Eurasiamongoliaoutlook2012

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We􀀃remain􀀃bullish􀀃on􀀃MSE􀍲listed􀀃 equities􀀃in􀀃 2012.

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Eurasiamongoliaoutlook2012

  1. 1. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Copyright © 2012 Eurasia Capital Ltd. All rights reserved. This report or any portion thereof may not be reproduced or used in any manner whatsoever without the express written permission of Eurasia Capital except for the use of brief quotations. Eurasia Capital Ltd. th Suite 65, 6 Floor, Grand Office Center st Jamiyangun Street 12, 1 Khoroo Ulaanbaatar, Mongolia www.eurasiac.com www.eurasiac.com 1
  2. 2. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 CONTENTS Summary...................................................................................................................................................3 2011 At a Glance.......................................................................................................................................4 Economy ...................................................................................................................................................7 The Year of Records......................................................................................... 7 Trade Exceeds US$11bn .................................................................................. 8 Robust FDI Inflows and M&A Activity .............................................................9 Expansive Fiscal Policy..................................................................................... 9 Inflation Contained by Tight Monetary Policy.................................................11 Politics.......................................................................................................................................................13 Parliamentary Elections................................................................................... 13 Global Economy........................................................................................................................................15 Commodities: Bullish Amid Modest Global Growth.................................................................................16 Mining.......................................................................................................................................................17 Banking .....................................................................................................................................................20 Asset Classes.............................................................................................................................................26 Local Equities: Second Best Performing Market Globally ...............................26 International Equities ...................................................................................... 33 Mongolian Tugrik ............................................................................................ 34 Fixed Income ................................................................................................... 36 Property........................................................................................................... 38 Private Equity .................................................................................................. 40 Infrastructure .................................................................................................. 42 Annex 1: 2011 M&A League table ............................................................................................................45 Annex 2: Silk Road Composite Index Companies......................................................................................46 Annex 3: Silk Road Hong Kong Index Companies .....................................................................................48 Annex 4: Silk Road Australia Index Companies.........................................................................................48 Annex 5: Silk Road Mongolia Index Companies........................................................................................49 Contacts....................................................................................................................................................80 www.eurasiac.com 2
  3. 3. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 SUMMARY Mongolia continued its strong performance in 2011 in terms of the pace of economic growth, equity market, exports and foreign direct investment inflows. The country’s performance in 2011 has exceeded nearly all our projections we made in our Mongolia Outlook 2011 report published in January 2011. We estimate Mongolia overtook Qatar and has become the world’s fastest growing economy in 20111. Investor sentiment and attractive valuations have supported the stock market and ranked this frontier market as the second best equity market globally last year. Robust international commodity prices and firm demand in China, the key market for Mongolian commodities, have boosted exports to an all time high. Accelerated development of the Oyu Tolgoi project and investor appetite for quality resource assets have attracted a record level of foreign direct investments. We believe that Mongolia that is emerging as a key commodity supplier in Asia will continue its stellar performance through 2012 and beyond. We project Mongolia to experience astonishing 20% GDP growth this year, further solidifying its undisputable position as the world’s fastest growing economy in 2012. Substantial increase in exports (in particular, coal and iron ore), government spending, investments in major mining projects, primarily in Oyu Tolgoi and rapid surge in consumer spending will be the key drivers of the growth this year. We remain bullish on MSE listed equities in 2012. We expect the Mongolian equities to benefit from increased capital inflows and estimate the MSE TOP 20 Index to reach 28,000 by the end of this year, or +30% gain for 2012. We favor small caps that will outperform the index due to high growth of their businesses buoyed from low base effect and attractive valuations. We anticipate more IPOs and secondary offerings of Mongolian companies, both domestically and internationally, especially much anticipated jumbo IPO of Erdenes Tavan Tolgoi. Therefore, we strongly recommend our clients to invest in the Mongolian local equities as the most effective way to gain exposure to the Mongolian growth story. We target the Silk Road Mongolia Index (SILKMN) that includes Mongolia focused internationally and selected locally listed companies to reach 1,330 (+20% growth) in 2012, to be somewhat weighed down by expected subdue share performance of Ivanhoe Mines, the largest component of SILKMN index. SILKMN index finished 2011 poorly, down 27% due to negative investor sentiments toward emerging/frontier markets, triggered by the EU debt crisis and risk aversion. As a result, Mongolia related stocks have been unjustifiably oversold last year. We advise investors to snap up the most beaten up stocks as the companies’ strong fundamentals and value of their resource assets become more apparent. Our key investment themes in 2012 are opportunities across asset classes local and international equities, fixed income, private equity and real estate. Our top picks for the next 12 months among local stocks are Tavan Tolgoi (coking coal), APU (beverages), Remicon (construction materials) and Mongolia Development Resources (property). Mongolian Mining Corp. (coking coal), Prophecy Coal (thermal coal, power), Entrée Gold (gold) and Erdene Resource Development (molybdenum, coal) are our top picks among the SILMN index companies. 1 We assume that the economy of Qatar is estimated to have grown 15% in 2011, according to “Qatar Economic Outlook 2011 2012” report published by the General Secretariat of Development Planning of Qatar on October 1, 2011. www.eurasiac.com 3
  4. 4. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 2011 AT A GLANCE World’s fastest growing economy Our call made in our “Mongolia Outlook 2011” published on January 11, 2011, for the growth of the Mongolian economy played out as the Mongolian GDP grew 17.3% in real terms last year (vs our 10% growth target) and is likely to have become the world’s fastest growing economy outperforming Qatar (The General Secretariat for Development Planning of Qatar projected a 15% growth rate in 2011). Record high exports, investments, government spending and consumption have transformed the domestic economy and driven the growth. Second best equity market globally As we estimated in January last year the Mongolian stock exchange has maintained the top two best equity market globally in 2011 with an impressive growth of 32.6% in US$ terms (compared to Iraq Stock Exchange +35%). After being the best in 2010, MSE benefitted from improved investor sentiment and attractive valuations last year. Beating record FDI Foreign direct investments (FDI) hit a record level of US$3.8bn last year as we estimated. The ongoing Oyu Tolgoi, operating key coal and other mineral projects and exploration stage mines have attracted substantial capital amid robust demand in China and untapped potential in the resource rich country. Mongolia also saw robust M&A activity with most of the deals being struck in the mining sector. We estimate that M&A deal values amounted to over US$2bn. Foreign trade all time high In 2011, the Mongolian foreign trade surpassed its historical high set a year earlier, in line with our projections. Total trade turnover surged 85.1% y o y to US$11.3bn. Exports registered back to back record years growing 64.4% y o y to US$4.8bn in 2011 thanks to high international prices for key export commodities and physical volume expansion. China remained the biggest trading partner of Mongolia accounting for 56.7% of total trade, including 92.1% of exports and 30.8% of imports. Coal production exceeded 30Mt and exports 21Mt in 2011 that enabled Mongolia to overtake Australia as the biggest coking coal supplier to China. Moreover, China surpassed Russia in terms of selling more goods and services to Mongolia and became largest importer to the country. Government spending feeding expansion The economy experienced record fiscal expansion in 2011. General government expenditure surged 55.6% y o y to US$3.8bn. The budget performed extremely well for most of 2011 registering around 3% surplus at the end of 3Q2011. State budget flipped into US$310mn or 3.6% of GDP deficit at the end of the year with increased government expenditure, particularly capital spending and government consumption. Capital spending jumped 80.6% y o y to US$843.3mn. A 23.6% increase in public sector salaries and wages and 59.3% rise in subsidies and transfers, including almost 150% jump in social cash transfers supported strong private sector consumption. www.eurasiac.com 4
