisis in the euro zone, and the economic slowdown in China, once again negatively impacted the trade balance. For example, the World Bank forecasts copper prices to rise to US$8,500 in 2012 before steadily 6
  7. 7. ResCap Resource Investment Capital declining in 2013 and beyond, putting pressure on Mongolian exports. Figure 7 shows price growth for key commodities from 2008 to present. Figure 7: Commodity Price Growth, 2009 - 2012 (%) 250% 200% 150% 100% 50% 0% Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 -50% Coking Coal (New Castle) Copper (3m active contract) Gold Source: Bloomberg Foreign Direct Investment Dramatic increases in FDI Mongolia is classified as a frontier market with a favorable tax regime, relatively high ease of doing business, functioning democracy, and a vast supply of untapped natural resources. FDI into Mongolia has been steadily increasing since 2001, driven by a favorable investment and legal climate, and foreign investment in mining-related projects. In 2008, FDI surpassed 10 percent of GDP for the first time. As the OT project drives a majority of capital flows, FDI is expected to decrease in the coming years upon the completion of OT construction, which is nearly 95% complete at the time this report was published. The  country’s  FDI  increased  three-fold in 2011 reaching an all-time high of US$5.3bn or approximately 62 percent of GDP. China, the single major export destination for Mongolian commodities, has also remained the largest investor in Mongolia ahead of South Korea, Japan and Russia. Foreign inflows have historically financed Mongolia’s  widening  trade  deficit,   and will continue to do so in the near term. Consequently, the togrog is expected to appreciate modestly in 2013 due to export growth and continued mining-related FDI flows. Figure 8 presents an overview of recent FDI trends. 7
  8. 8. Resource Investment Capital ResCap Figure 8: FDI and Current Account, 2008 - 2011 (US$bn) 1.5 (US$ billion) 1.0 0.5 0.0 -0.5 -1.0 2008 2009 FDI 2010 IV quarter III quarter II quarter I quarter IV quarter III quarter II quarter I quarter IV quarter III quarter II quarter I quarter IV quarter III quarter II quarter I quarter -1.5 2011 Current account Source: Bank of Mongolia Fiscal policy Government’s  expansionary  fiscal   policy is a double-edged sword The   government’s   expansionary   fiscal policy and a sharp plunge in world commodity prices (mainly copper) in 2008 contributed to a much larger contraction of GDP in Mongolia than experienced in other resource-rich countries. However, large scale election-driven cash hand-outs and miningrelated capital expenditures have also been significant contributors to Mongolia’s  economic growth. Expenditures climbed to 44.2 percent of GDP in 2011, while revenues reached only 40.6 percent, both driven by the mining sector. The 2011 y-o-y growth of total expenditures and net lending was 56 percent, whereas total revenue and grants grew by 41 percent. This led to a larger fiscal deficit in 2011 than in 2010, at MNT 391bn. Figures 9 and 10 provide a breakdown of increases in government expenditures and revenues respectively. Figure 9: Government Expenditure Growth, 2010 - 2011 (%) 250% 236% 2011 2010 200% 150% 104% 100% 81% 59% 56% 50% 33% 43% 40% 26% 24% 33% 32% 29% 12% 0% Total exp. & Net lending Curr. Exp. Wages & Salaries Goods & Services Subsidies & Trans. Capital Exp. Net Lending Source: Bank of Mongolia, Ministry of Finance 8
  9. 9. ResCap Resource Investment Capital Figure 10: Government Revenue Growth, 2010 - 2011 (%) 250% 2011 2010 200% 150% 91% 100% 75% 50% 41% 35% 40% 43% 9% 0% Total Rev & Grants Curr. Rev. Corp. income Indiv. income tax tax VAT Excise tax Taxes on FT Source: Bank of Mongolia, Ministry of Finance The IMF, among other agencies, has warned Mongolia against highly expansionary fiscal policy and high domestic inflation. Mongolia will soon introduce its Fiscal Stability Law, which aims to shield the economy from boom-bust cycles in the dominant mining sector. The legislation caps the structural deficit at 2 percent of GDP and establishes a Stabilization Fund, aimed to save revenue generated from high commodity prices in order to buffer the economy from unforeseen shocks. According to Fitch, Mongolia has so far saved only 2 percent of its GDP in this fund, which is considered insufficient to provide the country with fiscal flexibility and shelter its currency   from   shocks,   should   price   declines   affect   Mongolia’s   main   export   commodities. Despite the legislation, the fiscal deficit has expanded to 7.6 percent of GDP in May 2012, and the government has continued to announce major spending programs on transfers and public-sector salaries. On the other hand, enhanced fiscal prospects from Mongolia’s   rapid   economic growth and increasing taxable activity in all sectors of the economy are expected to offset the spending planned for 2012. Monetary policy Inflation remains a primary threat to the togrog Inflation. Over the past decade, inflation has been relatively high and volatile, compared to benchmark economies such as the ASEAN-5 (Association of Southeast Asian nations), as seen in Figure 11. The Consumer Price Index (CPI) reached 26.8 percent in 2008, fell to 6.3 percent in 2009 during the financial crisis, and returned to double digits during the recovery period thereafter. This volatility and recent upward trend in inflation has also been reflected in the exchange rate. 9
