The media frenzy surrounding Mongolia’s current economic crisis is akin to what was seen in 2011-2012, when newswires were filled with stories declaring the country the world’s greatest economic growth story. At the time, there seemed little that could go wrong, Mongolia was posting massive GDP growth, commodities were booming and investors were flocking to the country en masse. In retrospect, with hindsight being 20/20 and all, commodity markets during this time were topping out and the Government of Mongolia (GOM) was about to start an illadvised war with their largest investor Rio Tinto over the Oyu Tolgoi mine. For a country nicknamed “Minegolia,” the aforementioned proved deadly to its growth story, yet positive headlines continued in earnest into 2013:
- “Rio set to open mammoth Mongolian mine” – ABC News, February 2013
- “Booming Mongolia: Mine, all mine” – The Economist, January 2012
- “Mongolia: A speculator’s fantasy” – Fortune February, 2011
- Mongolia targets global mining role as investments soar – BBC News, April 2011
Today, the media are in an equal but opposite frenzy, focused on Mongolia’s current economic and fiscal crisis. But in reality, Mongolia has been in a perpetual crisis which began in August 2013, when Rio Tinto halted underground construction at Oyu Tolgoi due to the GOM’s attempts to unilaterally re-negotiate the project’s Investment Agreement. For anyone who was watching, Mongolia has been running large budget deficits since 2012 and using international debt markets and Chinese swap borrowing to finance it. Yet only recently has the GOM acknowledged these issues and the media firestorm begun:
- “This country went from boom to economic nightmare in 5 years” – CNN Money, August 2016
- “The Land of Genghis Khan Is Having an Epic Economic Meltdown” – Bloomberg, August 2016
- “From ‘Minegolia’ to a country in crisis” – The Globe and Mail, May 2016
- “Economic imbalance leads to Mongolia crisis” – Global Times, August 2016
A barrage of headlines (positive or negative) regarding stocks, currencies and/or countries has long been considered a contrary indicator. This was certainly the case with Mongolia in 2011-2012, when stock prices, sentiment and Mongolia’s Tugrik were at all-time highs. This dynamic was actually studied in 2007 by a group of professors at the University of Richmond, where they aggregated headlines from stories in Business Week, Fortune and Forbes over a 20-year period. What they found (unsurprisingly) was that positive cover stories appeared following periods of strong performance, whereas negative stories followed periods of very poor returns.
Companies receiving the most positive coverage had, to that point, outperformed the index by 42.7%. Those companies receiving negative coverage, had underperformed by 34.6%. The performance after cover stories suggest these headlines are useful as contrary indicators, since the most negatively portrayed companies beat the market by an average of 12.4%, whereas the media darlings outperformed by only 4.2%. Hence, overwhelmingly positive stories generally indicate stocks have topped out, whereas negative stories in many cases call the bottom. Since Mongolia seems destined for a bailout (be it the IMF or the Chinese), we looked at how GDP performed historically post IMF assistance. In Figure 1, we have listed average Mongolian GDP growth for 1, 3, and 5 years post an IMF bailout.
As can be seen, Mongolian GDP tends to perform well in the years following IMF bailouts and seem to correlate with cyclical economic recoveries. News headlines were also quite negative in the midst of these bailouts, but in reality, these were excellent times to allocate capital to Mongolia, with the exception being 1991.
What’s also interesting is that the numbers the new government are using to calculate Debt-GDP, Foreign Reserves, etc. have been well known for some time and are not materially different (though incrementally weaker) from what was released in 1Q’16. What has changed is the method used for calculating these numbers versus the numbers themselves. For instance, when the Ministry of Finance states “Net” Foreign Reserves are ($429M USD), that applies swap borrowing against the $1.296B of reported Foreign Reserves for 1H’16. New Debt-GDP and Budget Deficit numbers, likewise are different (and look much worse) since “off balance sheet” spending and debt are being consolidated in these revised figures. Consider what the US government’s Debt-GDP would look like, should they one day include “off balance sheet debt” which is estimated at $70 Trillion, instead of the “official” figure for US debt of ~$20 Trillion. Oddly, ratings agencies seemed to have been fooled by these non-comparable statistics, given the downgrades of recent days. Yet these agencies had access to these same 1H’16 economic statistics on July 19 when they were released. Ratings agency downgrades have resulted in forced selling within Mongolia’s sovereign debt complex, which looks to be self-reinforcing and may result in even higher borrowing costs in the near term. It’s almost as if ratings agencies reward large budget deficits, off balance sheet spending and money printing, but penalize fiscal discipline, transparency and austerity.