  5. 5. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Long term bullish on MNT Our call made on January 31, 2011 that the MNT may repeat global outperformance and continue appreciating another 10% in 2011 played out well in 1H2011. However, in 2H2011, MNT weakened on the back of the heightened global market volatility. The currency strengthened 5% to MNT1,195 per US$ through April 1 after which it has weakened 16.8% by end 2011 to MNT1,396 amid expanding current account deficit to US$2.4bn (end 2011) fuelled primarily by more than expected increase in imports of capital goods for mining projects. Booming banking sector Mongolian banking sector expanded a record rate of 50.1% y o y in assets to MNT9,372bn (US$6.7bn), compared with 41.2% in 2010 (assets to GDP ratio reached to the new high of 86.5%). Deposits surged 40% y o y last year as individuals and business entities as well as international institutions, which benefitted from significant increase in disposable income and sought portfolio diversification viewed the strength of the local currency MNT and high interest rates as a good investment. A year active with RTOs In 2011 mining IPOs were not as dynamic as in 2010. There was only one full fledged IPO on ASX by FeOre Ltd (FEO:AU), a Mongolia focused iron ore explorer, who raised A$35mn. In 2011 several companies came to the market through reverse takeover (RTO) of Mongolian assets (exploration licences). These companies, Draig Resources Ltd. (former C@ Ltd), Modun Resources Ltd. (former TVN Corp. Ltd), UTMI (former Wedge Energy International Inc.), Mongolian Resources Corp. Ltd (former Alamar Resources Ltd) and Kincora Copper Ltd. (former Brazilian Diamonds Ltd.), are currently trading on stock exchanges in Australia and Canada. Erdenes Tavan Tolgoi IPO delayed Much anticipated IPO of Erdenes Tavan Tolgoi, the state owned enterprise that holds the mining licence for the world’s largest untapped coking coal mine, didn’t take place in 2011 as it was expected. Early in July, the Government announced that it has selected China’s Shenhua Energy Company, U.S. Peabody Energy Corp. and Russian Mongolian consortium to develop the Western Tsankhi area of the Tavan Tolgoi mine. However, due to the public pressure and dissatisfaction among the bidders over the selection process as well as refusal by the National Security Council the Government had to backtrack on the deal. Later the Government resumed negotiations with all bidders and announced that Erdenes Tavan Tolgoi may raise more than US$3bn in IPO on the Mongolian and London Stock Exchanges by July 2012. Strengthening political ties 2011 was a successful year in the political life of Mongolia. The resource rich country signed a Strategic Partnership Agreement with China in June 2011. We expect the agreement to expand cooperation and bolster economic ties, and add further impetus to Chinese investments into and exports from Mongolia. As a result of bilateral visits of the state leaders, Mongolia and South Korea agreed to elevate relations to a “Comprehensive Partnership” status that seeks to expand cooperation in resource and infrastructure www.eurasiac.com 5
  6. 6. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 development. As a landlocked country, Mongolia puts emphasis on developing balanced relations with its two large neighbours and countries beyond or “third neighbours” through high level official visits by President and Prime Minister of Mongolia to USA, Australia, Italy and the Middle East countries. www.eurasiac.com 6
  7. 7. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 ECONOMY The Year of Records We estimate Mongolia was the world’s fastest growing economy in 2011. It registered record real GDP growth of 17.3% y o y and hit our 10% projection made in January last year. Growth was supported by record investments, exports and government spending. GDP Performance 14 25 12 20 10 15 8 10 6 Foreign direct investments (FDI), exports and 5 industrial output were driven by insatiable 4 Chinese demand for commodities. FDI reached 0 2 historical high US$3.8bn in 2011, a huge boon to 0 5 US$6.2bn (Y2010) Mongolian economy. In our 2007 2008 2009 2010 2011 2012F estimate, over 80% of FDI went into mining. GDP, US$bn (LHS) Real GDP growth, % (RHS) Mongolian exports registered back to back record years with exports reaching US$4.8bn in 2011. Source: National Statistics Office of Mongolia (NSOM), IMF, Eurasia Exports grew 64.4% y o y thanks to high Capital international prices for key export commodities and physical volume expansion. Industrial output increased 9.7% y o y, including 9.5% in mining and 11.6% in manufacturing. Coal production exceeded 30Mt rising 22.6% y o y in 2011. Iron ore output nearly doubled reaching 5.7Mt from 3.20Mt in 2010. Crude oil output rose 16.8% to 2.55MMbbl. Manufacturing expanded 11.6% y o y in 2011 with major industries such as food and beverages growing 10.5%, production of non metallic mineral products 40.5% and small 1.7% y o y advance in textiles. Expansive fiscal policy supported impressive GDP growth in 2011. Total government expenditure increased 55.6% y o y to record US$3.79bn. Capital spending surged 80.6% to US$843.3mn. Increases in public sector salaries led to 23.6% growth in government spending on salaries and wages. Private consumption was supported by 59.3% y o y increase in social cash transfers and subsidies. Albeit significant increase in government spending, state budget deficit remained small at about US$310mn or 3.6% of GDP. The deficit is much smaller than initially budgeted 9.9% of GDP. The state coffers were boosted by high price of mineral exports with mining sector accounting for about one third of government revenue. Tight monetary policy kept inflation in check at 10.2%. Significant depreciation of the national currency in the second half of 2011 alleviated risks of mining crowding out other industries in the economy. Cheaper currency is allowing time to other industries to adapt to rapid structural changes in the economy. Meanwhile, the Bank of Mongolia maintains record US$2.5bn hard currency reserves to fight any sudden swing in exchange rate in either direction. Overall, macroeconomic fundamentals of Mongolia have probably never been better. We project Mongolia to experience astonishing 20% GDP growth this year, further solidifying its undisputable position as the world’s fastest growing economy in 2012. www.eurasiac.com 7
  8. 8. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Substantial increase in exports (in particular, coal and iron ore), government spending, investments in major mining projects, primarily in Oyu Tolgoi and rapid surge in consumer spending will be the key drivers of the growth this year. Trade Exceeds US$11bn In 2011, Mongolian foreign trade surpassed its historical highs set in the previous year, in line with our projections. Robust international commodity prices and firm demand in China, the key market for Mongolian commodities, have boosted exports to an all time high. Total trade turnover surged 85.1% y o y to US$11.3bn. China remained the biggest trading partner of Mongolia accounting for 56.7% of its total trade, including 92.1% of exports and 30.8% of imports. Last year China overtook Russia as Mongolia’s largest imports market. China remains vastly the largest export market for Mongolian goods. It primarily buys natural resources from Mongolia. Its demand for commodities fuelled 64.4% y o y growth in Mongolian exports to record US$4.8bn. The country purchases almost 100% of Mongolia’s coal, copper, iron ore, crude oil and zinc exports. In 2011, coal exports to China exceeded 21Mt generating US$2.2bn in export revenue. Mongolian exports such as coal and iron ore, are usually sold at a discount at Chinese border. Mongolian producers lack scale and off take agreements to sell to end users directly and middlemen catch high margins from commodity trade. Mongolian exporters realized average price of US$110/t for their high quality hard coal in 2011. With the ramp up of production, Mongolian producers will be able to realize higher prices. Exports by Resources (US$mn) Exports by Markets (% of total, 2011) 5000 4000 3000 2000 Others US$0.38bn 7.9% 1000 0 2004 2006 2009 2010 Coal Copper Gold Zinc Fluorspar Molybdenium 2011 Iron ore Crude oil China US$4.4bn 92.1% Others Source: NSOM Source: NSOM Mongolian imports grew over 200% to US$6.5bn in 2011 from US$3.2bn in the previous year. Imports are driven by large scale construction in mining sector and growing consumption of population. Petroleum products, mining equipment and machinery, and food products are the major imports to Mongolia. We expect Mongolian foreign trade to register another record year in 2012. Mongolian trade is primarily driven by demand for commodities in China and mining related development inside the country. We do not expect slowdown in demand for Mongolian www.eurasiac.com 8
  9. 9. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 commodities. Mongolian exports are set to benefit from regional development focus in China. Mongolia borders some of the fastest growing regions of China. Infrastructure bottlenecks inside China and cheaper prices make Mongolian exports highly competitive. Mongolian exports may realize higher prices in 2012 due to diminishing role of middlemen and traders. China is to remain the largest trading partner of Mongolia. Mongolian exports are set to increase in volume with growth in coal and iron ore output, as well as in value due to higher realized prices. Robust FDI Inflows and M&A Activity In line with our expectations, Mongolia experienced another year of record foreign direct investments in 2011. Accelerated development of the Oyu Tolgoi project and investor appetite for quality resource assets have attracted US$3.8bn in FDI to Mongolia. We estimate that over 80% of FDI went to mining sector. Ivanhoe Mines’ construction budget for Oyu Tolgoi project alone was in excess of US$2.4bn. Foreign Direct Investments (US$mn) 4,000 3,000 2,000 1,000 0 2006 2007 2008 2009 2010 2011 Source: Bank of Mongolia Mongolia also saw robust M&A activity with most of the deals being struck in the mining sector. We estimate that M&A deals value doubled reaching over US$2bn. Most notable deals were Mongolian Mining Corporation (HKSE: 975) acquisition of QGX Holdings for US$464.5mn, to increase to US$950mn on reserve and output results, and Banpu Minerals purchase of Hunnu Coal (ASX: HUN) for US$537mn. We expect continued strong FDI inflows to Mongolia in 2012. Mining related projects drive investments again. We expect Ivanhoe Mines to invest in the region of US$2bn into construction of the Oyu Tolgoi project. Expansion of production at the East Tsankhi Tavan Tolgoi coalfield and tendering out of West Tsankhi will attract investments into Mongolian mining. Public private partnerships in infrastructure, including construction of power plants, railroads and roads under BOT model may attract further foreign investments into Mongolia. Expansive Fiscal Policy Mongolia experienced record fiscal expansion in 2011. General government expenditure increased 55.6% while revenue went up 40.9% y o y. General government budget performed extremely well for most of 2011 registering around 3% surplus at the end of 3Q2011. State budget flipped into US$310mn or 3.6% of GDP deficit at the end of the year with increased government expenditure, particularly capital spending and government consumption. Equilibrated general government budget (that is excl. approx. US$190mn in Stabilization Fund) deficit stood at 5.8% of GDP. The deficit is much smaller than initially www.eurasiac.com 9
  10. 10. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 planned 9.9% of GDP, primarily due to high price of commodities. Total general government budget revenue, including revenue allocated to Stabilization Fund was MNT4.4tn (US$3.5bn). Mining sector accounts for about one third of government revenue. Price assumptions for core mineral revenue generating commodities in state budget 2011 were copper US$5,983/t, coal US$98.8/t and gold US$1,350/oz. Total government expenditure and net lending reached MNT4.8tn (US$3.8bn) in 2011. Capital spending increased by 80.6% to US$843.3mn. 23.6% increase in public sector salaries and wages and 59.3% increase in subsidies and transfers, including almost 150% increase in social cash transfers supported private sector consumption. Subsidies and transfers accounted for 34.8% of total government expenditure and net lending, reaching 15.4% of GDP. Government Budget Performance (MNTbn) 6000 5000 4000 3000 2000 1000 0 2006 2007 2008 Revenue 2009 2010 2011 2012F Expenditure Source: NSOM, Eurasia Capital estimates The Government plans further increase in expenditure in 2012. Approved state budget envisages record MNT6.31tn (US$4.7bn) spending and MNT6.15tn (US$4.6bn) revenue. The Government seeks to increase expenditure by 31.7% y o y, whilst revenue side of the state budget is expected to increase by 39.7% y o y. GDP assumed to reach MNT16.13tn (US$11.9bn). Budget deficit will be 1.0% of GDP. Equilibrated general government budget (excl. Stabilization Fund) deficit will reach 3.0% of GDP. The Government expects to accumulate MNT322.45bn (US$240mn) or 2% of GDP in the Stabilization Fund. Underlying assumptions for mineral commodities in budget 2012 were copper US$6,663.5/t, gold US$1,723.75/oz, processed coal US$166.58/t, coking coal US$102.60, bituminous coal US$72.4/t and thermal coal US$57.2/t. We hold a cautious view on budget performance in 2012. Increased spending comes at a time of elevated risks to global growth. Cumulative spending on wages & salaries and subsidies & transfers is expected to grow 34% y o y to reach 20.5% of GDP. That includes social transfers exceeding 13% of GDP. Furthermore, capital expenditure is planned to almost double to MNT2.0tn (US$1.5bn) reaching 12.4% of GDP. The Government expects MNT522bn (US$400mn) from major mining project advance payments to finance budget deficit. In our view revenue side and GDP assumptions could be slightly optimistic considering risks to global economy and concerns about growth in China. Revenue side may not expand at a rate expected by the government. Advance payments from major mining projects may not materialize yet, putting government fiscal standing under pressure. Actual budget deficit may be higher than planned. On the other hand, strong commodity prices, diffusion of www.eurasiac.com 10