  10. 10. ResCap Resource Investment Capital Source: Bank of Mongolia Most recently, headline inflation rate in Ulaanbaatar was 15.1 percent y-o-y in June 2012 while the national rate was 14.7 percent y-o-y. Both are significantly higher than the BoM’s  inflation  target  of 9-12 percent in 2012 and 8 percent by 2013. It is also higher than 2011 average inflation of 9.5 percent. Inflation thus remains a major threat to the togrog, the overall economy, and political stability, and a priority for the BoM. In the 2013 government budget proposal, inflation is forecasted to be 9.8 percent in 2013 and 10.4 percent in 2014, in addition to being targeted at a single digit in the new government action plan in 2012-2016. We believe that this would be a tough target to reach for the government without significant fiscal tightening in addition to bold moves by the BoM on monetary tightening. Mongolia imports a majority of its non-meat foods from China, thus food price movements in Mongolia follows Chinese trends. The current decrease in Chinese food price inflation implies that this element of inflation in Mongolia should also continue to decelerate (after a period of rapidly rising food price inflation). Furthermore, potential fuel cost increases from Russia, a main energy supplier to Mongolia, can also add to inflationary pressures. Rapid money supply growth attributable to increases in deposits and money in circulation Money supply. Money supply growth has also fuelled inflation in Mongolia. From 2000 to 2008, money supply has grown at an average of 34 percent per year, reaching MNT 2.5 trillion in August 2008, prior to the financial crisis (Figure 12).   Mongolia’s   relatively   speedy   recovery   is   reflected   in   the   money supply growth experienced in late 2009. In 2011, money supply experienced tremendous growth on a y-o-y basis attributable to increases in both deposits and money in circulation. Indeed, the Central Bank intervened to stabilize the exchange rate and contain inflation. In April 2012, money supply increased to a record-high of MNT 3.5tr, representing an 80 percent y-o-y increase, while currency issued in circulation grew 41 percent y-o-y. Such rapid growth rate has fuelled inflation, which started 10
  11. 11. ResCap Resource Investment Capital rising again from June 2011 onward. Money supply growth decelerated to 24 percent on average during the first half of 2012, reaching MNT 7tr in June 2012. Figure 12: M2 (MNT trillion) and M2 Growth (%), 1998 - 2012 8.0 90% 7.0 80% 70% 6.0 60% 5.0 50% 4.0 40% 3.0 30% 20% 2.0 10% Jan-12 Jun-11 Nov-10 Apr-10 Sep-09 Jul-08 Feb-09 Dec-07 Oct-06 M2, MNT trillion (LHS) May-07 Mar-06 Jan-05 Aug-05 Jun-04 Apr-03 Nov-03 Sep-02 Jul-01 Feb-02 Dec-00 Oct-99 May-00 -10% Aug-98 0.0 Mar-99 0% Jan-98 1.0 M2 rate YoY (RHS) Source: Bank of Mongolia Interest rates. The 1-week Central Bank Bills (CBB) is the main monetary policy instrument of the BoM and represents the BoM policy rate that guides the interbank money market. CBB climbed to MNT 1tr at the end of 2009 from just over MNT 100bn prior to the financial crisis. In mid-2010, the BoM changed its policy towards less intervention, reducing the CBB amount to MNT 557bn by May 2012 (Figure 13). Figure 13: Net CBB (MNT billion) and CBB Rate (%), 2009 - 2012 1.4 14.0% 1.2 13.0% 1.0 (MNT billion) Policy rate increased twice in 2012 to 13.25 percent 12.0% 0.8 11.0% 0.6 10.0% 0.4 9.0% 0.2 0.0 Dec-09 8.0% May-10 Oct-10 Mar-11 Net CBB (LHS) Aug-11 Jan-12 CBB rate (RHS) Source: Bank of Mongolia The BoM has taken significant policy action by raising the policy rate three times from 11 percent to 12.25 percent in 2011 and twice again to 13.25 percent in 2012 to control inflation. However, inflation also grew by 15.1 percent y-o-y in June 2012, in large part due to a misalignment between 11
