Mongolia's rapid growth masks its vulnerability

While fears have mounted about a double-dip recession in the US and Europe, Mongolia’s small, open economy grew a staggering 17.3% year-on-year during the first half of 2011, according to a World Bank report released late last week.

The country’s booming copper and coal mining industry is driving the economy, but at the same time makes it vulnerable to a global downturn. Mining comprises 22% of overall GDP and the sector expanded 40% in 2010, despite continued political controversy about how best to exploit the natural riches held in the two vast mining complexes of Oyu Tolgoi (copper) and Tavan Tolgoi (coal).

The surge in economic growth marks a prelude to a further five years of average annual real GDP expansion of at least 13%, said leading Mongolia brokerage, Frontier Securities. The country’s small stock market was the best performer in the world in 2010, and has already risen more than 50% so far this year. And, in a further boost to the small nation's standing, US vice-president Joe Biden made a visit to Ulan Bator last week as part of his China trip.

However, the reliance on natural resources and its attraction to hungry overseas investors has fuelled inflation and led to a widening trade deficit — major investments lead to large imports of machinery and equipment — and raised concerns that Mongolia might be afflicted by the so-called Dutch disease, whereby manufacturing might be squeezed out by an uncompetitive currency caused by capital inflows. The Mongolian togrog was the second best-performing currency against the US dollar in 2010.

The transportation and construction sectors grew at 39.9% and 38.4% respectively in the first six months of this year, and retail and wholesale trade grew at 24.7%. Mongolians are also spending more on consumption as a result of higher incomes, contributing to an inflation rate of 11.4% (year-on-year) in July that is further stoked by higher government spending, food prices and by imports — up 106% during the past year.

The sustainability of Mongolia’s rapid growth will depend heavily on global macroeconomic factors. In particular, China’s policy reaction will be crucial.

If China reacts as fast and as strongly as it did in 2008-09 then the effects of a global recession on Mongolia will be mitigated, largely owing to Chinese demand for minerals from Mongolia, said the World Bank.

As Frontier Securities pointed out, 85% of total exports go to China and more that 60% of mining exports are either coal or copper. The reliance on China forces Mongolia to sell coal at a 40% discount, and while this is obviously a disadvantage it means “current revenues are coming from a low base with more upside in the long run”, argued the brokerage. In addition, the country should be able to deliver coal and copper more cost efficiently than any other producer.

Although Frontier expects those exports to start outpacing imports from 2013, it also warned that market diversification is needed, which can only be possible if railway lines are built. But, “while there are plenty of plans for new lines, financing is difficult and significant results are probably many years down the road”.

Industry estimates indicate that mining-related foreign investment in coal, copper and gold could exceed $10 billion in the next five years alone, higher than the country’s total GDP of around $6 billion in 2010.

Yet, there is apparently widespread domestic opposition to China and Russia enjoying the benefits of the country’s natural resources — especially if they seem to be grabbing them cheaply. This causes headaches for the government, which is starkly aware of Mongolia’s dependence on and vulnerability to its two powerful neighbours. China, of course, is its main export destination, but Russia is the source of almost all its fuel.

Trying, but failing, to balance its domestic and foreign constituencies led to the failure of the bidding process in July for the western block of the 7.5 billion tonne Tavan Tolgoi project, the world’s biggest coking coal deposit. The chaos surrounding the bid has now put in jeopardy the proposed IPO of the mine’s eastern block, which had been slated for later this year.