  11. 11. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 global economy concerns and continued strong growth in China may dramatically improve budget performance. Inflation Contained by Tight Monetary Policy Rapid growth and expansive fiscal policy kept inflationary pressure on Mongolian economy throughout 2011. Government expenditure on wages and salaries increased 23.6% y o y. Subsidies and transfers to population grew 59.3% to about US$1.3bn accounting for 38.8% of total government expenditure. Consumer Price Index (%, YoY) 15 12 9 6 3 Dec 11 Oct 11 Aug 11 Jun 11 Apr 11 Feb 11 Dec 10 Oct 10 Aug 10 Jun 10 Apr 10 Feb 10 Dec 09 0 To contain inflation the Bank of Mongolia tightened monetary policy in 2011. Inflation Source: NSOM threatened to get out of control in 1H2011 with core inflation hitting 11.4% y o y, whilst headline CPI number of 6.2% y o y remained low. Government coordinated sales of meat helped to bring down food prices. Meat and meat products remain a staple food in Mongolia and account for 16.5% of total CPI. In the same period, loans outstanding grew 57.9% y o y. Loans grew incredible 7.2% m o m in June 2011. Money supply (M2) jumped 63.8% y o y. Double digit inflation, incredible loan growth rates and strong economic growth indicated at overheating economy in 1H2011. The Bank raised its policy rate by 75 basis points to 11.75% in August and by 50 additional basis points to 12.25% in October. Furthermore, the Bank of Mongolia raised the banking sector reserve requirement twice in the year, by a total of 900 basis points to 11%. Tight monetary policy kept core inflation at 10% y o y and headline national inflation at 10.2% y o y in 2011. Money supply (M2) growth rate declined to 37.3% by the end of 2011. However, lending continued rising and registered 72.8% y o y growth in 2011. The Bank of Mongolia policy moderated inflationary pressure; however risks of high inflation becoming entrenched in the economy still remain. Strong growth and record government spending in 2012, including social transfers exceeding MNT2.1tn (US$1.6bn) will put considerable inflationary pressure on the economy. The central bank announced its intention to keep inflation below 10%. However, increased consumption will drive up prices, especially, food and fuel prices, in our view. We expect aggressive monetary tightening late 2Q2012. To contain inflation, the central bank may need to increase its policy rate as well as banking sector reserve requirement. We believe monetary policy may not be enough to keep inflation below 10% and it may hit 15% y o y during the year 2012. www.eurasiac.com 11
  12. 12. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Key Economic Indicators for Mongolia Indicator Population and income Population, mn GDP per capita, US$ 2004 2005 2006 2007 2008 2009 2010 2011e 2012f 2.53 720 2.56 905 2.59 1327 2.63 1620 2.68 2108 2.74 1688 2.76 2267 2.81 3045 2.86 4056 National accounts Nominal GDP, MNTbn Nominal GDP, US$bn Real GDP growth, y o y, % 2,152 1.8 10.6 2,780 2.3 7.2 3,715 3.2 8.6 4,599.5 3.9 10.2 6,555 5.1 8.9 6,591 4.6 1.3 8,415 6.6 6.4 10,830 8.6 17.3 16,134 12.0 20.0 Monetary indicators and inflation M2 growth, y o y, % CPI, y o y, % Exchange rate, MNT/US$, end year International reserves, US$mn 20.4 11.0 1,209 208 34.6 9.2 1,221 333 34.8 4.8 1,165 718 56.3 14.1 1,170 1,001 5.5 22.1 1,267 657 26.9 4.2 1,443 822 62.5 13.0 1,257 2,000 37.3 10.2 1,396 2,500 50.0 15.0 1,300 2,500 33.1 35.0 2.1 30.1 27.5 3.2 36.6 28.5 3.9 40.9 38.0 2.2 35.4 40.2 5.0 32.9 38.3 5.4 37.1 36.6 0.5 40.6 44.3 3.7 38.1 39.1 1.0 4,780 6,527 64.4 104.1 1,747 3,818 5,740 7,500 20.0 15.0 1,760 3,000 Government finance Revenue, % of GDP Expenditure, % of GDP Budget balance, % of GDP Balance of payments Exports, US$mn 872 1,069 1,545 1,952 2,539 1,885 2,909 Imports, US$mn 1,021 1,224 1,516 2,170 3,616 2,909 3,200 Exports, y o y, % 41.2 22.4 44.9 22.5 30.3 24.9 54.3 Imports, y o y, % 27.5 16.0 25.4 36.1 66.6 34.3 49.7 Trade balance, US$mn 149 155 30 218 1,077 252.3 291.6 FDI, US$mn 92.9 182.3 367 500 709 801 1,400 Source: National Statistics Office of Mongolia, the Bank of Mongolia, IMF, Parliament resolutions, Eurasia Capital estimates e = estimate, f = forecast www.eurasiac.com 12
  13. 13. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 POLITICS We view 2011 as a successful year for Mongolian foreign policy. The country is playing an active and growing role in North Asia. The number of high level visits to and from Mongolia reflects increasing significance of the country in the region. The country signed a number of important bilateral agreements on cooperation and investments. As a landlocked country sandwiched between Russia and China, Mongolia puts emphasis on developing balanced relations with its two large neighbours and countries beyond or “third neighbours”. Among many dignitaries, Mongolia hosted US Vice President J. Biden, German Chancellor A. Merkel and South Korean President Lee Myung Bak. Mongolian President and Prime Minister paid visits to China, Russia, USA, Australia, Italy and the Middle East countries. Mongolia signed a Strategic Partnership Agreement with China in June 2011. We expect the agreement to expand cooperation and bolster economic ties, and add further impetus to Chinese investments into the Mongolian economy. Mongolia also enjoys strategic partnership status with Russia. During the visit of Korean President to Mongolia, the countries agreed to elevate bilateral relations to a “Comprehensive Partnership” status. The parties agreed to expand cooperation in resource and infrastructure development. Mongolian astute and pragmatic foreign policy places the country at the heart of political and economic developments in North Asia, while the country enjoys very good “neighbourly” relations with many countries in the region and beyond. Mongolian lively domestic policy demonstrated stability and continuity. The ruling coalition government focused on development and poverty reduction. Consecutive years of record FDIs indicate at the government’s aptitude to attract investments. The government provided strong and unequivocal support to the Oyu Tolgoi Investment Agreement, albeit calls from some Members of Parliament for re negotiation. Mongolian political process is consensus driven and major decisions are hotly deliberated and contested. The decision process is time consuming, but the decisions enjoy wide support afterwards. The abortive Tavan Tolgoi tender reflects the nature of multi dimensional political process and difficulties of driving major decision in pre election year by a coalition government. Parliamentary Elections The country will hold parliamentary elections in June 2012. Gearing towards elections the Democratic Party, a junior partner in the government, has left the ruling coalition with the Mongolian People’s Party (MPP). We expect lively political discourse on equitable economic development, poverty reduction and welfare, society and environment in the run up to the elections. A number of parties will participate in the elections, but we expect the Mongolian People’s Party and the Democratic Party to dominate the elections and political agenda. The elections will be held under the new Elections Law adopted in December 2011. The law introduced proportional system into the election process. Previously, all 76 MPs were elected by direct vote from single mandate districts. Under the new law, 48 MPs will be elected by direct vote and 28 MPs will be elected on party list voting. The number of MPs www.eurasiac.com 13
  14. 14. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 remains unchanged at 76. The Mongolian nationals living abroad will be able to vote only on party lists. Everyone will be wary of a repeat of the post 2008 elections crisis. The elections in 2008 saw a brief period of turmoil and civil unrest before the forming of a coalition government between MPP and DP. The coalition government succeeded in stabilizing the country and focused on attracting investments, diversifying economy and fighting corruption. Overall, we do not expect repeat of 2008. The country is developing at furious pace and there is an intuitive consensus among major political parties on economic development. Regardless of the election outcome, we do not expect reversal of recent achievements and major changes to the economic governance. www.eurasiac.com 14
  15. 15. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 GLOBAL ECONOMY With an economy dependent on exports and foreign capital, Mongolia is not immune from the trends in the global economy, in our view. Significant decline in international prices for commodities may pose a risk to the Mongolian export revenues. The moderately growing U.S. economy, sovereign debt crisis in Europe and slowdown in developing countries may affect the demand for commodities, therefore putting downside pressure on prices. The World Bank estimates the world economy to grow at a moderate rate of 3% in 2012 according to its Global Economic Prospects report released in January 2012. In particular, growth in high income economies is projected to slow to 1.4% GDP growth rate this year and the developing economies to 5.4%. The economy of China, the largest export market for Mongolia, may slow to 8.4% amid expected weakening demand in the US and European markets. Global Economic Growth (2010 2012f) 18 16 15.1 14 12 10 8.4 8 5.4 6 4 3 1.4 2 0 0.3 2 World High income Euro area Developing economies 2010 2011e China Mongolia 2012f Source: The World Bank (GEP, January 2012), NSOM, National Statistics Bureau of China Despite all these, we believe that the current demand level in China should still be considered strong for the Mongolian commodities exports. In our view, Mongolia may strengthen its market position further in China this year by winning more market share from its competitors such as Australia and Indonesia through supplying commodities at relatively cheaper price and due to infrastructure bottlenecks in the respective provinces of China. Even if a moderate decline in the commodities prices is expected to persist, Mongolia should benefit from the increase in physical volume of its exports, primarily coal and iron ore. www.eurasiac.com 15