  12. 12. ResCap Resource Investment Capital Mongolia’s   monetary   and   fiscal   policies.   While the BoM attempts to curb inflation  by  increasing  the  policy  rate,  the  government’s  expansionary  fiscal   policy adds upward pressure to inflation, which, on net, continues to grow on a y-o-y basis. Nevertheless, the BoM has left rates unchanged at 13.25 percent since April 2012 on the back of a deteriorating global growth outlook and declining commodity prices. As the 10 percent inflation target has not been reached, the BoM remains prepared to take further measures to cool down an overheating domestic economy, and further rate hikes are likely in 2012 and 2013, according to EIU forecasts. However, monetary policy may continue to have limited effectiveness because of the linkage between inflation and global commodity and food price trends, driven in large part by Chinese demand. In March 2012, the People's Bank of China (PBOC), the country's central bank, extended its currency swap agreements with the BoM, doubling the scale of a 2011 bilateral swap deal. The agreement allows the two central banks to swap CNY 10bn / MNT 2tr in order to maintain regional financial stability and facilitate bilateral trade and investment between the two countries. The BoM has already sold CNY 269m to commercial banks. Foreign reserves reach recordhigh US$2.91bn in June 2012, approximately 30 per cent of GDP Foreign reserves. Foreign reserves exceeded US$1bn in mid-2007 but were halved by January 2009 at US$0.55bn as a result of the financial crisis. However, the adoption of a flexible exchange rate regime has allowed Mongolia to rebuild its reserves, which climbed again to US$1bn in September 2009 and reached a record-high US$2.91bn in June 2012 and showing y-o-y growth of 14.4 percent. The flexible exchange regime has been widely praised by the World Bank and the International Monetary Fund (IMF) as a tool to help smoothen out exchange rate volatility and opportunistically build up international reserves. Prior to 2009, Mongolia utilized a tightly controlled exchange rate regime which contributed to the dramatic decline in foreign reserves during the financial crisis. Figure 14 shows recent trends in FDI. 12
  13. 13. ResCap Resource Investment Capital Figure 14: Foreign Reserves (US$bn) and Growth Rate (%), 2009 - 2012 3.5 25% 20% 3.0 15% 2.5 (US$ billion) 10% 2.0 5% 1.5 0% -5% 1.0 -10% 0.5 0.0 Jan-09 -15% -20% Jul-09 Jan-10 Foreign Reserve (LHS) Jul-10 Jan-11 Jul-11 Jan-12 Month-to-Month change (RHS) Source: Bank of Mongolia Banking sector Banking sector assets and bank assets-to-GDP ratio reach new highs Banks have recovered well from the financial crisis, improving the quality of their balance sheets and trending towards greater financial sector stability. Reflecting an expanding economy, banking sector assets have now surged to MNT 9.4tr (US$6.7bn) and bank assets-to-GDP have reached 86.5 percent. Figure 15 shows that total outstanding loans have almost doubled to MNT 6tr from December 2010, peaking at 74.7 percent y-o-y growth in November 2011. A similar trend has been observed in total deposit growth, Figure 16, reaching 72.7 percent y-o-y growth in April 2011. Growth has since decelerated, but upon speaking with top management of commercial banks in Mongolia, we believe that the banks are actively controlling the pace of credit growth recognizing vulnerabilities in the global economic outlook and also the recent decline in commodity prices. Since the Development   Bank   of   Mongolia’s   successful bond issuance in March 2012, Mongolian commercial banks also have planned to tap into international capital markets to increase capital Trade and Development Bank of Mongolia(TDB) was the first to re-enter the market, recently raising US$300 million at a record low yield of 8.5 per cent. 13
  14. 14. ResCap Resource Investment Capital Figure 15: Total Outstanding Loans (US$m) and Growth Rate (%), 2010 - 2012 7.0 80% 74.7% 70% 6.0 60% 5.0 Millions 50% 4.0 44.1% 40% 3.0 30% 2.0 23.0% 20% 1.0 10% 0.0 Dec-10 0% Apr-11 Aug-11 Dec-11 Outstanding loan Apr-12 Loan Growth, YoY Source: Bank of Mongolia Figure 16: Deposits (US$000s) and Growth Rate (%), 2008 - 2012 7.0 80% 72.7% 70% 6.0 60% Thousands 5.0 50% 40% 4.0 30% 3.0 23.9% 20% 10% 2.0 0% 1.0 -10% - -20% Dec-08 Jun-09 Dec-09 MNT deposits Jun-10 Dec-10 FX deposits Jun-11 Dec-11 Total Deposit, Growth YoY Source: Bank of Mongolia Exchange rate Exchange rate has been highly volatile since adoption of flexible exchange rate regime in 2009 Until 2009, BoM followed a fixed-rate policy regime, keeping the exchange rate within a certain fixed band which is evident in Figure 17. After the implementation of flexible exchange rate policy in 2009, the togrog become more volatile. The same year, the global financial crisis and sharp declines in commodity prices contributed to a 38 percent depreciation between October 2008 and March 2009. As the economy recovered quickly in 2010, the togrog became the world’s   second best-performing currency in 2010, finishing the year 13 percent higher against the US dollar behind the South African rand, which appreciated 14 percent. 14