Mongolia Cannot Cut Their Way to Prosperity
While fiscal discipline is essential for long term sustainable growth and wealth creation, this alone will not fix Mongolia’s problems. Government spending as a percentage of GDP has been above 13% since 2012 (Figure 2), making large spending cuts (in isolation) a catalyst for a deep recession.
This is further reinforced in Figure 3, where we calculated the factors which correlate most positively with Mongolian GDP growth. Given that the government is such a large percentage of the economy and employment, it is no surprise that GDP growth is correlated most highly with GOM spending. Aside from Budget Expenditures, one of the only major GDP growth drivers Mongolia has control over is Mineral Export Growth, making a deal for ETT the top priority for this government, more on that below.
In addition, the elixir of prosperity may not be found in new 25% personal tax rates (a 250% increase) on a population whose budgets have been impaired by four years of falling GDP growth and will be further impaired by government spending cuts. While many economic factors are out of the government’s control, one thing we do expect from this government is a meaningful uptick in Foreign Direct Investment. The bar is set quite low, as FDI as a percentage of GDP for 2015 was the second worst year in Mongolia’s post-communist era.
While a recovery in FDI is expected in 2017 as Oyu Tolgoi spending accelerates, this alone may not be enough to achieve escape velocity from Mongolia’s ongoing economic crisis. Despite being home to an estimated $7 Trillion USD in mineral wealth, the Mongolian Government has only managed to sign one major mining project (Oyu Tolgoi in 2009) in the last 25 years. Interestingly, this deal was signed in the midst of the Great Financial Crisis and Mongolia’s financial troubles at the time played a significant role in finally moving that project forward. With a similar economic dynamic in place today, we expect the GOM will finally sign a deal for Erdenes Tavan Tolgoi (ETT), (world’s largest undeveloped coal mine) after 8 years of indecision, infighting and waffling.
The Dynamics of a Deal for Erdenes Tavan Togloi
ETT is a massive coal deposit, with reserves of about 8B tons (65%-78% coking coal), making it the largest undeveloped coal project in the world today. Until recently, negotiations to develop ETT was a comedy of errors, with potential partners coming then going and deal after deal falling apart. With ETT’s parent corporation, Erdenes Mongol, under new leadership the process for an agreement has become more deliberate and consistent. While exact details are not available, negotiations have focused on China Shenhua and Sumitomo as strategic partners, with Mongolia Mining Corp (HK:975) as the local partner and operator. This deal has the potential to create significant value, since the entirety of the ETT deposit would be brought under one operator Mongolia Mining Corp (MMC), which would result in less competition, higher pricing and volumes. MMC has the only real wash plant in the region, which is critical to Mongolia realizing maximum efficiencies and royalties from this world class deposit. Furthermore, washed coal produces higher Average Selling Prices and is consistent with the GOM’s mantra of value added exports.
The political dynamics in Mongolia have shifted very favorably for an ETT deal post elections, which delivered a victory and super-majority (65/76 seats) to the Mongolia’s Peoples Party (MPP). The Democratic Party (DP) during recent election campaigning labelled the MPP “The Coal Party”, given MMC’s affiliation with the MPP and strong ties to the industry throughout the party. The GOM was quite close to finalizing a JV with Shenhua and Sumitomo in 2015, which ultimately didn’t happen, at least partially because the process became highly politicized. With an MPP super-majority in Parliament and Mongolia in desperate need of investment, we see the odds of an ETT deal as being extremely high.