  16. 16. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 COMMODITIES: BULLISH AMID MODEST GLOBAL GROWTH Prospects of commodities whether it will be attractive or daunting largely depend on the performance of the global economy in particular on the ability of the U.S. and China to successfully support their economies and on the ability of European leaders to come up with a constructive solution to the Eurozone crisis. However, the uncertainty is that the outlook for the global economy in 2012 is not strong which if realized might put downward pressure on commodity prices. According to the IMF, the World Bank and to the median of 70 economist estimates compiled by Bloomberg, the worldwide economy is likely to slowdown in 2012. Although this is the case, the pessimistic global outlook is not fully reflected in the forecasted positive commodity prices according to the analysts’ estimates compiled by Bloomberg. The bullish forecast by the analysts about commodity prices shows the anticipation that the world in particular the U.S., China and Europe will be able to positively resolve the economic challenges ahead of them supporting demand for commodities. It is worth noting that although the analysts in Bloomberg Survey were able to predict correctly a downturn in commodity prices for 2011 they were off the target for 2010 predictions. Putting Mongolia into perspective, we think Mongolia as a heavily mineral dependent economy will remain vulnerable to commodity price fluctuations since mineral exports of Mongolia constitute the lion’s share, approximately 88%, of total exports. Moreover, Mongolia’s prospect partially depends on the reasonable budget assumptions about the price of the key commodities (coal and copper) and China’s ability to engineer soft landing for the economy. Commodity Price Forecasts 2010 2011 Actual Difference +21.7% 98.83 +13.5% Forecasted (median) 100 +48.8% 8,859 7,600 14.2% 8,625 147 +37.4% 135.63 168 +23.8 150 18,375 2,062 24,750 2,454 +34.7% +19% 23,937 2,375 18,710 1,875 21.8% 21.1% 20,812 2,140 Lead, US$/t 1,874 2,550 +36.1% 2,450 2,035 16.9% 2,250 Gold, US$/t 1,099 1,420 +29.2% 1,426 1,563 9.6% 1,572 Copper, US$/t Iron Ore Fines 62% FE spot, US$/t Nickel, US$/t Zinc, US$/t Actual Difference 94.31 6,450 9,600 107 2012 Forecasted (median) 87 Crude oil (WTI), US$ Forecasted (median) 77.5 Hard quality Coking Coal, *191 *289 US$/t Thermal Coal Australian 106.03 129.58 Newcastle, US$/t, average annual Source: Bloomberg Survey, Steel Index, globalCoal, *BREE, ABARES Australia Japan average contract price *226 www.eurasiac.com 16 120
  17. 17. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 MINING Importance of mining industry for the Mongolian economy has been increasing over the last years. Contribution of mining and quarrying industry to GDP increased 8.7% in 2011 compared to 3.6% in 2010. Even though production of copper, molybdenum, fluor spar, zinc concentrates and gold declined compared to the last year, the production of commodities which are the key contributors to GDP increased significantly. Coal, crude oil and iron ore output rose substantially by 22.6%, 16.8% and 77.3%, respectively, in 2011, according to the preliminary data provided by the Mongolia National Statistical Office data. It should be noted that our projection regarding coal output is in line with actual statistics. As we have forecasted coal production hit all time high of 30Mt in 2011 on the back of strong demand from China. In 2012 we forecast that Mongolia would produce 38Mt of coal. For the long term we stick to our view that Mongolian annual coal production will surge to 100Mt by 2020 in a pattern similar to what Indonesia experienced during 1997 2004. Exports of Key Commodities 2009 Volume Gold, tonne Copper concentrate, 000 tonnes Molybdenium ores and concentrate, 000 tonnes 10.9 587 6.7 Fluor spar ores and concentrate, 314 000 tonnes Iron ore, 000 tonnes 1,598.1 Iron ore scrap, tonnes 656 Zinc concentrate, 000 tonnes 150.7 Coal, 000 tonnes 7,113.2 Crude oil, 000 barrel 1,938.5 Source: National Statistics Office of Mongolia 2010 Value, US$’000 308,473.2 501,923.7 50,308.8 Volume 2011 2010 vs 2011 Volume, Value, % % 47 36 0.72 25 12.5 9.8 Volume 5.1 568.7 4.8 Value, US$’000 178,339.0 770,594.2 51,989.1 2.7 572.8 4.2 Value, US$’000 113,046.6 963,596.0 46,393.6 48,223.9 405.6 68,824.5 404 94,876.7 0.39 37.9 88,769.5 139.9 122,494.3 306,300.6 115,632.5 3,563.7 1,010.2 119.8 16,726.2 2,070.8 253,825.1 313.9 134,135.3 881,998.3 154,386.1 5,753.1 1,261.9 120.7 21,105.6 2,540.5 437,328.3 512.0 142,678.4 2,250,046.4 252,191.8 61.4 24.9 0.8 26.2 22.7 72.3 63.1 6.4 155.1 63.4 Mongolia Dwarfs Australia in Coking Coal Exports to China As we have identified in our Mongolia Outlook 2011, coal exports surpassed copper exports in monetary value by US$111.4mn in 2010 for the first time in Mongolian export history. In 2011 value of coal exports exceeded that of copper 11.5 times or by US$1.28bn. Moreover, in 2011 another important milestone was achieved as Mongolia overtook Australia as the largest exporter of coking coal to China. In just three years Mongolia emerged from being a minor to a major coking coal exporter to China. We estimate that in 2011 Mongolia met approximately 38% of China’s coking coal imports demand. The main reasons for China increasing its coking coal imports from Mongolia are big price difference (more than 2 times) between seaborne market supplied coking coal and Mongolian coking coal, transportation bottleneck in China to bring coal from coastal areas to developing regions in the north and extreme flooding in Australia that decreased coking coal supply from Australia. Looking forward we anticipate that Mongolia will likely strengthen its position in China’s coal imports. www.eurasiac.com 17
  18. 18. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 China’s Coking Coal Imports by Source 2009 Others 13% 2010 2011E Mongolia 12% Canada 9% Mongolia 32% Others 24% Mongolia 38% Others 31% Canada 7% Australia 66% Australia 37% 34.5Mt 47.3Mt Canada 6% Australia 23% 55.19Mt* Source: China Customs data, Statistics Offices of Australia, Canada and Mongolia, *Eurasia Capital estimates Mining IPOs Not As Dynamic As in 2010 In 2011 mining IPOs were not as dynamic as in 2010. There was only one full fledged IPO on ASX made by FeOre Ltd (FEO:AU), a Mongolia focused iron ore explorer, that has started trading on December 15, 2011 after raising A$35mn. Another Mongolia focused exploration company, Kara Minerals, was planning to raise A$20mn through IPO on ASX and start trading in early December 2011. However, the company has withdrawn its application from ASX without being able to generate enough interests in the offering, in our view. Kara Minerals Ltd. was incorporated in Australia to acquire and develop Nasryn Hundlun Tin Project in north east of Mongolia. Guildford Coal was also considering listing its unit, Terra Energy, on ASX. A float is still under consideration in 2Q2012. In 2011 several companies came to the market through a reverse takeover of Mongolian assets (exploration licences). These companies, Draig Resources Ltd. (former C@ Ltd), Modun Resources Ltd. (former TVN Corp. Ltd), UTMI (former Wedge Energy International Inc.), Mongolian Resources Corp. Ltd (former Alamar Resources Ltd) and Kincora Copper Ltd. (former Brazilian Diamonds Ltd.), are currently trading on stock exchanges in Australia and Canada. Much anticipated IPO of Erdenes Tavan Tolgoi, the state owned enterprise that holds the mining licence for the world’s largest untapped coking coal mine, didn’t take place in 2011 as it was expected. Early in July, the Government announced that it has selected China’s Shenhua Energy Company, U.S. Peabody Energy Corp. and Russian Mongolian consortium to develop the Western Tsankhi area of the Tavan Tolgoi deposit. However, due to the public pressure and dissatisfaction among the bidders over the selection process as well as refusal by the National Security Council, the Government had to backtrack on the deal. Complex and opaque process caused considerable concerns among investors over the Government’s ability to successfully finalize the deal. Later the Government resumed negotiations with all bidders and announced that Erdenes Tavan Tolgoi may raise more than US$3bn in IPO on the Mongolian and London Stock Exchanges by July 2012. In our view, the government www.eurasiac.com 18
  19. 19. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 anticipates that it will be able to do the IPO of Erdenes Tavan Tolgoi in 2012 since it has already included the prepayments from the deal in the 2012 budget. We are slightly cautious about the government’s ability to successfully launch the IPO this year taking into account upcoming parliamentary elections and uncertainties in global markets. Political Maneuvering Triggered by Elections In September 2011 twenty MPs and several lawmakers demanded the coalition government to reconsider existing agreement on the Oyu Tolgoi mine by requesting to increase Mongolia’s stake in the project to 50% from 34%. However, Rio Tinto and Ivanhoe Mines refused to accept proposed amendment to the agreement. This situation gave a warning signal to international investors indicating that Mongolia could be an unstable country to invest. As a result the share prices of international mining companies with operations in Mongolia tumbled significantly on the back of this news. Fortunately, for the benefit of investor community and Mongolia as whole, the coalition government issued a joint statement with the two mining companies in which it reaffirmed its commitment to the existing investment agreement. We view that request for renegotiation of investment agreement was politically driven amid the forthcoming parliamentary elections in June 2012. Looking forward we see the risk that ahead of upcoming elections similar unusual requests might make the country go through turbulent times. Nevertheless, even though Mongolia, similar to other countries, is sensitive to such kind of events, we think that the government is acting in the public interest and taking pragmatic approach to manage the challenges. New Exploration Licences Still Not Granted Temporary suspension of granting new exploration licenses set in 2010 was not lifted in 2011. Instead government agencies were cleaning holders of exploration and mining licences from companies that were violating the laws. The State Specialized Inspecting Agency (SSIA) has shut 73 mining companies down that were operating illegally near the river and forest basins. Majority of closed companies were small illegal gold mining companies. The ban on granting new exploration licences is expected to be effective until the government passes a new law on mineral resources. Moreover, the government intends to reduce total area of Mongolia covered by exploration licences from today’s 17% to 10%. As of November 25, 2011 there were 3,763 active exploration and mining licences in Mongolia. www.eurasiac.com 19
  20. 20. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 BANKING Representing the Booming Economy Mongolian banking sector expanded a record pace of 50.1%, compared with 41.2% in 2010, along with the rapid expansion in the economy. Large FDIs particularly in the mining sector and the consequent increase in commodity export income had significant positive impact on the whole economy. Goods and services industries benefited from increased demand from households, growth in state and corporate investments, and strong corporate and individual income boosted tax revenue to the budget. The banking sector assets surged to MNT9,372bn (US$6.7bn) and bank assets to GDP ratio reached to the new height of 86.5%, clearly representing the booming economy. Bank Assets and Growth Assets/GDP Ratio, % 10,000 60% 100% 8,000 50% 80% 40% 6,000 30% 4,000 20% 2,000 10% 0% 0 2007 2008 2009 Assets, MNTbn 2010 2011 Growth, % Source: The Bank of Mongolia, Eurasia Capital 87% 74% 67% 74% 56% 60% 40% 20% 0% 2007 2008 2009 2010 2011 Source: The Bank of Mongolia, Eurasia Capital Current accounts (CAs) and deposits grew 30.2% and 40.0% in 2011 compared with 109.5% and 49.5%, respectively, in 2010. Combined growth of 36.5% to MNT5,739bn in CAs and deposits created half of the sector growth. Other capital sources grew more than CAs and deposits in 2011. Loan from the banking sector increased 61% (77% of this growth came from the central bank) to MNT672bn supporting sector wide growth by 4.1%. Foreign liabilities grew 54.4% to MNT688bn and government deposits surged 120.6% to MNT932mn, each supporting sector growth by 3.9% and 8.2%, respectively. Together with shareholders’ equity growth of 77% to MNT677bn and other liabilities growth of 78.3% to MNT662bn, all the “non CAs and deposits” capital sources contributed to the other half of growth in 2011. It should be noted that there was an extraordinary increase in each of loans from the Bank of Mongolia, foreign liabilities, and government deposits in December because of the competition among the banks to show higher year end asset numbers in their balance sheets. XacBank announced its plan to sell US$300mn bonds on Euro Medium Term Note programme in international markets. The bank plans to raise up to US$150mn within the programme in 2012. This has been in line with our general expectation that the banks will www.eurasiac.com 20