  15. 15. ResCap Figure 17: MNT/USD Exchange Rate, 2000 - 2012 Financial crisis hits Mongolia harder than in other resource-rich countries 1800 Resource Investment Capital FDI reaches record high of $2.91bn 1700 1600 1500 1400 Flexible exchange rate introduced as part of IMF agreement with GoM in 2009 1300 1200 1100 1000 MNT becomes the second best performing currency 900 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 800 Source: Bloomberg Strong capital inflows and BoM intervention have supported MNT appreciation in the first half of 2012 In 2011, the togrog depreciated by 11.4 percent against the US dollar, reflecting a substantial increase in the current account deficit and a significant reduction in net foreign exchange inflows. The drivers of this are considered to be high domestic inflation, rising global risk aversion on the back of the euro zone crisis, and declining commodity prices. However, the togrog has once again appreciated markedly in the first half of 2012, rising from Tg1,396.4:US$1 at end-December 2011 to Tg1,329.8:US$1 at end-June 2012. Strong capital inflows and BoM intervention in currency markets have helped   curb   the   togrog’s   fall with timing of appreciation linked to the national election in June 2012. After the election, the currency has depreciated by 7 per cent to MNT 1410:US$ 1 at the end of September 2012. 15
  16. 16. ResCap Resource Investment Capital Case study: The Economic Impact of Oyu Tolgoi Oyu Tolgoi (OT) is a large open pit and underground mine located in the south Gobi desert in Mongolia. Upon completion, it is expected to produce 450,000 tonnes of copper and 330,000 ounces of gold per year at full capacity, establishing it as one  of  the  world’s  largest  copper and gold mines. The mine has been under construction since 2010 and is expected to start exporting in 2013. The extraction process is estimated to last a minimum of 50 years. OT is a joint venture between Turquoise Hill Resources (66 percent) and the Government of Mongolia (34 percent). Since December 2010, it has been fully managed by Rio Tinto, the majority shareholder in Turquoise Hill Resources (formerly known as Ivanhoe Mines). Statistics:     Total Phase I development capital expenditures (capex) : US$6.2bn o Mongolian government benefit from capex : US$950m o Mongolian private sector benefit from capex : US$1.385bn o Total Mongolia benefit from capex: US$2.335 (37.6 percent) Phase 1 : 94 percent completion in August 2012, exports will start after power issue is resolved Phase 2 : the underground mine will start production in 2015 Private sector involvement in OT development: 1,000+ Mongolian firms Figure 18: The OT effect on Mongolian real GDP, 2010 - 2045 Figure 19: The 2013-transition period, phase 1 Source: BAEconomics According to a study by BAEconomics, the Mongolian economy would be 36 percent larger in 2019 because of the OT project. The study further concludes that with OT, wages will be 30 percent higher, the value of exports will increase by 60 percent and the value of imports by 20 percent. These factors together will allow economic growth in the 2013-2020 period to average 11.7 percent, as compared to 7.7 percent without the OT project. OT is also expected to contribute an average of 30 percent of government revenues in the coming years, representing up to US$626m each year over the life of the project. According to the IMF, the government of Mongolia will receive 55 percent of the project cash flows through taxes, royalties, fees and dividends. An additional $500-800m per annum is expected to be distributed through procurement to the private sector. 2013 is widely considered to be a transition year, from a period of significant FDIfinanced expenditures to one of significant export-led revenues. According to OT estimates, 37.6 percent (or US$ 2.3bn) of the total development capex has gone to the government via fees and taxes, and to the private sector through local procurement for goods and services. We believe that until OT export pick up in the first half of 2013, the decline in FDI associated with the completion of OT construction could lead to a possible depreciation of the togrog in the short-run. However, the scaling-up of OT exports in the medium- and long-run support an appreciation of the local currency. 16
  17. 17. ResCap Resource Investment Capital Summary and currency implications The Mongolian economy experienced a robust recovery from the 2009 financial crisis and zud, recording economic growth of 6.4 percent in 2010 and 17.3 percent in 2011. This rapid expansion has continued through the first quarter and half of 2012, with real year-on-year GDP growth of 16.7 and 13.2 percent respectively outpacing BRIC and other nations. GDP growth is expected to remain close to 15 percent in 2012. GDP growth continues to be led by mining-related FDI and government spending. FDI reached a US$5.3bn or 62 percent of GDP in 2011, and is forecasted to grow at 26 percent per annum in 2012-13 according to the EIU. Government expenditures were US$3.496bn, which represented approximately 41 percent of GDP in 2011 and is forecasted to grow another 