If a deal for ETT is to happen, we see Mongolia Mining Corp (HK:975) as a compelling value with significant upside. MMC equity is down 99% post its 2010 IPO at 7.02 HK (Figure 5), as the political and industry headwinds of the last 3 years took a severe toll on its finances. MMC defaulted on its debt earlier this year which is in the process of being reorganized under equitable terms for debt and equity holders. There appears to be three primary areas of confusion where an investment in MMC is concerned, which have shares trading at heavily distressed levels.
1. Is Mongolia Mining Corp About to Be Liquidated?
The answer to this question in our view is No.
The holders of MMC’s $600M USD Senior Notes are supportive of the company’s reorganization plans, meaning secured bank debt holders of $93M USD (who are holding out) are unable to force the company into liquidation. The reorganization plan calls for an aggregate creditor haircut of approximately 40% and ~11% common equity dilution which is to be distributed to creditors. The Joint Provisional Liquidators (JPL’s), who independently assess assets in default within the Grand Cayman court system said in a report on August 26 that in the case of liquidation, “the recovery to creditors is estimated to be significantly limited.” Given there is no real precedence for international creditors effecting large scale asset recoveries in Mongolia, our own estimates for a net recovery would be between 0%-5%, only after further and lengthy legal actions. Recovery efforts could easily result in a net loss. With MMC’s $600M bond issue currently trading at 26, the adoption of MMC’s reorganization has the potential to return in excess of 100% from current levels, making the adoption of this plan a “when” not “if” proposition in our view.
2. Coal Stocks are Dead
Coal stocks have been indeed left for dead, but few are aware that coking coal prices are up 40% in the last month and 80% this year (Figure 5). China has cut statutory working days for coalmines from 330 to 276, while bankruptcies globally in the sector have significantly reduced supply. These higher prices haven’t materially flowed through to MMC ASP’s, since they are effectively competing with ETT (and by extension the GOM) who are selling coking coal for $27/ton at their mine gate, unwashed. A deal for ETT would eliminate this counter-productive competition, as the deposit would be managed by MMC, as part of a consortium with Shenhua and Sumitomo. In the meantime, the GOM may choose to enforce its “One Window Policy”, which states Mongolian coal producers are required to collaborate on pricing, versus undercutting each other. We would also not be surprised to see GOM legislation limiting sales of raw coal, which could require all ETT coal to be washed at MMC. MMC’s wash plant is a critical asset to drive higher ASP’s from the deposit, which would generate higher royalties for the GOM and revenues for ETT & MMC.
3. You Can’t Make Money in Mongolian Stocks
In most developing economies, politics play a central role in business and Mongolia is certainly no exception. Generally speaking, the MPP as a party have significant leverage to mining assets, specifically coal, whereas the DP are less leveraged to mining. As such, the last four years were exceedingly difficult for companies like MMC, which had to contend with both industry and political headwinds. However, those days are gone with the MPP sweeping this last election and coming away with a 65 seat (out of 76) super-majority. There is another super-majority worth keeping in mind and that is the shareholders of MMC, who are among the most influential companies and individuals in the MPP and Mongolia as a whole. About 55% of the stock is held by these local individuals and organizations (Figure 6), who in many cases have seen their holdings in MMC decrease in value by as much as 99% over the last four years. To invest in MMC today, is to invest alongside some of the most notable people and organizations in the country. It is difficult to put into words how beneficial this dynamic may prove to be.
In summary, with commodities and emerging markets having bottomed earlier this year, an economic recovery in Mongolia should be expected in 2017. Key to this recovery will be the GOM’s ability and appetite to push forward with the ETT mine development, which would show the world Mongolia is indeed “open for business.” A deal for ETT would unlock funding for rail and a power plant, lowering costs to produce and transport coal, while driving ASP’s as much as 100% higher from current levels. It would also yield $3B-$5B in project development and investment. Despite sitting on as much as 10% of the world’s total coal reserves, Mongolia has achieved little in improving transportation and infrastructure for this critical commodity in the last 10 years. Our bet is that this is going to change and with it, the overall fortunes of the country.
Nick Cousyn is Chief Operating Officer at BDSec JSC, Mongolia’s Largest Broker and Investment Bank.