  21. 21. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 seek access to foreign capital markets primarily through bond deals and private equity to increase capacity to provide long term loans. The banks were also able to add MNT86.5bn into their equity last year. The large state budget had its place in the banking sector balance sheet having 120% higher figure compared with the previous year. In monetary terms, the government deposit increased by MNT509bn to MNT932bn representing almost 10% of the sector asset sources. CAs and Deposits, Growth and Share in Assets 8,000 Banks Financing Sources 2011 80% Current Accounts 60% 6,000 7% 7% 40% 21% 4,000 20% 0 8% 20% 2007 2008 2009 2010 2011 CAs and Deposits CAs and Deposits % in Assets CAs and Deposits Growth, % Source: The Bank of Mongolia, Eurasia Capital Liabilities to the Banking Sector Foreign Liabilities 10% 0% 2,000 Deposits 7% Government Deposits 40% Equity Others Source: The Bank of Mongolia, Eurasia Capital The domestic loan demand was very strong during 2011 and is expected to continue growing the following years. Total outstanding loans jumped 73.4% y o y to MNT5,598bn which was 59.7% of total assets at the end of 2011. As the sector wide loan quality, measured by past due in arrears and non performing loans (NPLs) ratios, significantly improved in 2010, the banks started loosening credit policy from the beginning of 2011. During 1H2011, the total outstanding loans increased 40% (5.8% per month) or by MNT1,289bn. The global financial market uncertainty during 2H2011 had a negative effect on the MNT performance, export income and FDI inflow, thus eventually raising risk aversion of the banks. New loans granting speed observably slowed from July. During 2H 2011 new loans increased only 24% (3.6% per month) or by MNT1,080bn. The Bank of Mongolia raised reserve requirement ratio from 5% to 9% in February and further to 11% in August last year against surging inflation. However, as the banks had plenty of reserves, this tool didn’t effectively work to slow loan growth. The central bank’s only effective tool was policy rate, in our view, and therefore, the already high rate was further raised three times by 50bps to 11.5% in April, by 25bps to 11.75% in August, and by 50bps to 12.25% in October. www.eurasiac.com 21
  22. 22. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Loans, Growth and Share in Assets Reserve and Liquidity Ratios 80% 6,000 5,000 60% 4,000 60% 50% 40% 3,000 40% 2,000 20% 1,000 30% 20% 10% 0 0% 2007 2008 2009 2010 2011 Outstanding Loans, MNTbn Loans/Assets, % Outstanding Loans Growth, % Source: Bank of Mongolia, Eurasia Capital 0% 2007 2008 2009 2010 2011 Reserve, Cbills/CAs and Deposits, % Liquidity Ratio, %* Source: Bank of Mongolia, *Eurasia Capital Estimates In line with our expectation, past due in arrears and NPLs ratios improved throughout the year, the former dropping to historical low of 1.3% and the latter substantially down to 5.8% at the end of 2011. In absolute terms, these sub loans declined 17.3% and 11.8%, respectively. NPLs and Past Due in Arrears Ratios 17.4% 20% 15% 10% 5.8% 5.8% 3.3% 5% 2.4% 4.6% 2.0% 1.3% 0% 2005 2006 2007 NPL/Loans, % 2008 2009 2010 2011 Past Due in Arrears/Loans, % Source: Bank of Mongolia, Eurasia Capital Market Bet for MNT The currency structure of CAs and deposits give us some notion regarding the market bet on the currency rate. Domestic currency CAs and deposits soared 48.3%, y o y. Its share in total CAs and deposits increased to 70% while foreign currency CAs and deposits increased only 15.3% y o y and its share down to 30%. www.eurasiac.com 22
  23. 23. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Respective weighted average annual rates 10.5% and 2.8% on MNT denominated CAs and deposits against 4.5% and 1.1% on US$ denominated CAs and deposits, at the end of 2011, show the attractiveness of holding assets in MNT. Throughout 2011, individuals and corporate entities preferred holding their money in MNT as they were betting on MNT appreciation, though the local currency had steadily lost against US$ during 2H2011. The MNT depreciation during 2H 2011 didn’t clearly show dragging impact on the MNT denominated CAs and deposits’ growth. Currency Structure of CAs and Deposits 100% 80% 60% 67% 62% 61% 64% 70% 33% 38% 39% 36% 30% 40% 20% 0% 2007 2008 Foreign Currency 2009 2010 Domestic Currency 2011 Source: The Bank of Mongolia, Eurasia Capital The Blanket Guarantee Law on CAs and deposits approved in 2008 expired in January 2012. The Bank of Mongolia, the Financial Regulatory Commission and the Ministry of Finance had developed a commercial deposit insurance law during the last two years. As we projected a year ago, the law was not approved in 2011 and the parliament is currently discussing the law. We expect the law will be approved this year and it will serve for the sector development in the long term. Record Earnings 2011 was a golden year for the banking sector. It counted 2.8 times larger net earnings compared with the previous year. The sector wide net earnings summed to MNT184.3bn, the central bank numbers show. The profitability of the sector gauged by ROA and ROE ratios peaked to the top rates of our reference period of since 2003. These ratios peaked to 2% and 27.2%, respectively, last year. During the past financial crisis the sector netted MNT210bn cumulative loss in 2008 2009, which was mostly cost of the bankruptcies of two banks Zoos and Anod. www.eurasiac.com 23
  24. 24. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Record ROA and ROE Largest 10 Banks By Outstanding Loans (2011, MNTbn) 40% 20% 27% 17% 15% 0% 20% 2007 2008 2009 2010 2011 20% 40% ROA, % 60% 80% 1,600 1,400 1,200 1,000 800 600 400 200 62% Source: The Bank of Mongolia, Eurasia Capital ROE, % Source: The Bank of Mongolia, Eurasia Capital 2012 Outlook: Will Hopefully Manage Well We expect the banking sector to expand about 30% this year. We believe this growth estimate is reasonable based on our economic growth target, inflation and MNT forecasts, and FDI expectation. On one hand, highly expansionary state budget and anticipated fund raising by the banks from the international capital markets may cause the sector to see higher than our estimated growth. On the other hand, heightened inflation fueled by the budget would possibly drag the growth of the sector through lower capital inflow. We expect that the market will remain betting on MNT in 2012 as we retain our long term bullish outlook on the local currency and target 1,300 MNT/US$ rate. In our view MNT denominated CAs and deposits’ share in total will stay stable at 70% and the balance will be on foreign currencies. Annual rates on CAs and deposits are likely to remain stable, we believe, as the banks have plenty of reserves in cash in Central Bank accounts (12.2% of total assets at the end 2011), Central Bank bills (9.4% of assets), assets deposited abroad (7.6% of assets), and government bonds and stocks (5% of assets). Therefore, the banks will not fiercely compete for capital by raising deposit rates, in our view. On the contrary, tightening monetary policy and heightened inflation expectation would possibly push the banks to raise rates. The Bank of Mongolia raised the liquidity ratio requirement for banks to 25% effective from January 2012. Due to the short term nature of banking sector liabilities (CAs and less than one year term deposits), the banks must seek access to long term capital available in the international capital market. XacBank intends to issue US$150mn of its planned US$300mn Euro Medium Term Notes in Singaporean Stock Exchange this year. We may see that the largest two banks also contemplate to tap into the bond market. Golomt Bank received the debut ratings from Standard & Poor's and Moody’s in November 2011 that may indicate preparation for bond issuance. In 2011, the Bank of Mongolia resolved that the equity capital adequacy ratio will be raised from current 12% to 12.5% on June 30, 2012, to 13% on December 31, 2012, and further to 14% on June 30, 2013. In addition, the banks have to increase their equity capital at least to www.eurasiac.com 24
  25. 25. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 MNT16bn by May 1, 2013. Meeting the absolute equity requirement does not pose a problem for most of the banks. However, increased capital adequacy requirement and sharp sector expansion will inevitably force the banks to go public in the coming years. We view that the banks will try to raise capital in private equity deals this year, and starting from the next year they will seek opportunities for possible IPOs. We recall that earlier in 2010, the CEO of Golomt Bank stated that the bank may go public on an international stock exchange in 2012. We estimate 40% more new loans to be granted in 2012 taking into account of continued strong demand, significant reserves of banks, capital growth as supporting factors. Meanwhile inflation threat and the expected more tightening monetary policy from the Bank of Mongolia will still be present. The Bank of Mongolia has been increasing reserve, liquidity and capital adequacy requirements and policy rate decline is unlikely this year. It appears that interest rates are not likely to decline in 2012. Loan quality will further improve, in our view. Loans in arrears rate already at the record low level, and we anticipate this to remain stable. Non performing loans ratio was markedly down from 11.5% to 5.8% as of the respective 2010 and 2011 year ends, and we expect to see further improvement on the ratio, smoothly declining below 5%. 2011 was a golden year for the Mongolian banking sector as it counted record profits. The local banks will do well again this year, based on our belief that the banks will not raise rates offered for capital, loans interest rates will not decline and loan repayment will further improve. www.eurasiac.com 25
  26. 26. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 ASSET CLASSES Local Equities: Second Best Performing Market Globally MSE Hit the Target In line with our projections that the Mongolian equity market will be among the world’s top three best performing markets, the MSE closed 2011 as the second best performing market globally. The market benchmark, the MSE Top 20 Index, surged 46.9% (32.3% in US$ term) to 21,687.57. This is higher than our initial target of 20,000, +40% growth estimated in our 2011 outlook. The MSE Top 20 Index outperformed developed and emerging markets, while the S&P 500 Index remained flat, and MSCI EM Asia and MSCI Frontier indices lost 19.1% and 22.1%, respectively. MSE Top 20 Index Performance 2011 MSE Top 20 vs Global and Regional Benchmarks 34,000 20,000 30,000 250% 15,000 22,000 10,000 18,000 200% MNTmn 26,000 MSE Top 20 MSCI EM Asia S&P 500 MSCI Frontier 150% 5,000 14,000 100% Dec 11 Source: MSE, Eurasia Capital Dec 11 Nov 11 Oct 11 Sep 11 Jul 11 Aug 11 Jun 11 May 11 Apr 11 Mar 11 Jan 11 Top 20 index Feb 11 Top 20 Trading Volume (MNTmn) 50% Dec 10 Oct 11 Nov 11 Sep 11 Jul 11 Aug 11 Jun 11 Apr 11 May 11 Feb 11 Mar 11 Jan 11 10,000 Source: MSE, Eurasia Capital MSE market cap reached MNT2,168.6bn (US$1,554.5mn) at the end of 2011 adding MNT794.6bn (US$570mn) in total during the year. Shortly after exceeding US$1bn threshold first time in mid November 2010, MSE market cap almost tripled in three months hitting US$2,829.5mn at the peak on February 25, 2011. However, the market declined till the end of May. The total equity trading volume at the MSE was MNT109.1bn (US$78.2mn) last year, 28.2% higher compared with 2010. MSE Market cap, US$mn MSE Stock Trading Volume, US$mn 3,000 US$mn 2,500 2,000 1,500 Source: MSE, Eurasia Capital www.eurasiac.com Dec 11 Nov 11 Oct 11 Sep 11 Aug 11 Jul 11 Jun 11 May 11 Apr 11 Mar 11 Feb 11 Jan 11 1,000 90 80 70 60 50 40 30 20 10 78 53 16 11 2006 50 47 2007 2008 2009 2010 2011 Source: MSE, Eurasia Capital 26