32 percent in 2012, with increased tax revenues supporting social welfare spending, among other priorities. Key risks to economic growth include continued high inflation that hampers consumer confidence, economic slowdown in China and declining global commodity prices, which would all place pressure on economic expansion. Exports surged between 2010 and 2011 from US$2.90bn to US$4.78bn or 56 percent of GDP, as a result of high global commodity prices and strong Chinese demand. However, imports grew even faster, from US$3.3bn in 2010 to US$6.5bn in 2011, to expand Mongolia’s  trade   deficit  to  a  recordhigh US$1.7bn (as compared to US$379m in 2010). Imports almost doubled in 2011, driven by mining-related purchases and fuel as well as private domestic demand for foreign products. According to the World Bank, exports will climb to US$5.2bn in 2013 reflecting strong external demand (particularly  from  China,  which  comprises  almost  all  of  Mongolia’s  sales).  As a result, a greater than expected contraction in the Chinese economy poses a  risk  to  Mongolia’s  export  earnings.  Imports  will  also  grow  in  2013  on  the   back of strong domestic demand, contributing to a widening trade gap in the short-term before the trend reverses. However, the overall balance of payments is expected to remain positive with foreign capital inflows financing the trade deficit expansion. Therefore, widening trade deficits in the near term are likely to place some pressure on the togrog, but this is counteracted by the positive and growing capital account, which results in increased demand for the local currency and thus a higher exchange rate relative to other currencies. As previously mentioned, a main driver of exports in Mongolia is commodity price, notably for coking coal, copper and gold. In 2011, soaring prices for all these commodities improved the terms of trade in favor of Mongolia. However,  according  to  the  World  Bank’s  June  2012  price forecast, prices for these commodities are generally forecasted to fall and stabilize in the 17
  18. 18. ResCap Resource Investment Capital medium term, beginning in 2012. In the short-term, the togrog has and will continue to benefit from favorable commodity prices, until price declines materialize. Despite forecasted price declines, however, the anticipated rise in commodity exports starting in the fourth quarter of 2012 is likely to place upward pressure on the currency. For example, in addition to demand for raw  materials  from  Mongolia’s  main  trading  partners,  Russia  and  China,  the   country is actively building closer links with other regional economies such as South Korea and Japan, which may support longer-term growth in export volumes. Thus despite commodity pricing pressure, increasing export volumes may support increased demand for the togrog. A second order implication of this is known as the Dutch Disease, where currency appreciation due to commodity exports make exports in other sectors such as manufacturing and agriculture less competitive. This is also a real risk for the Mongolian economy. The government experienced a budget deficit in 2011 and has continued to announce and execute major spending programs on infrastructure, publicsector salaries, transfers, and other programs. In May 2012, Mongolia recorded a widened fiscal deficit of 7.6 percent of GDP. In response to potential fiscal vulnerabilities, the government has enacted a Fiscal Stability Law that is scheduled to take effect in January 2013. This law prohibits the government from incurring large budget deficits by setting a 2 percent ceiling to the structural deficit, and also requires the country to set aside revenue generated from mineral sales.  This  is  necessary  since  the  country’s   fiscal position is highly sensitive to commodity price declines, as experienced in 2008 and 2009. Therefore, while growing fiscal deficits have placed downward pressure on the togrog, this tightening of fiscal policy, if effective, would place upward pressure on money demand and consequently, appreciate the local currency. Strong economic growth and increased taxable activity and tax revenues, from mining and all other sectors, should support public spending, improve the fiscal position and favor an upward trend for the currency in the long-term. Inflation has been a major threat to the togrog, the overall economy, and political stability. Headline inflation (y-o-y) in Ulaanbaatar was 15.1 percent in  June  2012,  significantly  higher  than  the  BoM’s  target  inflation  rate  of  9-12 percent in 2012 and 8 percent by 2013. The BoM has responded by gradually increasing interest rates, with further rate hikes likely in the remainder of 2012 and 2013. The BoM has already increased the 1-week CBB twice in 2012, from 12.25 percent to 13.25 percent. This has also been reflected in foreign exchange researches, which climbed to US$2.91bn in June 2012, representing a y-o-y increase of 14.4 percent. Another driver of international reserves growth has been a US$580M bond issuance by the Development Bank of Mongolia. 18