  27. 27. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Bubble and Burst MSE experienced significant volatilities last year due to low liquidity, increased awareness of the market, new development initiatives and international financial market turbulences. Rush to take exposure as early as possible created a bubble in the MSE pushing the Top 20 Index up 123.3% to 32,954.97, within less than two months at the beginning of 2011. The 2010 global outperformance of the MSE (138.4%), the London Stock Exchange (LSE)’s strategic partnership agreement and the Master Service Agreement to modernize the MSE and the country’s stock market as a whole combined with positive general economic outlook loudly signaled about the opportunities of the market. Furthermore, the government announced that 10% common shares of Erdenes Tavan Tolgoi (ETT) will be distributed to every Mongolian citizen in 1Q2011 raised awareness of the market among the Mongolian people and foreign investors. Though the total market capitalization gained US$1.7bn during this period, an average daily volume was only US$230,000. During three months till the end of May following the peak, the index went through significant correction and lost 43.8% to 18,534.23 on an average daily volume of US$330,000. The international financial market slide and increased volatility started from 2Q further worsened through the remainder of the year which had a freezing impact on the cash inflows from foreign investors. During the second half of the year, the index ranged between 18,000 and 22,000 while the average daily volume further improved to US$370,000. Our 2011 Calls Played The top 5 companies of the exchange together with other two big gainers comprised over 80% (US$511mn) of the total market gain (US$570mn) in 2011. Tavan Tolgoi (TTL) and APU (APU) hit our 2011 targets. TTL, the largest cap stock of the bourse, surged 91% and APU, becoming the second largest, jumped 111.1% supporting the market expansion by US$198mn and US$118mn, respectively. However, Mongolia Development Resources (MDR), a real estate play, declined 22.3%. The third and fourth largest stocks of Main contributors to MSE 2011 Growth the bourse, Baganuur (BAN) and Shivee Ovoo (SHV) advanced at 16% relatively moderate rates of 24.8% and 4% 35% 17.7% adding US$39mn and US$22mn 4% to their market caps, respectively. The 5% other two big gainers were Berkh Uul 7% (BEU) which contributed US$50mn, 9% 20% the third biggest, to the market cap as its share price soared over 24 times from a year earlier level and UB BUK Source: MSE, Eurasia Capital (BUK) which contributed US$23mn as it grew over 6 fold. Tavan Tolgoi APU Berkh Uul Baganuur Sharyn Gol UB BUK Shivee Ovoo Others Our belief that the Mongolian stock market had been well undervalued has been proved by the spectacular growth for the past several years. The investors who understood the real opportunity in the market counted tremendous performance in their portfolios again in www.eurasiac.com 27
  28. 28. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 2011. The high performance of the blue chip large cap stocks was supported by the factors that first, these were fundamentally undervalued and second, they have strong growth outlook. We view that the valuations of some large cap stocks have reached the bottom of their reliable intrinsic value ranges considering their fundamentals, growth outlooks and, as well as the market and individual company risks. We believe that the downside risk in the market is limited as the Mongolian economy expanded 17.3% last year and is expected to speed up further this year and to remain as the world’s fastest growing economy for several years to come. MSE Top 20 Companies Share Performance 2011 50% Bayanteeg Suu Talkh Chikher Mogoin Gol Remicon APU Tavan Tolgoi Hotel Mongolia Bayangol Hotel BDSec State Department Store Baganuur Shivee Ovoo Sharyn Gol Khukh Gan Genco Tour Bureau Gobi 8% Mongolia Development Resources 22% Mongolian Telecom 23% Aduunchuluun 25% 0% 50% 100% 150% 200% 250% 300% 350% 400% 450% 414% 210% 184% 163% 144% 111% 91% 61% 50% 40% 35% 25% 18% 8% 7% 0% Source: MSE, Eurasia Capital “Hidden Jewels” Being Exploited Many small caps grew at skyrocketing rates emerging from very low bases. In 2011, 54 small caps out of the total listed 334 (MSE) companies surged more than 100%. The average share price growth of these 54 companies was 1,600% (median 491%), ranging from 107% to 28,010%. The combined market cap of these “hidden jewels” increased by MNT184bn (US$130mn) to MNT215bn (US$154mn) from a year earlier level of only MNT31bn (US$25mn). Most of them are industrial, consumer goods and mining plays. The tremendous growth is attributed to the following factors: The balance sheet assets were significantly undervalued or asset book values were much lower than the market values or replacement costs, Profits are hidden. The fundamental problem of accounting misreporting peculiar to frontier and early emerging markets is common in Mongolia. The belief that the accounting issues will be resolved leading to realization of hidden profits is one factor which supported the performance. www.eurasiac.com 28
  29. 29. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Speculation. It should be noted that there is a speculation component with the general view that the market is undervalued and the Mongolian corporate sector has very positive prospects. We believe there are certainly a number of “hidden jewels”, however, investors should be mindful of the risks to explore and exploit them. The inherent risk of low liquidity of the market must be noted. The US$130mn market cap growth of these small caps was generated only on US$4.1mn total annual trade volume. 2011 MSE Top 10 Performers 0% Top 10 New Million $ Companies 10000% 20000% APP (Sudut) 30000% 28010% Teever Darkhan 13014% Tav 10917% Ar Bayankhangai 3221% 0 1 Market Cap, US$mn 2 3 4 5 APP (Sudut) Teever Darkhan Gutal Tav Berkh Uul 2447% Khereglee Impex 2148% Sor USIB 2014% Agro Tech Impex Ikh Barilga 1650% Nekheesgui Edlel Mongeo 1513% Darkhan Hotel 2010 Market Cap 1338% Bukhug 2011 Market Cap Khusug Trade Source: MSE, Eurasia Capital Ikh Barilga Source: MSE, Eurasia Capital MSE Fund Raising Activity Improving and New IPOs Expected in 2012 We expect a number of additional share offerings and few IPOs in 2012. Several currently listed companies and private companies submitted their IPO and additional offering documents to the Financial Regulatory Commission (FRC) for approval. Three companies received approval from FRC for additional share offering last year. On August 9, Silikat (SIL), an operator of light concrete plant in Darkhan city in Mongolia, successfully raised MNT3.65bn (US$3mn) issuing additional 16.2mn shares at MNT225 per share. On October 17, one of the blue chip coal stocks of the MSE, Sharyn Gol (SHG) completed MNT18.3bn (14.2mn) fund raising additionally offering 1.65mn or 16.2% of its shares at a price of MNT11,117 per share. This was the first capital raising by a mining company on the MSE and one of the largest. New York based Firebird Management’s funds acquired a controlling stake of the company in 2010 and SHG carried out additional exploration worth US$5mn in that year. In February, 2011, SHG released the new JORC compliant resource of 373.8Mt of thermal coal. Remicon (RMC), which operates concrete mixture plant in Ulaanbaatar, received approval from the FRC on its planned MNT7.5 9.4bn (US$5.4 6.7mn) secondary offering in December and currently collecting orders. www.eurasiac.com 29
  30. 30. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 New IPOs and more additional fund raisings are expected in 2012. As we reported last year the Mongolian Government approved a list of State Owned Enterprises (SOEs) that are slated for privatization; these are entities in mining, mineral processing, power generation and distribution, construction materials, telecom and transportation. The leaders among these expected privatizations we closely watch in 2012: Erdenes Tavan Tolgoi (ETT): The Mongolian government has planned to float up to 30% of the shares of ETT, who holds world’s largest untapped coking coal deposit, on the LSE and MSE within 1H2012. 10% of common shares were already distributed to all Mongolian citizens without charge in April, 2011. Another 10% should be sold to Mongolian companies according to the parliament resolution in 2010. However, the parliament is currently discussing whether to sell that 10% to Mongolian companies or to distribute it additionally to citizens. Mongolian Railway: In May 2011, the government announced that it had decided to raise the required fund for the construction of government’s planned new 1,100km railroad selling 49% of Mongolian Railway LLC on the MSE. The enterprise was established in 2008 with the intention to construct, own and use the railroads which will be built according to the state policy. And, now it is building the 1,100km railroad from South Gobi to the eastern border of Mongolia, in accordance with the state policy approved in 2010. The project cost is estimated to be US$2 3bn. We view that after the Erdenes Tavan Tolgoi IPO, the state priority will shift to this project though the time requirement for the project would possibly be longer than a single year. Baganuur: In 2010, the government approved Baganuur’s (MSE: BAN) additional share offering in the market by 2012. The company started the tender process to select technical and financial advisors for the project in October, 2011. The size of the offering is expected to be about 24% of the total shares. LSE and MSE Strategic Partnership Evolving In April 2011, Mongolia took a historically important step to develop its capital markets as the State Property Committee of Mongolia (SPC), MSE and London Stock Exchange (LSE) signed the landmark Master Service Agreement (MSA) to develop the MSE. The three institutions agreed on the details of modernizing the MSE with the support by the LSE during the next three years. According to the service agreement, the LSE will assist the MSE to introduce an integrated securities trading system, create effective legal environment, bring the infrastructure, technology, and help upgrade human resources capability in line with the international standards appointing a management team at the MSE. Since the agreement was signed, the LSE team together with the MSE and SPC has made an important progress in the areas of sector legal environment improvement, internal restructuring of the bourse, and professionals education. These include: Securities Market Law development: The restructured MSE led by the LSE team together with other sector regulatory and participatory organizations have developed new Securities Market Law and submitted to the Ministry of Justice for www.eurasiac.com 30
  31. 31. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 the review on September 1, 2011. The new law defines custody services and enables set up of custodians, nominee and omnibus accounts, trading and settlement of Depository Receipts. The law is expected to reduce legal conflicts. These amendments and revisions introduce international standards and are in line with the strategic partners’ plan to transform the securities settlement system of the MSE from current T+0 to T+3 which is standard in developed countries. MSE Rules and Regulations: The revised trading rules, membership rules are already approved, and listing rules, clearing & settlement rules are at the stage of approval. As the MillenniumIT system is installed in the MSE, the appropriate international standard trading and clearing & settlement rules are being developed. MillenniumIT: The system is completely installed by December, and the market professionals are currently exercising on trial trading. Training: The Academy of the LSE has carried out training programs for regulators, market participants and other stakeholders in UB and London during the last year. The major developments investors should expect to see in the Mongolian securities market and MSE in 2012 include: New Market and Trading Structures: MillenniumIT system will start officially and T+3 settlement cycle will replace T+0. Custodian services will be introduced, and Mongol Bank will start operating as a settlement bank, trading and clearing members will be registered. Minimum capital, financial and risk requirements for those participants will be re regulated. The Settlement Guarantee Fund (SGF) will be funded and enhanced. Listing and Membership Fees to Change: The MSE plans to change the initial listing and annual membership fees based on the market cap rather than nominal volume. They expect it will serve as an incentive for new companies to raise money listing on the exchange. Lower Trading and Settlement Fees: Currently the trading and settlement fees are very high compared with other international markets, and the MSE proposes to decrease the fees by 50% in 2012. As liquidity increases over time, the fees will be lowered to international levels, and be based on transactions not on monetary volumes of trades. The development will support the market liquidity making the market more attractive for international and domestic investors. Erdenes Tavan Tolgoi Listing: This will have significant direct and indirect impact to increase market size and liquidity attracting local and international investors. The MSE plans to improve corporate governance and transparency of the listed companies from this year. The new Company Law approved in October 2011 inserted many new concepts on corporate governance and transparency. We believe the law will support the securities market development. www.eurasiac.com 31
  32. 32. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 2012 Outlook We remain bullish on MSE listed equities in 2012. We expect the Mongolian equities to benefit from increased capital inflows and estimate the MSE TOP 20 Index to reach 28,000 by the end of this year, or +30% gain for 2012. We favor small caps that will outperform the index due to high growth of their businesses buoyed from low base effect and attractive valuations. We anticipate more IPOs and secondary offerings of Mongolian companies, both domestically and internationally, especially much anticipated jumbo IPO of Erdenes Tavan Tolgoi. Therefore, we strongly recommend our clients to invest in the Mongolian local equities as the most effective way to gain exposure to the Mongolian growth story. Our top picks for the next 12 months are Tavan Tolgoi (coking coal), APU (beverages), Remicon (construction materials) and Mongolia Development Resources (property). The pace of the upward move measured by the performance of the TOP 20 companies will be at a slower pace than the last year. Because first, the market has already come out of the low base and second, we view that the valuation of some large cap stocks have come into the their reliable intrinsic value ranges considering their fundamentals, growth outlooks as well as market and individual company risks. In our view, the downside risk is limited as the market has already reflected the significant correction since March 2011. We note that Mongolian stock market still remains illiquid and any inflow or outflow of hot money may significantly move the market up or down, as was the case in both 2010 and 2011. Erdenes Tavan Tolgoi’s IPO is expected to create crowd in the market. The MSE schedules to implement the public education programme during the year as all Mongolians are now shareholders of Erdenes Tavan Tolgoi. Flow of funds from foreign individual and institutional investors into Mongolia is projected to intensify starting from 2H2012. We expect within 1H2012 the European crisis situation will stabilize and Erdenes Tavan Tolgoi IPO will take attention of international investors into Mongolia. Although the market liquidity is currently low, it is likely to improve as new IPOs and new investors are expected to come into the market. In addition, the “Hidden Jewels” (small cap non resources sector companies) on the MSE will be further explored. The renovation and development measures at the MSE including start of MillenniumIT system, T+3 settlement, custodian services establishment, improvement in listing and membership fees and 50% decrease in trading commission are all to support the liquidity and attract new investors. www.eurasiac.com 32
  33. 33. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 We target the SILKMN index to reach 1,330 (+20% growth) in 2012, to be somewhat weighed down by expected subdue share performance of Ivanhoe Mines, the largest component of SILKMN index. Mongolian Mining Corp. (coking coal), Prophecy Coal (thermal coal, power), Entrée Gold (gold) and Erdene Resource Development (molybdenum and coal) are our top picks among the SILMN index companies. We advise investors to snap up the most beaten up stocks as the companies’ strong fundamentals and value of their resource assets become more apparent. www.eurasiac.com 33 Dec 11 Oct 11 Nov 11 Sep 11 Jul 11 Jun 11 Apr 11 May 11 Jan 11 Feb 11 Mar 11 Dec 10 Oct 10 Nov 10 Sep 10 Jul 10 Aug 10 Jun 10 Apr 10 May 10 Feb 10 Mar 10 Financial turbulences and debt crisis in Silk Road Mongolia Index Euro zone sent down emerging market 1,880 stocks significantly. Mongolia linked 1,780 internationally listed companies have 1,680 also suffered along with other emerging 1,580 markets companies. Total market 1,480 capitalization of Silk Road Mongolia 1,380 Index (SILKMN) which tracks 32 1,280 Mongolian companies was US$25.91bn 1,180 in 2011 and the index is down 27% y o 1,080 y. Silk Road Hong Kong Index (SILKHK), 980 includes 10 Hong Kong listed Mongolia 880 focused companies, is down 51% y o y. Ivanhoe Mines, Centerra Gold and Mongolian Mining Corp., the largest companies by market capitalization in Source: Silk Road Management SILKMN index are down 22.9%, 10.2%, 35.6% y o y, respectively. The main reasons behind the drop of share prices of the SILKMN index companies are, in our view, the overreaction by the investment community to the economic events occurring globally and, to some extent, their response to company specific events. However, thanks to strong demand by China for the Mongolian resources, sound fundamentals of the companies and while the global markets stabilize, we believe that internationally listed companies with operations in Mongolia are poised to experience recovery in 2012. Aug 11 International Equities
  34. 34. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Mongolian Tugrik We maintain our long term bullish MNT and Current Account (2011) view on the MNT while short term Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec volatilities may occur in 2012. Our call 1450 made on January 31, 2011 that the 186 1,396.37 1400 500 MNT may repeat global outperformance and continue 1350 1,000 appreciating another 10% in 2011 1300 1,500 played out partially. The currency strengthened 5% to MNT1,195 per US$ 1250 2,000 1245.5 through April 1 after which it has 2,500 2,421 1200 weakened 16.8% by end 2011 to MNT1,396 amid expanding current 1150 3,000 account deficit to US$2.4bn (end Current account, $mn (cumulative) (LHS) MNT/US$ (end month) (RHS) 2011) fuelled primarily by more than expected increase in imports of capital Source: Mongol Bank, NSOM, Eurasia Capital estimates goods for mining projects. The currency depreciated 11.1% y o y in 2011. The commercial banks experienced demand pressure for the US$ amid accelerated imports that exceeded export revenues. The current account deficit reached its record level of US$2.4bn by end 2011. The central bank that follows the flexible exchange rate regime has not intervened in the foreign exchange market and supplied limited amount of foreign currencies in the market. This resulted in accumulation of international reserves in the central bank a record level of over US$2.3bn at the end of 2011. We expect the MNT to experience volatility this year. Our target for the currency is 1,300 per US$ that represents approximately 7% appreciation in 2012. On one hand, there is a possible downside risk caused by further acceleration in imports for the development of key mining projects, including Oyu Tolgoi copper gold and Tavan Tolgoi coal mines as well as for building the major transport infrastructure. For example, import of trucks surged 177% to US$578mn last year. Expected high prices for petroleum products (petrol, diesel fuels) that represent over 16% Mongolia’s total imports and whose value jumped 68% last year (to US$1,052mn in 2011 from US$626mn a year earlier) may also increase the pressure on the downside. On the other hand, the national currency should expect some strength supported by ramp up in exports by key coal producers and inflow of foreign investments. Assuming that international prices for the country’s major export commodities – coal and copper – are expected to stay firm in 2012, and demand in China remains firm, the Mongolian economy should benefit from increase in physical volume of their exports, especially that of coal. We estimate that the coal exports may increase at least 40% y o y to 30 million tonnes in 2012 (from over 21 million tonnes in 2011) easing the downside pressure on the currency. www.eurasiac.com 34
  35. 35. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 In addition, we expect the central bank will likely intervene in the foreign exchange market to stem high inflation as political stress rises amid the June 2012 Parliamentary elections. We already see growing critics from the members of the Democratic Party, which withdrew from the coalition government this month, to seek more support from the voters as the elections approach. The democrats blamed the central bank that the high exchange rate of the US$ has affected fuel prices and, consequently other consumer goods that caused concerns among the people. Therefore, in our view, the central bank sold relatively large amount of US$ in the market to ease the accelerated depreciation of the MNT in January this year. www.eurasiac.com 35
  36. 36. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Fixed Income Positive outlook is expected in 2012 for government bonds, certificates of deposits (CDs) and term deposits in major commercial banks in Mongolia. We view that in 2012 the government of Mongolia will further utilize debt markets both domestically and internationally for development in mining, construction of roads and houses, as well as to support social spending. The issuance of dollar denominated government bonds will accelerate the process to tap global international debt markets. It is currently unclear that the upcoming year will be successful for corporate bonds as they continue to undergo the test period started in 2011 with the Meat Bond offering. CDs and term deposits of major banks in Mongolia will continue offering attractive investment opportunities with high interest rates. The last year experienced relative improvement in government bond figures backed by confidence in Mongolia’s expected growth. Primary bond sales increased over 7.867 times in nominal terms year over year with a total amount of MNT236.73bn (over US$169mn) in 2011, although there was significant slowdown in later offerings. During June through August, the government offered bonds to finance the long term housing loan program for 4,000 government officials, and nearly MNT65bn was successfully sold out of the MNT72bn offer. The Mongolian government announced MNT300bn bonds issue in several offerings starting from August, to support cashmere, wool industries, and small and medium enterprises (SMEs). Though nearly MNT172bn of the issue was traded, further sales in October and November declined next to zero, affected by the negative global sentiment over government debts. Therefore, it is worth noting that further developments in government bond offerings might be significantly affected by the same factor in 2012. The Development Bank of Mongolia (DBM), with the unconditional backing of the Ministry of Finance of Mongolia and ING Groep of the Netherlands, established a US$600mn euro medium term note program. In December, the DBM sold the initial US$20mn one year bonds at 6% to ING Groep in a private placement. Given that Mongolia needs huge amounts of investment to finance railway, mining, and agriculture projects, construction of roads and accommodation, and various social spending, the DBM is expected to facilitate access to foreign debt for several debt issues. Meat Bonds (also “Makh Bond”) issued by Just Group kicks off the corporate bonds offer after a long break since 2007. While tapping into the debt market by the companies may be considered a good sign to diversify the sources of capital to implement projects at the company level, Mongolia is currently undergoing a testing period to measure the appetite of the corporate debt investors. Just Group was able to raise only just over MNT4bn out of the planned MNT30bn to finance meat processing activities. The disappointing bond sales were mainly due to risk aversion toward the debt instrument. We may expect such uncertainty in 2012, and it is unclear if there will be any bond offer by local companies, considering the risks of investing in untested market. CDs and term deposits at the top four commercial banks offer over 13% rates annually in MNT and 6% rates in the US$ for individuals. These banks offer negotiable rates for www.eurasiac.com 36