  19. 19. ResCap Resource Investment Capital While tightening monetary policy typically could lead to a local currency appreciation, this has not been the case in Mongolia. According to the World Bank and IMF, an overheating economy has counteracted the expected effects. Another explanation for the limited effectiveness of monetary policy is the linkage between inflation and global commodity and food price trends, driven by Chinese patterns and demand. Money supply and loan growth have also fuelled inflation in Mongolia. The M2 measure of money supply expanded by 22.2 percent y-o-y in June 2012 and bank lending has grown to MNT 6tr. Dramatic increases in bank lending have contributed to rising inflation by furthering money supply growth. On the other hand, the banking sector has recovered well from the financial crisis by improving the quality of their balance sheets, notably through deposit growth and decreases in non-performing loans (NPLs). These improvements point to greater financial sector stability, consumer confidence, and a favorable effect on the togrog in the long run. Political risk, particularly given the uncertain policy environment after the recent change of government, will be another source of volatility for the togrog. In the past, the government has taken several steps to enhance the country’s  credibility  among  investors.  For  example,  international  institutions   highlight the benefits of the flexible exchange rate regime implemented in early 2009 that limited intervention and built transparency. As well, the CNY-MNT swap deal was subscribed by many companies including the Mongolian Mining Corporation, the largest Mongolian coal miner, with US$600M in debt financing for infrastructure such as railroads. These measures further support favorable currency trends. The factors affecting the togrog are both wide-ranging and complex, and so are their effects. In the short-run (6-12 months), the global macroeconomic landscape, widening trade deficit, declining commodity prices, high domestic inflation, loose fiscal and monetary policy, and renewed political uncertainty will drive volatility and potential depreciation of the togrog. In the long-run, however, rapid economic growth, favorable trade and fiscal balances, tightened monetary policy, banking sector recovery and political reform are likely to be the drivers of togrog appreciation. 19
  20. 20. Mongolian togrog (MNT) report ANALYST CERTIFICATION AND DISCLOSURES Analyst Certification We hereby certify that all of the views expressed in this research report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our respective compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Important Disclosures Resource Investment Capital ("ResCap") is a boutique corporate finance advisor working with clients in connection with mergers and acquisitions, project development, public and private capital raisings and other strategic matters. ResCap is based in Ulaanbaatar, Mongolia with a dedicated focus advising on Mongolian-related transactions. ResCap seeks to foster long-term, seniorlevel relationships with clients and offers the services to both Mongolian and international enterprises focused on natural resources and related infrastructure projects. Disclaimer This report is made for information purposes only, and does not constitute an offer, solicitation of an offer to purchase, hold, sell, invest or make any other financial decision. In making decisions, investors may rely on their own examinations of the parties and risks involved. Information contained in this report is obtained from the sources believed to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors such information provided 'as is" without warranty of any kind and ResCap, in particular, make no representation or warranty, express or implied, as to accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances, ResCap has any liability to any person or entity (-ies) for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligible or otherwise) or other circumstances or contingency within or outside the control of any of their directors, managements, officers, employees, or agents in connection with compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, loss profits) even if ResCap is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. Address 3rd Floor, Monnis Tower, 15 Chinggis Avenue 1st Khoroo Sukhbaatar District 210648, Ulaanbaatar, Mongolia Tel: + 976 7010 0095 Fax: + 976 7010 0097 For general inquiries: inquiries@resource-cap.com Web: www.resource-cap.com ResCap Resource Investment Capital © 2012 ResCap Securities LLC. All rights reserved. 2

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