  37. 37. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 corporate clients at about 6% 8% in the national currency. Despite these favorable rates, for foreign investors, we believe the deposits in MNT should be considered together with the risks involved in the exchange rate. Deposits rates by major banks Bank Golomt Bank Trade and Development Bank Khan Bank Xac Bank Source: Company Data www.eurasiac.com 12 month rate in MNT 13.8% 13.5% 13.4% 13.2%/14.4% 12 month rate in US$ 6.6% 6.6% 6% 6%/6.2% Type CDs CDs Term deposit “Housing”/“Age gracefully” deposits 37
  38. 38. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Property US$/sqm In Mongolia Outlook 2011, we mentioned Silk Road Ulaanbaatar Property Index, US$ per sqm that strong economic growth, national 1050 currency appreciation and speculative inflow 1000 of foreign capital have driven residential 950 property prices up nearly 20% during 2010. 900 We also concluded that growth of property 850 prices in US$ terms was mainly attributed to 800 MNT appreciation of 12.9%. At the end of 750 2011, Silk Road Ulaanbaatar Property Index 700 (SRPUB), the benchmark that tracks the 650 property prices in Ulaanbaatar advanced 600 18.4%. It implies that the average price of Jan 09 Jun 09 Nov 09 Apr 10 Sep 10 Feb 11 Jul 11 residential property in the secondary market reached US$1,018 per square meter and for Source: Silk Road Management the first time during the past 3 years it exceeded US$1,000 threshold. It has to be mentioned that unlike 2010, when Mongolian currency appreciated, this year MNT lost 11.1% y t d. The plunge of tugrik had downside impact in property prices in US$ terms, which suggests that price growth in MNT is even more significant. Mongolian banking system has been rapidly expanding but the effect of mortgage loan penetration was not significant at 4% in 2010 and 6% in 2011. Despite this, mortgage loans still nearly doubled from last year from MNT334bn to MNT656bn and had major impact in residential property market during 2011. We expect that Ulaanbaatar residential property prices will continue appreciation as the availability of mortgage financing increases and the rate of loan penetration grows. Mortgage loans, MNTbn 700 600 500 400 300 200 100 0 2008 2009 2010 2011 The Central Bank of Mongolia Luxury residential property segment is driven by foreign investors in the market and the growing number of wealthy Mongolians. With population of 2.7 million and fast growing economy, the significance of wealth creation for Mongolians will be even more apparent in the coming years. This factor has already resulted in increasing number of luxury residential developments as well as stimulating the demand from local population. In addition, cost of construction has increased as a result of appreciation of land prices in central locations. Majority of the luxury apartments were priced at US$1500 2700 per sqm during 2011 and average house or larger apartment could be priced at over US$500,000. www.eurasiac.com 38 Dec 11
  39. 39. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Although the pace of construction slowed during 2009 2010 and office property projects stalled, market has picked up from 2H2010 and the supply of quality office space is expected to increase significantly going forward. Completion of Monnis Tower and Central Tower (51% owned by Shangri La Asia), has contributed to the increase of quality office space, followed by launch of Express Tower and Blue Sky Tower, all concentrated in the Sukhbaatar Square area. However the total space of modern class office space is estimated at 160,000sqm, still not adequate to alleviate demand pushing rental rates up. In the immediate future we do not expect that Grade A offices will be impacted by the increased supply and the rental rates will continue to increase. Situation might change from 2H2013 when the major projects will be completed and the market will see substantial increase of new office spaces. Mongolian commercial property market has rather young history. Robust economic growth during the last few years and improving living standards of the local population of Construction by property type, MNTbn Mongolia has driven retail sector to expand 300 significantly. According to National 250 Statistical Office, wholesale and retail trade 200 in Ulaanbaatar surged 57.7% from 1.75bn to MNT2.75bn in 2011. With the launch of 150 Max Mall and Naran Mall, the supply of 100 prime retail space has increased but rental 50 rates remain to be close to office rents, suggesting that there is significant potential 0 for growth. 2006 2007 2008 2009 2010 Residential Trade & service Other 2011 Industrial Hospitals, schools and cultural Estimated total contribution of the tourism sector to GDP in Mongolia remains to be Source: National Statistical Office of Mongolia around 9%. The number of visitors in Mongolia has been on the rise and reached all time high of over 492,800 visitors in 2009. In 2011, total of 460,360 tourists visited Mongolia according to General Authority for Border Protection. The demand for luxury hotel rooms is expected to grow as the booming mining sector will stimulate business travel. Currently operating hotels, that are considered to be 4 5 stars, do not fully comply with international quality standards. However situation is changing quickly. In 2011 Ramada hotel opened its doors, the first in a new wave of international brands to move into Ulaanbaatar. Construction projects are already underway for Shangri La, Best Western, Hilton, Sheraton, Hyatt and Radisson. In 2012, we reiterate our view that the Mongolian property market possesses significant growth potential. With the robust economic growth expectations, we estimate that property prices will continue to grow at double digit rates. Residential property prices in Ulaanbaatar should add another 15% in 2012 and reach US$1,150 per sqm. We also stand by our view that the growth will be boosted by economic growth, wealth creation and national currency appreciation. However we expect that from 2012 mortgage loans will start playing major role in property market growth. www.eurasiac.com 39
  40. 40. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Private Equity Accelerating economic growth in Mongolia will offer a strong appeal for more sophisticated investors to search for private equity deals in financial services (banking, insurance, leasing), agricultural, manufacturing, media, IT, property advisory, tourism and hospitality sectors. Moreover, we believe that there are numerous under capitalized small to medium sized resource companies in Mongolia which are seeking for funds to develop their resources. A growing number of privately held companies, looking to list domestically and internationally, will create pre IPO opportunities. The telecom market appears to be relatively saturated with more than 60% penetration rate of cell phone users, according to South Korea’s SK Telecom. In 2011, SK Telecom exited the market selling its entire 29.3% stake at Skytel LLC for US$25mn to existing shareholders. Terra Energy LLC (TE), owned by Guildford Coal, may create a pre IPO opportunity as the owners initially planned to list TE with several exploration licenses in South Gobi region of Mongolia. M&A Mongolia experienced significantly larger M&A activities during 2011 in line with our projections the previous year. We estimate 39 M&A deals were observed with the total volume of over US$2bn in 2011, nearly twice as much as in 2010. Mining and exploration is an exclusive sector for M&A in Mongolia, particularly in 2011, many international mining and exploration companies were active participants in the process. According to our estimates, since 2007, the Mongolian coal industry has experienced over 50 M&A deals with total value of US$2.19bn. In 2011 only, 27 coal related M&A deals worth US$1.65bn were completed. The most prominent names in terms of the M&A deal size throughout the year include Banpu (Thailand), Mongolian Mining Corp. (Mongolia), Noble Group (Asia), Guildford Coal (Australia). Banpu, Thailand’s coal magnate, acquired Hunnu Coal with over 800Mt JORC compliant coking and thermal coal resources in 11 exploration projects in Mongolia. Banpu acquired 12.2% of Hunnu in March for AUS$45mn and the rest for AUS$477mn (US$493mn) in September through November at AUS$1.8 per share, paying nearly 30% takeover premium to shareholders. Mongolian Mining Corp. acquired the Baruun Naran (QGX) coking coal mine with 253Mt NI 43 101 compliant Measured and Indicated resources for US$464.5 from Kerry Mining (90%) and MCS Minerals (10%). The acquisition value may be adjusted to US$950mn depending on the proven and probable reserves as well as production from the Baruun Naran mine. Noble Group, a large Asian commodities trader, acquired 10.1% undiluted interest in Aspire Mining by the end of 2011. Through a joint venture (50/50) with Xanadu Mines, Noble owns the Nuurstei coking coal project (with the right to own up to 80%) and Javkhlant project. www.eurasiac.com 40
  41. 41. Mongolia Outlook 2012 World’s Fastest Growing Economy 31 January 2012 Guildford Coal, an Australian exploration company, made exploration license acquisitions worth a total of US$50.73mn through its joint venture, Terra Energy, with local partners. The company managed to increase its stake in Terra from 50% to 70% this year for US$7.23mn. Guildford recently carried out talks with potential buyers. Draig Resources (formerly C @ Ltd.), another Australian exploration company, acquired 100% shares of BDBL LLC, a subsidiary of Peabody Winsway Resources, with 8 coal exploration licenses. The settlement worth of US$7.87mn was completed in late 2011. We believe Mongolia continues to be one of the most appealing targets for M&A deals in 2012. Coal companies, both exploration and mining, will dominate in the list of potential strategic buyers. Mongolia holds estimated 160 billion tonnes of coal resources with significant further exploration potential and only 17% of the area has been explored. M&A target prospects, in our view, will include SouthGobi Resources (SGQ: TSX), Mongolia Energy Corp. (276: HK), Aspire Mining (AKM: ASX), Guildford Coal (GUF: ASX), Sharyn Gol (SHG: MSE), Xanadu Mines (XAM: ASX), Mogoin Gol (BDL: MSE). Naturally, the international players will account for the majority of the strategic buyers as they contribute to the development with much needed funds and expertise. We expect potential strategic buyers such as ArcelorMittal, Vale, Xstrata, Glencore, Noble Group, KORES, JOGMEG, Teck Resources to expand actively in Mongolia. Following the activities in mining, logistics will be an attractive topic. In 2011, Tembusu Investments (TIL: AIM), a logistics company, acquired Salins Limited, a local company with assets licensed to carry out coal transportation and other logistics services in Mongolia. www.eurasiac.com 41

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